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Technicals Still Deteriorating

(January 14, 2011)

Dear Subscribers and Readers,

I apologize for the late publication—I intended to publish last night but wanted to observe the reaction to Germany's latest declaration that it will do “whatever it takes” to save the Euro before doing so.  Sovereign spreads in the PIGS countries have pulled back significantly in the last few days, while the world's equity markets have risen further and have stabilized.  The Euro is up more than two cents against the U.S. Dollar; and 1.6 Yen over the Japanese Yen.  As we mentioned before, Germany's declaration sounds a bit hollow.  Why hasn't Germany already done something if that's the case?  The reason is that it's been politically infeasible, and it will continue to be so—unless all of a sudden, German citizens are willing to put up with 5% inflation (significant deterioration in the Euro though ECB purchases, etc.), or significant wealth transfers from Germany citizens to the rest of the EMU, including France and Italy.  More important, it is not obvious that the PIGS will recover even if global economic growth surprises on the upside, as the PIGS's industries (including tourism) remain uncompetitive relative to the rest of the world.  The rally in the Euro and the decline in PIGS sovereign spreads over the last 72 hours seems like a bear market rally to us—we continue to expect the Euro to decline to $1.20 sometime this year.

We also expect the ongoing European sovereign debt crisis to reassert itself soon—and that it will have an adverse impact on the global equity markets.  As we have discussed in the last several weeks, we expect a market to correct 5% to 10% very soon.  Aside from our deteriorating liquidity indicators, our technical indicators are also still deteriorating.  For example, while the NYSE Composite Index have been powering to cyclical bull market highs, the NYSE Common Stock Only Advance/Decline Line has not been as strong (despite also making new highs).  More ominously, the NYSE CSO Advance/Decline Volume Line (as shown in the below chart, courtesy of Decisionpoint.com), still has not yet confirmed the new high in the price indices. 

With global liquidity still at challenging levels (especially with the US$ rally in the last four days), the negative divergence between the NYSE Composite and the NYSE CSO A/D Volume Line should not be ignored.  At the same time, sentiment among retail investors has gotten highly bullish in recent weeks (as exemplified in the AAII, Investors Intelligence, and Market Vane's Bullish Consensus surveys)—and in fact, have been making new highs not seen since July or October 2007.  Aside from the popular sentiment indicators that we feature every week, subscribers should note that the ten-day moving average of the equity put/call ratio is also near its most bullish level since mid-April 2010 (right before the last major correction) as shown in the following chart courtesy of Decisionpoint.com:

Finally, negative divergences are still very prevalent even as the market has gotten more overbought.  One area where this is evident is the number of new 52-week highs vs. 52-week lows in the NYSE Common Stock Only Index.  As shown in the below chart (courtesy of Decisionpoint.com), the number of new highs vs. new lows peaked in mid-October of last year, and has been making lower highs despite the ongoing rally in the major stock indices:

Again, I believe the correction would be in the 5% to 10% range.  With long-term technicals still flashing bullish signals, however, I anticipate shifting from a neutral position to a 50% or 100% long position in our DJIA Timing System once we've determined that the upcoming correction has nearly run its course. 

Signing off,

Henry To, CFA, CAIA

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