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Could Inflation Dangers be the Trigger?

(February 22, 2011)

Dear Subscribers and Readers,

Let us begin our commentary with a review of our 13 most recent signals in our DJIA Timing System:

1st signal entered: 50% short position on October 4, 2007 at 13,956;

2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

3rd signal entered: 50% long position on January 9, 2008 at 12,630;

4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;

5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;

6th signal entered: 50% long position on June 12, 2008 at 12,172;

7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;

8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;

9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;

10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.

11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;

12th signal entered: 50% long position initiated on May 21, 2010 at 10,145;

13th signal entered: 50% long position SOLD on December 15, 2010 at 11,487, giving us a gain of 1,342 points; the DJIA Timing system is currently in a neutral position.

Despite ongoing negative divergences in our technical indicators, extremely overbought sentiment indicators, and declining global liquidity (not to mention increased geopolitical risks), the market keeps powering higher.  We have been looking for a correction since late last year, and still expect a major correction sooner rather than later (we now expect it to be a 6% to 12% correction).  Should the Dow Industrials rise to the 12,600 to 13,200 level, we will likely shift to a 50% short position in our DJIA Timing System.  Subscribers better get ready for the ride.

One example of ongoing negative divergences is the number of new 52-week highs vs. new 52-weeks lows on the NYSE (Common Stock Only), vs. the NYSE Composite.  As shown in the below chart (courtesy of Decisionpoint.com), the number of new 52-week highs (as well as the ten-day moving average of the NYSE CSO high-low differential) has been  making lower highs, despite the continued rise in the major market indices, and the all-time highs in the S&P 400 (four hundred; not shown):

Note that the lower highs pattern is also evident in the 52-week highs vs. 52-week lows in the NASDAQ Composite.  Another blatant example of negative divergences is the lower highs in the percentage of NYSE stocks above their 50-day EMAs, and 20-day EMAs, as shown in the following chart (also courtesy of Decisionpoint.com):

With the ECRI Future Inflation Gauge now at a nine-month high—and with crude oil prices spiking on geopolitical concerns and natural gas storage levels near the low-end of its five-year range—investors are going to be much more focused on any inflationary pressures than ever before.  Note that both the European Central Bank and the Bank of England have already signaled their intentions to tighten their monetary policies.  Could an ever-rising fear of inflationary pressures—compounded by the world's central banks' reactions—be the trigger to a significant correction?  As I am penning this commentary, the S&P 500 futures contract is down 18 points due to rising geopolitical concerns (and its contribution to higher oil prices).  Frankly, I would not be surprised if the S&P 500 has already made its high for the first half of 2011.

Let us now discuss the most recent action in the U.S. stock market using the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown in the following chart from January 2008 to the present:

For the week ending February 18, 2011, the Dow Industrials rose 117.99 points, while the Dow Transports rose a whopping 60.69 points.  Both the Dow Industrials and the Dow Transports again made new cyclical bull market highs—thus extending the life of the bull market, per the Dow Theory.  However, the Dow Transports is still only marginally (1.3%) higher than its January 13th peak.  In addition, the market is highly overbought, with the Dow Industrials having risen 7.0% since the beginning of this year.  With our technical indicators weakening and given highly bullish sentiment, I expect the stock market to experience a 5% to 10% correction soon. We remain neutral in our DJIA Timing System, and will likely shift to a 50% short position should the Dow Industrials rally to the 12,600 to 13,200 range.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The four-week moving average of these sentiment indicators increased slightly from a reading of 26.7% to 26.8% for the week ending February 18, 2011.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1998 to the present week:

After declining three weeks in a row, this sentiment indicator finally bounced—and more important, remains extremely overbought.  At the same time, the ten-week MA (not shown) rose for the 24th consecutive week to 28.3%, and is at its highest level since the first week of March 2007.  By any measure, both the stock market and investors' sentiment is severely overbought.  Combined with our bearish liquidity and technical indicators, I expect the U.S. stock market to correct soon.  We will retain our neutral position in our DJIA Timing System, and will likely shift to a 50% short position should the Dow Industrials rally to the 12,600 to 13,200 range.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

The 20 DMA rose from 126.3 to 128.1 last week, after enduring a five-week decline.  Meanwhile the 50 DMA decreased slightly from 137.0 to 136.2.  Note that despite the latest bounce, the 20 DMA declined below the 50 DMA four weeks ago—suggesting that sentiment (and the stock market) is biased to the downside.  Meanwhile, the ISE Sentiment Index remains at a heavily overbought level—in fact, at the peak in late December, the 20 DMA rose to its highest level since mid-July 2007.  With both the 20 DMA and 50 DMA at extremely overbought levels (relative to their readings over the last three years), and combined with the overbought conditions in our other sentiment indicators, the challenging global liquidity conditions, and a slightly overvalued U.S. stock market, we believe the market will experience a correction soon.

Conclusion: With the flagrant amount of negative divergences evident in our technical indicators, and with the market highly overbought, the market remains highly vulnerable to a sizable (6% to 12%) correction.  Combined with the threat of higher inflation and higher energy prices due to rising geopolitical risks, I would not be surprised if the correction is already occurring.  We would also not be surprised if the Dow Industrials has already made its high for the first half of 2011.  Again, we remain neutral in our DJIA Timing System and will likely shift to a 50% short position should the Dow Industrials rally to the 12,600 to 13,200 area.  Subscribers please stay tuned.

Signing off,

Henry To, CFA, CAIA

 

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