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July 5, 2005:
Coming into the year
there were two dominant themes regarding investors expectations for
2005. The first and one that stands out the most was the fact that this
is the fifth year of the decade and that fifth years of a decade have
seen the market end higher for the last 120 years. The second was that
the majority of analysts and strategists expected to see a major shift
from small and mid cap stocks to big cap blue chip stocks, those that
make up the S&P and to a larger extent the DJIA. With last week came the
end of the first half of 2005 and has left some interesting results
The strong rally
expected in the fifth year has resulted in modest losses so far in all of
the major market averages. We know that there is a second half of the year
to go but so far this has to be a grave disappointment to the multitude of
investors, traders and market commentators who had expressively focused on
this phenomena as a reason to be bullish for the year. We had pointed out in
January that the market rarely accommodates the crowd and if there was to be
a fifth year failure this was certainly the year to see it happen. This also
coincided with a down January, something that has not occurred prior in a
fifth year of a decade, at least as far back as our data just prior to 1920.
Of course the year is only half over and the fifth year fans still have a
chance to pull it out but the first six months is not what they had expected
at all.
As for theme number two,
a shift into big cap stocks, well that too has failed to materialize. The
DJIA in fact is lagging the S&P for the first six months by nearly a three
fold margin and versus the Russell 2000 by nearly a 4 fold margin. This is
also evident in the NASDAQ as the Composite is off fare less than the NDX,
the latter comprising the largest 100 stocks in the overall composite. The
disparity here is not as bad as it is between the DJIA and S&P with the NDX
off about 50% more than the composite. But the story is the same. This also
goes to show that the majority view when it comes to the stock market tends
to be wrong more often than not. And when that view is excessive it is wrong
considerably more often than not. Meanwhile, we are also faced with a down
January and according to the January barometer "as January goes so goes the
year". This is not close to 100% but does have a fairly good record for
whatever reason and we should be aware of it and not dismiss it off hand.
The fact that this is also coinciding with a peaking four year cycle
suggests the strong likelihood that the January barometer will have a fairly
good chance of being correct this time around. We had said early in the year
that 2005 was to be a shift from a cyclical bull market back into the
secular bear market that began in 2000 and from what we have seen so far
this year the market has given us little reason to change that view and a
lot to confirm that view.
The month of June left a
number of divergences in its wake. Not only in regards to the momentum
indicators, of which there were plenty, but also among the various market
averages. The most notable is the divergence between the DJIA and DJTA as
the latter fell short of its early June peak in mid June and setting up a
Dow Theory non confirmation, the initial step to a Dow Theory sell signal
That signal has not been confirmed (the sell signal) but it is close and
raises a big caution flag. Keep in mind that while both averages went to new
joint highs in March, the DJTA had made new all time highs above its 1999
high which was not confirmed by the DJIA. This sets up an even bigger non
confirmation the likes of which we have not seen since 1999-2000. Other, not
as noticeable divergences include the failure of the DJIA to confirm the S&P
on June 22 and the NDX to fail to confirm the NASDAQ Composite on June 23
having peaked on June 2 and recording a sharply lower low on June 22. There
is even a smaller divergence within the post June 2 divergence as the NDX
made a lower low on June 23 versus June 17. Since the stocks comprising the
NDX are nearly 80% or more of the overall NASDAQ composite at least in
market value and to a degree trading volume as well we see periods of
relative strength in the Composite versus the NDX as more of a negative as
it suggests a lot of small, highly speculative stocks are leading the
way.
The leadership in the
post 2002 rally has been small cap and mid cap stocks, which in June
recorded new all time highs. At the same time both weekly and even
longer-term monthly momentum are seriously diverging showing a huge loss in
upside momentum. This is based on 13 period RSI, which shows a pattern
typically seen at or near the end of a bigger rally of two lower highs in
momentum versus two higher highs in price. The monthly divergence does not
show two lower highs but does show multiple divergences dating back to
1997-1998. These divergences have not been confirmed. And until they are
confirmed by price they will remain as always, potential divergences They
do, however, add to the myriad of developing long-term negatives that add
further to our view that the cyclical bull market is in its latter stages.
Speaking of divergences,
the break in price in late June finally confirmed the series of negative
divergences that had been building in an array of indicators since late
May-early June. These indicators have corrected to neutral but at the same
time the daily trend oscillators are now negative and beginning to
accelerate. They have also come off a very negative signal. This was coupled
with a sharp rise in acceptance of the rally from the majority of our
sentiment indicators. The two exceptions were the Rydex ratios which were
only neutral and the CBOE put to call ratio, which is still at the low end
of bullish. The polls on the other hand have continued to slip with
Investors Intelligence showing the most negative bull/bear ratio since early
January and not far from a multi decade high. Consensus and AAII have eased
the past week but Market Vane remains in the stratosphere with the four week
moving average above its March 2004 peak and the highest since March 1998.
The sentiment combo, which is comprised of all four polls is not as
excessive as it was in late December but is not that far away either and
other than the past two years it is at its most negative level in its 18
year history.
Our
short-term indicators are bearish and the wave structure from late June does
not look complete. Our expectation is for another wave down to carry the
averages below their late June low. However, what we are not sure of and
what the indicators and wave structure cannot confirm is whether or not we
get another small rally above last weeks late high prior to that next wave
kicking in or if what we saw last Thursday was it. This should be confirmed
today but in either case a move below last weeks low is expected.
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