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Where I See the Market Heading

Dear Subscribers and Readers,

I apologize for the belated commentary. Since I was not able to finish our commentary until the close on Thursday, I have also updated the DJIA volatility chart that you see below with today's data.

We switched from a 50% long position to a completely neutral position in our DJIA Timing System on Monday morning at DJIA 10,485. A bit early, you may say - but at least in the short-term, I don't believe the probability favors the bull's side right now. Like I said on Sunday, while the amount of short interest in the markets still remain high (which bodes well for the market in the longer-term), the global economic slowdown (particularly China) that we have been discussing over the last six months is coming to fruition. Coupled with the weakening technical conditions in the stock market since two weeks ago, it is most probably prudent to not stay long here (even though the Dow Industrials has been exhibiting relative strength against both the Dow Transports and the NASDAQ Composite).

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Ever since we began writing our commentary, I have said over and over again that the key to successfully trading or investing in the financial markets is all about probability - and the ability to properly assign probability levels to each potential event that may unfold in the financial markets. Some of these "potential events" may be logical, and sometimes not. Reading a lot of financial and stock market history will, of course, get you somewhere since most (if not all) of the successful stock market investors and traders have used past market scenarios as a basis for their thinking and trading. While this is important (and what I think is imperative), this is only a first step. The second step is the ability to continuously evolve with the stock market and with the world's economy - using the Dow Theory and the concept of globalization as your basis. The Dow Theory has withstood the test of time, given its ability to continuously evolve over the last one hundred years. The concept of globalization is nothing new, but this has been an important theme (especially from an economic standpoint) since the dawn of modern civilization and will continue to be for the foreseeable future.

I don't profess to have a crystal ball to the markets, but I am a great fan/student of history and of the Dow Theory. I am also a math and statistics nerd. In fact, I eat and breathe numbers. I will attempt to use today's commentary as a "springboard" in order to better gather my thoughts and to help guide our subscribers in making better investment decisions going forward. Please, as always, email me at hto@marketthoughts.com should you have any comments or any feedback. Alternatively, you can also post your thoughts on our discussion forum (which is, by far, the best way to learn how to "fish").

At this point, it will be great if we can just hand you our "report card" for the last few months and give you our reasons for why the market should weaken at least in the short-run, but that will be a cop-out, to say the least. So let's begin by discussing some of the indicators which are making us wary for calling or predicting weakness just right up ahead - starting with a discussion on Richard Russell's commentaries over the last couple of days.

First of all, Mr. Russell pointed out that the differential between Lowry's buying power and selling pressure was the highest in history - suggesting that the bull market is still intact. This is confirmed by the all-time high readings in Mr. Russell's Primary Trend Indicator (his PTI - which he usually defers to even though he is currently long-term bearish). These two closely-tracked technical indicators suggest that the cyclical bull market is still solidly intact.

By far the most bullish indicator that I am currently seeing is the action in the NYSE Specialist Short Ratio. Historically, the market has usually enjoyed a significant bullish rally whenever the 8-week moving average of the NYSE Specialist Short Ratio touches a level of 30% or so. This indicator worked beautifully in the 1940s right up to the 1990s. The question is: Why isn't this indicator currently working? Or is this indicator still working but we are just not seeing the implications of it yet? A subsequent rally of 30% to 50% in the Dow Industrials in the next couple of years certainly sounds far-fetched and ridiculous in the minds of most people, but this is certainly what this indicator is suggesting - given the many historical precedents. Following is a weekly chart showing the DJIA vs. the 8-week MA of the NYSE Specialist Short Ratio from January 2002 to last Friday. This chart is certainly making many bears lose sleep at night:

(Weekly) DJIA vs. 8-Week MA of the NYSE Specialist Short Ratio (January 2002 to June 10, 2005) - 1) The 8-week moving average of the NYSE Specialist Short Ratio continues to plunge - decreasing from 18.91% to another NEW RECORD LOW READING of 18.45% last Friday. 2) LOWEST READING EVER IN THE HISTORY OF THE NYSE ?  NOT ANYMORE! 3) Reading also bottomed out a full three weeks after the significant early August bottom.

Please keep in mind, however, that bull markets are also inherently subjected to frequent corrections - none more so when the stock market is overbought, at least on a short-term basis. While the recent performance of the differential between Lowry's Buying Power and Selling Pressure and Richard Russell's PTI suggest that the cyclical bull market is still intact, they also signal that the market is now overbought. Many corrections have occurred when both of these indicators are "overbought." That is, while the longer-term cyclical bull market is still intact, the chances of a correction are now pretty high. Moreover, it is also not a given that we will at once enjoy a substantial rally even though the 8-week moving average of the NYSE Specialist Short Ratio is in such an oversold status. There definitely have been lags in this indicator before and I would actually not be surprised if we experience a substantial correction before we see the bullish implications as foretold by this indicator.

On the other side of the coin, we are now seeing a slowing growth in the global economy as witnessed by our MarketThoughts Global Diffusion Index that we featured in our weekend commentary. In terms of the Dow Theory, we are also in the midst of a secular bear market. Just like the business cycle, the stock market also experiences cycles throughout the years. The present-day Dow Theorist, Richard Russell, suggests that cycles play no part in the Dow Theory, but I disagree. The concept of the primary trend and the assertion that the primary trend do not end until exhaustion (subsequently followed by another primary trend - this time in the opposite direction) tells me that a cycle does exist in the Dow Theory realm - that is, the cycle from undervaluation to overvaluation, and back to undervaluation. Numerous studies have been done suggesting that over the long-run, the action stock prices do not necessarily have to correlate to earnings or the growth of the economy. For example, the S&P 500 actually experienced more earnings growth in the 1966 to 1982 period than the 1982 to 2000 period, yet the S&P 500 was mired in a trading range for much of 1966 to 1982 - while rising nearly 15 times during the later period. The bulls may argue that it is because of lower nominal interest rates, but such was the case during the 1930s and yet the stock market continued to under perform during that time. Perhaps the issue is really REAL INTEREST RATES. That is, if we see an explosion of deflationary pressures coming from the emerging markets across the world, it is not a guarantee that stocks will rise even if nominal interest rates are dropped to the zero level. Japan has been cited very often in the popular media. Another great example was the United States in the 1930s. If stock market investors see deflation and subsequently declining pricing power and falling profits, then obviously they will get out of stocks - no matter what the current P/E is.

Do I see deflationary pressures? Sure, I do. I see deflationary pressures coming from China, India, and Eastern Europe. China also has a huge overcapacity in the steel and auto manufacturing sector. If China experiences an economic slowdown in the next three to six months, then short of a Renminbi revaluation, we will see significant deflationary pressures being exported out of China. Oil is also another deflationary factor. It has been cited that oil acts like a tax on consumers by the popular media. This is one of the few times that I agree with the popular media, as most of the oil profits typically flow to individual governments - either to dictatorships, other government officials, or to support social programs. All of these are inherently deflationary. Let's play devil's advocate and ask another question here: What happens if, say, GM is forced into Chapter 11 bankruptcy? My guess is that most if not all of the pension and healthcare costs will be eradicated. The result: GM just got rid of a significant chunk of their cost structure and will most probably lower prices on all their car models in order to better compete with Ford, Toyota, Honda, and so on. Is this deflationary? You bet. Finally, I have mentioned that my current target for the recent rally in the US$ index is the 92 to 97 area. If the US$ continues to rally, is this deflationary? Yes - and this will most probably once again raise our current account deficit in a significant way.

Technically, the performance of the Lowry's indicators and the NYSE Specialist Short ratio signal higher prices ahead - for the long-term. In the meantime, I think the market isn't too overly worried about the slowing global economy and the potential deflationary pressures lurking out there. All it takes is for one thing to go wrong and deflation will be back - big-time. I don't need the market to discount the worst-case scenario - what I am looking for here is for the market to experience a significant correction over the next three to five months in order to shake out some of the too-optimistic bulls out there, including hedge funds. Historically, the market has always had a shake-out of some king before embarking on a sustainable uptrend. We have not had one for the last 18 months - and we WILL need one before I can be longer-term bullish. Given the slowing global economy, the lack of liquidity growth, and the bullish sentiment in some of my technical indicators, the next three to five months will be the perfect to undergo such a correction.

The call for lower prices ahead is all the more justified given the low volatility levels that we have been witnessing. Sure, all we can really at this point is that volatility will be back at some point, but please note that a decline in the stock market has virtually all been preceded by a bottoming in volatility levels in the market indices (I have used the Dow Industrials in our analysis) since the bear market began in Spring 2000. Following is a daily chart showing the running 10-day and 21-day annualized volatility levels in the Dow Industrials from January 2003 to the present:

Running 10-Day and 21-Day Annualized Volatility of the DJIA vs. the DJIA (January 2003 to Present) - 1) Please note that since January 2004, most of the decline in volatility levels in the DJIA has led to a subsequent decline in the stock market.  The current 10-day annualized volatility is at 4.99% - the lowest since October 1996, while the current 21-day annualized volatility is 7.67%, the lowest since the first week and early second week of January 2005. 2) Moreover, every market decline has ended with a volatility spike (with arguably the exception of the May 2004 decline).

As witnessed by the above chart, we are currently experiencing very low volatility levels in the Dow Industrials. Today, the running 21-day annualized volatility dropped below 8%. The last time this happened was December 31, 2004. Prior to that July 12, 2004, then February 27, 2004, and finally, September 14, 2000. And we all know what happened after those dates. I believe at least a ST (but sharp) correction is in order here before we can maintain a sustainable uptrend again.

Conclusion: I am very wary of all the optimism out there, considering that the market hasn't gone anywhere over the last 18 months and considering that the global economy is slowing down as we speak. The latter is very important in that for the first time since 1998, there are extreme deflationary brewing - as will be evident should a country like China slow down or should a company like GM go into Chapter 11. Currently, investors are not discounting any of these scenarios occurring. The recent fall in volatility levels does not bode well for the stock market just up ahead - considering that the bottoming of volatility has nearly always preceded a significant decline in the stock market ever since the bear began in Spring 2000. Finally, during the last couple of months in this commentary, I have been maintaining that we will most probably see another correction in the Summer or Fall of this year before we can embark on a sustainable uptrend, and I still stand by this "prediction."

Signing off,

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