Dear Subscribers and Readers,

We switched from a 50% long position to a completely neutral position in our DJIA Timing System on the morning of June 13th at DJIA 10,485. With the exception of the NYSE ARMS Index (the 10-day moving average is currently at 1.08), most of our technical indicators are still too overbought. In fact, a few of our technical indicators are at levels which haven't been witnessed for the last six months. The "recovery rally" from the London terrorist attacks is most probably a mere bounce - given the market was actually in an overbought condition prior to the terrorist attack. Again, please note that the market also quickly recovered after the 3/11 Madrid attacks last year - but subsequently underperformed again. Our position of a continuing correction and then a "blow off" rally sometime in the next two to four months is still very much in effect.

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Out of all the rallies we have been witnessing over the last 18 months, this latest rally from last Thursday seems to be one of the weakest rallies among them. First of all, this rally started from an overbought condition - and second of all, I am now seeing divergences everywhere and very bullish sentiment among retail investors (as an aside, the AAII Survey is now showing 58% bulls and 14% bears - a Bulls-Bears% differential of 44%) thinking that we are already at the "blow off stage" - despite the fact that the market never got too oversold in mid April and despite the fact that we are still seeing very dismal volume on all the exchanges. We believe that the intermediate trend is still down - and therefore, we will shift to a 25% short position in our DJIA Timing System as soon as feasible - most probably as early as Thursday morning. We will send our subscribers a "Special Alert" as well as posting it on our discussion forum once we have initiated our 25% short position.

I would like to begin our commentary by discussing the various divergences I am currently seeing. Nowhere is that more straightforward and obvious than three of the major indices that most investors keep track of - that of the S&P 500, the Dow Industrials, and the Dow Transports. Following is a very simple and straightforward Yahoo! Chart showing the relative performance of the S&P 500 vs. both the Dow Industrials and the Dow Transports over the last 12 months:

I almost kicked myself for posting such a simple graph, but I think the above chart paints a very powerful picture. The fact that no other major commentator has mentioned such a divergence (despite its simplicity) is amazing - but from a contrarian standpoint, makes this divergence doubly authoritative. Please note that such a "double divergence" has not occurred in the markets since the cyclical bull market began in October 2002.

This divergence can also be seen in the latest action of the NYSE McClellan Oscillator. Following is a two-year chart - courtesy of Decisionpoint.com - showing the most recent divergences of the NYSE McClellan Oscillator and the NYSE Composite Index. Note that the action of the NYSE Composite has also been tracking the action of the S&P 500 very well in recent times:

Like I mentioned in the above chart, please note that the three most recent series of negative divergences in the McClellan Oscillator (a higher high in the NYSE Composite accompanied by a lower low in the NYSE McClellan Oscillator) were all followed by a significant decline in the stock market - will the most recent negative divergence suffer the same fate? Probability suggests that it would - and the downtrend will be confirmed once the NYSE McClellan Oscillator declines into negative territory - made all the more authoritative given that the NYSE McClellan Summation Index is now at a very overbought level.

Recently, there has also been some talk of the Philadelphia Bank Index - that the action of the Bank Index is still very strong and thus there are no impending lending crisis (whether it is domestically or in emerging markets) - for now. However, as we have been mentioning for the past four to five months, our analysis shows otherwise - as the relative strength of the Bank Index vs. the S&P 500 had already broken down approximately four to five months ago. Following is a weekly chart of the relative strength of the Bank Index vs. the S&P 500 from February 1993 to the present:

Please note that the relative strength of the Bank Index violated its support line (a support line that dates back to over two years ago) approximately four to five months ago - and is still currently vacillating below this support line - despite the rally of the Bank Index over the last week or so. Coupled with the fact that the Fed is still hiking the Fed Funds rate, I will need to conclude that we are still more in a bearish scenario than a bullish scenario.

I would like to spend a paragraph discussing the Nikkei - as there has also been renewed optimism over the Japanese stock market in recent days. They may very well be correct but please note that despite the most recent upsurge, the Nikkei is still more than 200 points below its 52-week high. In fact, the Nikkei has been stuck in a trading range of 10,500 to 12,000 ever since the beginning of 2004. The monetary conditions in Japan aren't too impressive to write home either, as the growth rate of the Japanese monetary base has slowed down at a "blistering" pace since the end of 2003. Following is a chart showing the year-over-year growth rate and the change in the growth rate (second derivative) of the Japanese monetary base vs. the year-over-year appreciation in the Nikkei from January 1991 to June 2005:

The year-over-year growth of the Japanese monetary base has now declined to 1.74% - the lowest since February and prior to that, April 2001. Please note that while the change in the growth rate of the monetary base has ticked up slightly in June, it is still in negative territory - suggesting that the Japanese monetary base should continue shrink going forward. The momentum of the Nikkei is nothing to write home about either, as the year-over-year appreciation of the Nikkei is now in negative territory.

Conclusion: The negative divergences, the hugely bullish sentiment, and the world monetary conditions are still signaling bearish implications for me - despite the most recent price action in some of the major stock market indices. Hopefully, our message remains clear - the ST trend (two to three months) remains down. We will be going 25% short in our DJIA Timing System sometime today.

Signing off,