Dear Subscribers,

Readers who have followed our discussions (and our last Thursday morning's commentary) should notice that we have discussed Intel's business on and off basis - namely the competitiveness of its core microprocessor business against AMD and the recent divergence of INTC (the stock price) vs. the performance of the Philadelphia Semiconductor Index ("the SOX"). For readers who know Intel's business better than I do, you're definitely encouraged to jump in and join our discussion on "INTC vs. AMD." Will Intel continue to lose its edge in the microprocessor market to AMD? Will that matter? Will other external forces come into play to disrupt both Intel's and AMD's core businesses? Please let us know what you think.

As far as the recent divergence of INTC vs. the SOX, I had stated in our Thursday morning's commentary: "... the performance of Intel has been relatively dismal - suggesting that investors are still ignoring the proven, brand name stocks in favor of mid caps, small caps, international and energy stocks. Could the SOX be correct? That is, are Intel's woes confined mainly to the company (some would argue "yes" given that AMD just surged 12% in pre-market trading this morning) or will INTC lead the SOX into a decline for the foreseeable future? Can a whole industry continue to rally without the participation of its bellwether? This author would argue "no." While the fundamentals of the semiconductor industry are now at the best we have seen in over five years (take a look at AMAT), the recent rally of the SOX has most probably been too fast and too much. We are definitely due for a correction in the SOX here." The SOX proceeded to "graciously oblige" by declining more than 4% last Friday. Going forward, this author is looking for both the SOX to continue to correct and for both the performance of INTC and the SOX to converge over the next three to six months.

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. E-mails were sent to our subscribers on a real-time basis just seconds after these short positions were initiated. This author also posted a message on our discussion form on Wednesday afternoon (EST) reminding our subscribers to check their emails. For a more detailed explanation of the background and what we are trying to achieve with our DJIA Timing System (along with historical signals), please go to the following page. Please note that this page is only available to current subscribers.

The current stock market is following our 2006 mid-cycle slowdown scenario to a tee. Further evidence over the last week or so include the 3% decline in the MBA's seasonally adjusted purchase mortgage index - which is considered to be a very reliable real-time gauge of U.S. home sales (of course, all the headlines implied a very robust housing market). This is confirmed by an 8.9% decline in housing starts and a 4.4% decline in the number of building permits issued - and further compounded by a decline of housing affordability to a new all-time how. Following is a chart courtesy of the Bank Credit Analyst showing the historical correlation of real consumption and the Housing Affordability Index:

As the above chart implies, real consumption is set to decline going forward if we are to follow historical experience. Like we have mentioned in our past commentaries, the decline of the housing sector (a slowdown in the rise of housing prices, transaction volumes, and creation of real estate related jobs) and the subsequent decline in Mortgage Equity Withdrawal ("MEW" as we have labeled it in our past commentaries) remains the pillar of our mid-cycle slowdown argument - a mid-cycle slowdown that will shave 1% to 2% off U.S. GDP growth going forward in 2006 and which should be accompanied by a correction in many markets, including the commodity, international, and the U.S. stock markets. This is our most optimistic scenario for 2006 - but which we think has the highest chance to occur. For a rundown of what we believe pose the greatest risks to our economy in 2006 and 2007, readers are encouraged to go back and read our January 8th commentary, "Identifying Risks in the Upcoming Year."

Any upcoming correction in the world's major markets should affect the U.S. stock market disproportionately. That is, this author believes that the United States stock market will fare any upcoming "financial storm" relatively well, although I would not rule out a 10 to 15% correction in the Dow Industrials or the S&P 500 in the upcoming year. The decline in the U.S. stock market last Friday is ominous - and most probably signals a significant reversal in the U.S. stock market, for two major reasons:

1. Never mind too much that the decline in the Dow Industrials (213.32 points) represented the biggest decline in over two years. The most significant evidence that we got on Friday is the steady liquidation of stocks - accompanied both by high volume and liquidation in nearly all sectors, with the notable exception of the energy sector.

2. This steady but relentless liquidation was further accompanied by a still highly overbought market and extreme complacency on the part of both retail and institutional investors. That is, there was definitely no panic selling in the markets on Friday, despite a $68 oil price and relatively bad earnings reports from both GE and Citigroup. Make no mistake: GE's earnings report - given that it is the world's fourth most valuable brand name as ranked by Interbrand.com and given that its business encompasses nearly all aspects of the world's economy - is important. The fact that GE's revenues were light and that it only met earnings estimates (historically, GE has always beat estimates by a penny each quarter) is ominous for the stock market going forward.

At this point, the intermediate trend of the stock market definitely remains down - although this author would not rule out a consolidation phase ahead of the all-important Fed meeting and Google's earnings report on January 31st. This is further confirmed by our liquidity indicators, such as our "MarketThoughts Excess M" (MEM) indicator, the relative strength of the Bank Index vs. the S&P 500, as well as a flattening yield curve. Readers can read more about the details our MEM indicator in our October 23, 2005 commentary, and following is an update of our liquidity analysis as communicated by our MEM indicator:

While our MEM indicator did perk up slightly in the latest week, this author believes that the damage has already been done. In fact, a rising MEM indicator (after coming off from such negative territory) is actually bearish - as it signals that speculators now are becoming more risk-adverse and taking money off the table (e.g. slowing housing market, and so forth). The continue deterioration in liquidity can also be witnessed in the relative strength of the Philadelphia Bank Index vs. the S&P 500. While relative strength of the Bank Index has been weak and deteriorating since February 2005, it is interesting to note that relative strength took another substantial plunge in the last week, as shown by the following weekly chart of the Bank Index vs. the S&P 500:

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