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Divergences Everywhere!

Dear Subscribers,

As I am writing this in relatively balmy Houston, the second most powerful snow blizzard is in the midst of pounding New England and the New York Metropolitan area. According to Accuweather.com, New York's Central Park recorded 22.8 inches of snow - just shy of the all-time high of 26.4 inches set during December 26 to 27, 1947. Moreover, this cold weather is expected to affect the Deep South as well, with Florida averaging temperatures in the 50s (Fahrenheit) after having experienced temperatures in the high 70s and low 80s as late as Saturday.

The question to ask is: How will this affect natural gas prices? And if temperatures are to stay cold for the rest of February, how will this affect spending and home sales patterns? Given that we just had one of the warmest Januarys on record, my answer is "not good." The retailers will definitely take a hit on this one. As for the answer to the first question, it should be noted that based on the latest natural gas storage report from the EIA, natural gas stocks are still 437 Bcf above levels to that of last year and 649 Bcf above the five-year average. Unless colder-than-expected weather prevails until March, there is still plenty of natural gas. That being said, there is a good chance that the spot price of natural gas will spike and that hedge funds and retail investors alike will try to pile into the market on the long side as well.

Before we go on to our main commentary, let's recap and take a look at the following chart showing the month-end natural gas price vs. the crude oil price from November 2003 to February 2006 (using data as of February 10, 2006 as the February month-end prices):

Month-End Henry Hub Natural Gas vs. WTI Crude Oil Spot Prices (November 1993 to February 2006*) - 1) Historically, natural gas prices have pretty much tracked crude oil prices here in the United States. More importantly, the historical volatility in natural gas prices is far greater than that of crude oil (as noted by the wider movements in natural gas prices and by the two upside spikes at the end of December 2000 and February 2003). At the end of July of last year, I stated: 'Given the wide variations in weather patterns in recent years and give the tight supply situation, I think we are overdue for another such spike.' Now that February is projected to be one of the coldest on record, could we see another such spike? 2) Natural gas prices again lagging after spiking over $4.50/MMBtu from August to December 2005. Please note that these are month-end prices.

In our July 31, 2005 commentary ("Natural Gas - The Other Bull?"), we explored the possibility of an upcoming spike in natural gas prices, given the historical volatility of the commodity, tight domestic supplies, and the fact that its price has been lagging that of oil prices ever since late 2003. In the days immediately after that commentary, natural gas proceeded to rocket nearly $5.00/MMBtu higher (basis the December 2005 forward contract) - with the spot price tacking on more than $7.50/MMBtu in the days leading up to and immediately after the landing of Hurricane Katrina. Since that peak in August to September, and since another brief spike in December (which is not shown on the above chart since the above chart only shows month-end prices), the price of natural gas has come down significantly mainly due to warmer-than-expected weather in the last week of December 2005 and all of January. Given that storage levels were at all-time highs, this wasn't a surprise. In fact, the only reason why natural gas is staying as such elevated levels (relative to its price during most of the 1990s) is because of elevated crude prices (>$60 a barrel) and the perception of tight supplies going forward. The fact that LNG imports/supplies (due to demand competition from Western Europe and Asia) has been dismal has also helped natural gas price stay at such elevated levels.

It is important to note that the United States depends on natural gas for 22% of its energy requirements (with oil accounting for 41% and coal accounting for 23%) - which is pretty substantial. Readers should also keep in mind that every dollar increase in natural gas is equivalent to a $5.80 rise in a barrel of oil, given that a barrel of oil is roughly equivalent to 5.8 MMBtu. Going forward this year and into the rest of the decade, both the U.S. and the world economy will continue to be held hostage by both crude oil and natural gas - unless we manage to develop viable alternative energy sources in the next five to ten years. It should be noted that the topic of natural gas prices and supplies was also at the top of the agenda in the most recent G-8 meeting in Russia.

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. As of the close on Friday (10,919.05), our position is 49.05 points in the red - but given all the weakening fundamental and technical indicators that this author is currently witnessing, I believe that this short position will ultimately work out well.

Let's now cut to the chase and get into our main commentary - that of divergences in the current stock market. Speaking of divergences, this commentary will not be complete without a discussion of the Dow Theory and a quick look at the performance of the Dow Industrials vs. the Dow Transports over the last few years. Readers should keep in mind that when it comes to the study and application of the Dow Theory, the foremost consideration should be valuations. And on this point, both the Dow Industrials and the Dow Transports still do not qualify as undervalued or even at fair value levels - relative to historical P/E ratios. The second consideration is the concept of the primary trend, such as the secular bull market of 1949 to 1966 or the secular bear market of 1966 to 1974. In a secular bull market, bulls should be given the benefit of the doubt. That is, in a secular bull market, it is wise to treat non-confirmations on the downside as a bullish development, while a non-confirmation on the upside should be taken with a grain of salt. This author has gone through this many times before - but let me reiterate once again: I believe we are still in a secular bear market - a secular bear market which began with the bursting of the technology bubble in 2000, and accompanied by huge overvaluations in most other large cap stocks at the time. In a secular bear market, non-confirmations on the upside should be taken seriously. I will now break tradition and show the following chart of the Dow Industrials vs. the Dow Transports as the first chart in this commentary as a prelude to a discussion of this non-confirmation:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to February 10, 2006) - 1) After six years, the Dow Industrials still hasn't surpassed its all-time high of 11,723 made on January 14, 2000, while the Dow Transports surpassed its all-time high of 3,783.50 (made on May 12, 1999) way back in December 2004. This is one of the most flagrant non-confirmations in Dow Theory history. 2) Looking at the daily chart of the DJIA vs. the DJTA, readers should continue to note that the Dow Industrials has been range bound over the last few years, even as the Dow Transports has continued to overperform. Note that the Dow Industrials is still 6.8% below its January 14, 2000 all-time high while the Dow Transports is already 14.2% above its previous bull market high of 3,783.50 (made on May 12, 1999). For the week ending February 10, the Dow Industrials rose 125 points while the Dow Transports rose 58 points. Note that the end of the October 1966 to 1968 and the May 1970 to 1972 cyclical bull markets (within the great secular bear of 1966 to 1974) was preceded by such a flagrant, 'primary non-confirmation' by the two popular Dow indices. Given all the other weakening indicators I am watching, and given the maturity of this cyclical bull market, it is now time to take a defensive position.

It is always difficult when one studies a daily chart, but please keep in mind that an astute investor should always take into account "the big picture" before making an investment decision. As the above chart mentioned, the "big picture" story according to the Dow Theory right now is the "primary non-confirmation" of the Dow Transports on the upside by the Dow Industrials. This is something this author has been discussing since the Dow Transports broke its previous all-time high way back in December 2004. Such a "primary non-confirmation" also acted as an early warning to the impending end of the October 1966 to 1968 and the May 1970 to 1972 cyclical bull markets (within the secular bear market of 1966 to 1974). In order for this cyclical bull market to resume, the Dow Industrials will have to confirm on the upside by breaking its all-time high of 11,723 established at the close on January 14, 2000. And given the dismal performance of the DJIA McClellan Oscillator and Summation Index in recent months (as you will see below) - this is not likely to occur.

Continuing on our discussion of the Dow Jones Industrial average, this author would like to now take a look at the action of the DJIA McClellan Oscillator and the DJIA McClellan Summation Index. Readers should go back to our "stock market indicator section" and refresh one's memory on both the McClellan Oscillator and the McClellan Summation Index - but note that while they can be regarded as an overbought/oversold indicator, they are essentially foremost a breadth indicator. When the McClellan Oscillator or the Summation Index spends most of their time in negative territory - it usually means that money is leaving the market. Following is a three-year chart (courtesy of Decisionpoint.com) showing the Dow Industrials vs. the Dow Industrials McClellan Oscillator and Summation Index:

Dow Industrials vs. the Dow Industrials McClellan Oscillator and Summation Index - Note that the Summation Index spent most of its time in negative territory during 2005 - suggesting that money is leaving the Dow components en masse.

Please note that the DJIA McClellan Summation Index has been getting progressively weaker since March 2003. In fact, the DJIA Summation Index actually spent most of its time in negative territory during 2005 - suggesting that money has been leaving the Dow components en masse. While there was a brief spike towards the end of 2005, it should be noted that the DJIA Summation index is once again in negative territory, despite the brief rally in the Dow Industrials during the early part of January. This is a huge divergence - and suggests that the Dow Industrials should be getting progressively weaker going forward. It is just a matter of time before this weakness is reflected in the price of the DJIA as well.

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