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Charts and Commentary

The market is certainly benefiting from some extreme Fed M3 Liquidity Injections, and this is positive for stimulating the economy in order to avoid the impact of a deteriorated housing market.

Stimulating the economy when other sectors are dropping is an effort to dissipate negative economic divergences and bring them back to a positive condition while avoiding the pain that they normally bring.

What are divergences anyway? Divergences are out of balance conditions where one or more elements show an opposing force or direction. Small divergences can go unnoticed and have little or no impact on the market or economy. Multiple or even "single" large divergences can eventually overpower any opposing force to bring them out of a divergent condition. When two opposing forces are divergent, the two always end up coming to a state of balance where their extreme readings "net out" and a state of balance is achieved.

So, this morning, we will look for out-of-balance or divergent stock market conditions.

Our first look will be at the Long Term VIX (Volatility Index) which measures the implied degree of risk in the market. Since 2003, the VIX has had a perfect record of tracing out the concentric circle pattern below. So perfect, that the VIX bottomed out at the lower circle's support 11 out of 11 times and then rose higher with the market moving down.

The ebb and flow of this phenomena was a display of natural market forces not being interfered with. That all changed when two things happened ... When the Fed said that they would no longer publish M3, and when Bernanke came into the picture. And then ... the normal cycles and balance of the VIX's concentric circle pattern was altered and forced out of the circle. By definition, this is a Divergent condition from the normal balance condition of the market.

Divergent, because bonds have been depicting a future problem with the economy and the Fed calls it a conundrum while throwing huge amounts of money at the problem in an effort to give us a positive yield curve. Divergent, because we have had the worse housing slow down in years and the economy hasn't felt any impact ... because of the 10% increase in M3 injected by the Fed to "counter balance and offset" the negative, divergent economic implications of these events.

The problem is that if all the Fed M3 injections can't reign in and eliminate the divergences, and the divergences continue to expand, then the Fed will lose the ability to stimulate or manipulate the economy in an opposing direction.

The measure of the Fed's progress of solving any negative economic problem, and avoiding a recession can be seen by looking at market divergences. If the divergences are dissipating, then the dangers they are trying to avoid would be dissipating at the same time. If the divergences are remaining or increasing, then they would be facing an growing problem that would require extraordinary amounts of M3 increases to overcome ... and this would devalue the Dollar further. The Fed is quickly getting themselves in between a "rock and a hard place".

Let's now take a look at some the divergences that we see.

First, the VIX's concentric circle has clearly broken out of its cycle pattern and reached an "all time low" Volatility level last week. The implied message is that there is less market risk now then there has been since the beginning of the pattern back in 2003. The problem the Fed has, its that it is taking greater and greater amounts of liquidity injections to keep it at this same low level.

But, all is fine because the Dow Jones Industrials is reaching new highs ... right?

While the DOW is looking great, we have some fairly large and growing divergences as seen in the chart below.

The first is the Transports which is starting to worry many Dow Theorists. Note that the Transports is in a Divergent down trend to the DOW. Each rise against its resistance line has resulted in a lower top.

The next large divergence, also has many analyst worried ... and that is the SOX (the Semiconductor index).

Note that its divergence is even larger than the Transportation Index's. It has bounced off of its resistance line 5 times so far with each bounce producing a lower top.

Both of these divergences are implying an increasing "out of balance" condition that can only achieve a state-of-balance by either the DOW correcting ... or by the Fed injecting massive amounts of M3 liquidity to stimulate the Transport and Semiconductor Sectors into expansion. The divergences are starting to reach meaningful levels, so there is not a lot of time for the Fed to pull "the rabbit out of the hat".

Do you remember the game of Jenga where you build a tower of blocks higher and higher until the structure wobbles and is in danger of falling down? The present market divergences are saying that the Fed is facing a tower that may start to get get wobbly very soon if they don't come up with some real magic.

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