After yesterday's discussion of the U.S. Dollar/Euro and 2007 Stock Market, today we will do an update on the Dow Theory Divergences. (See yesterday's link on the 2007 Dollar/Stock update: Wednesday Link)

The chart for the DOW, the Transports, and the SOX Indexes are below.

Note how the DOW has continued to climb up against a resistance line. The DOW remains in an up trend from a daily peak it made in May.

The Dow Transports also made a daily peak in May, but what troubles Dow Theorists is that it has made two lower highs since them. This was contrary to the DOW and in "divergence with the DOW".

At the same time, the Semiconductor Index (SOX) has continued to trend divergently down since the beginning of 2006.

Both Indexes are divergent with the DOW and this is an out-of-balance condition for the markets. As with anything that is out-of-balance in nature, balance is always re-established and so it will be with the markets.

Balance can only be established in one of two ways. First, the DOW could seek balance with the other two indexes, but it would have to go into correction to do this. Or, the Transports and the SOX could seek balance with the DOW by trending up and making new highs.

So the question is, which will it be? The Fed has pumped in huge liquidity amounts this year and has increased the old M3 by nearly 10%. This was done to stimulate the economy away from a recession and to fight the inverted yield curve proactively.

In spite of the stimulation, the Transports and the SOX were never capable of exceeding the highs they made in the first half of the year. This puts the Fed in a precarious position. Do they continue to inflate the money supply if the results is a growing negative divergence in the indexes? At some point, somebody is going to lose the battle. Either Bernanke is going to turn the other indexes around, or they will over power his economic stimulation attempts and the markets will fall.

As we end the year, Institutional Investors, have reduced both the amount of their buying and the amount of their selling ... to the lowest levels since this past September. They are "holding" what they bought, and not buying any more.

If Bernanke can't do something to induce their confidence to start aggressive buying again, then the smaller investor will have to carry the load of moving the market up by himself in 2007 ... a difficult task because Institutional activity accounts for over half of all the stock buying in the U.S.

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