October 1st, 2007 

Serious Divergence

OVERVIEW:  Our two Indicators are tilted in different directions as you’ll see in their respective paragraphs below. My interpretation of the Dow Theory gave a sell signal in August while other theorists are waiting for new lows to cause them to proclaim a sell. The Schannep Timing Indicator is still in a buy mode and will not change unless the market rolls over AND the monetary situation changes from ease to tightening, NOT an imminent prospect. In the meantime “Mr. Market” has formed a double top. Notice from this chart how volume grew as the market declined in August and lightened up on the bounce, which is not usually a bullish sign.

The upper chart is the Dow Jones Industrials, the middle line is the S&P500 and the lower line is the Dow Jones Transports. The Federal Reserve’s uncharacteristically large cut in the Fed Funds interest rate target was an obvious attempt to head off the recession that the housing market and construction employment have been pointing to over the last year, and has been discussed in these Letters throughout the past year. So, if recession is still on the table, then isn’t a bear market assured? The answer as shown in the April Letter is that you can have a recession without a bear market and/or you can have a bear market without a recession, or, of course, you can have both – or neither. From Bear Markets and Recessions you’ll see that the bear markets of 1961-2, 1987 and others were not accompanied by recessions. Also the recessions of 1953-4 and 1960-1 were not accompanied by bear markets. Confused? That’s where letting “Mr. Market” tell the story comes in.

THE DOW THEORY:  The current Signal was a Sell (RED) on August 14, 2007 at 13,028.92. The market’s bounce off the pullback lows has been surprisingly robust except for the Transportation average. On the one hand, if all the market indices go on to new bull market highs then an “in the clear” signal would be flashed and the previous sell signal would have to be reversed with a new buy signal. The poor performance of the Transports, yet to exceed its first bounce high of 5079.39 shown in the August 14^th Letter, or its second bounce of 4932.86 shown below, makes a move to new highs look suspect. You can see on the chart (page 1 above) comparing the Transports to the Industrials and the S&P500 that the Transports have hardly bounced at all. In The Dow Theory by Robert Rhea he wrote that “Instead of looking for ‘double tops’ or ‘double bottoms’ as a clue to a possible change of trend at critical times when averages approach old highs or old lows, the students of the Dow theory would do better to remember that failure of both averages to penetrate previous highs indicates lower prices”.  As you know, I also use the S&P500 in my interpretation of the “Dow Theory for the 21^st Century: Technical Indicators for Improving Your Investment Results” (the latest name for my upcoming book).  If it and the Dow Jones Industrials get to new highs (only 1% to 2% away) then the bull market would, by definition, still be in force and cause a re-buy signal. However, since the Transports are in such a serious divergence, i.e, not moving to new highs, and needing to advance nearly +13% to reach new highs, I would not go to fully invested but would reluctantly raise investments to a 75% position, keeping 25% in cash. You’ll remember that in May of 2004 “The Transports Saved Our Bacon...” by not making new lows when the Industrials and S&P500 did. I overrode that sell signal by the Industrials (just under 10,000) and S&P as there was some capitulation at the time and odds favored an up market. So you see why I am reluctant to disregard the Transports now in 2007.

On the other hand, if the market falls back to newer lows then “everyone” will agree that a Dow Theory Sell has been signaled.

SCHANNEP ­TIMING ¯INDICATOR:  Most recent Signal: Re-Buy (GREEN) as of 10/12/06 at 11,948. As you know from the last Letter the momentum component of this Indicator had the necessary negative move and then the bounce required for a set up for a potential Sell signal. Then I mentioned that “it will either stay in a positive status or will falter and ‘roll-over’ into a likely Sell signal. It also requires a monetary tightening … (but) if Fed Chairman Bernanke follows his predecessor Alan Greenspan with a bailout of the financial markets with a ‘Bernanke Put’ then the markets will likely muddle on through to new highs”. As you know, Bernanke did just that, giving the market more than it had a right to expect by reducing the Fed Funds rate and the Discount rate by ½ percent, and “Mr. Market” showed its surprise and approval by making a run at the old highs. The term ‘put’ implies that the Federal Reserve will always come to the rescue of the market and therefore investors can keep on investing without fear of loss. Because the Fed similarly injected Free Reserves and reduced the Fed Funds rate in late 2000 this Indicator failed to complete a sell signal at the 10,707 level (on the way to the 2002 low of 7286). This current easing by the Fed again in 2007 may likewise prevent this Indicator from completing this sell signal, but we shall see. I will e-mail all subscribers if and when this Indicator gets a Sell signal. Until that happens the previous Buy signal continues in effect.

The COMPOSITE Timing Indicator:  The previous Signal was a Buy (GREEN) with an average “cost basis” of 10,932 but now with the Dow Theory Sell signal at 13,028, this Indicator is in a 50% invested, 50% in ‘cash’ position (YELLOW). It is likely to stay in this stance until one or the other of the above Indicators changes. The Conference Board Consumer Research Center has just reported that “The Consumer Confidence Index is now at its lowest level in nearly two years. Weaker business conditions combined with a less favorable job market continue to cast a cloud over consumers and heighten their sense of uncertainty and concern. Looking ahead, little economic improvement is expected and with the holiday season around the corner this is not welcome news.” Add to that the increasing cost of crude oil and it is hard to fathom what the stock market has to look forward to. Perhaps it is ‘looking across the valley’ and the double top in the stock market will turn into a double cross, but for whom, the bulls or the bears? Yes, a 50% in the market and 50% in cash is comfortable for now.

ÞThe BOTTOM LINE: The only other time, in the last 68 years that data exists, that there was a contraction in the number of employees in the Construction industry that was not a prelude to recession was in 1966-7 as shown on the chart in the August 14^th Letter. That period was called a “growth recession” by Forbes Magazine (1/23/89) because industrial production fell from the 1^st quarter through the 3^rd quarter of 1967. Some economists felt that the National Bureau of Economic Research should have anointed it an official recession, but they did not.  In any event, there was a bear market from February to October of 1966 which lost 25.2% on the Dow Jones Industrials. That may very well be the same situation in 2007-8. The Wall Street Journal (9/28/07) points out that about two-thirds of the 531,000 homes on the market were unfinished. Now we know why home builders have not been laying off many workers – yet.

                                                                                   
Dow Jones:      13,895.63
S&P 500:           1,526.75
NYSE:             10,039.28

A real-time, real money (Roth I.R.A.) conservative portfolio for serious major-trend investors is both the recommended ‘core’ portfolio of this Letter and also a bench-mark for your own investment results. Aggressive investors might use other more speculative investment vehicles in an attempt to improve on these results but I have chosen Exchange traded ‘Index’ funds and ‘Cash’ funds as the best ‘pure play’ vrs. Buy & Hold.  

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