Dow extremely overbought and ready to pull back strongly
We have series of interesting developments taking place this week.
The moving averages of new highs and new lows we maintain have once again suddenly changed direction. In fact the 20 day moving average of new lows completely thrashed the 20 day moving average of new highs; it has now issued one of its highest readings in over 90 days and this is taking place when the Dow is trading in record high territory Clearly the smart money is selling into strength.
The Lower Standard Deviation bands on the Dow actually lost value; only the positive bands gained value. Such developments are usually bearish.
We have now established that a relationship exits between the Dow industrials, the Dow utilities and the Dow transports. This relationship is different from that of the Dow Theory; in fact we are not true believers of this theory. We have also shown that this relationship has existed for a rather long time. According to this relationship the utilities lead the way up or down; there is usually a lag period of anywhere from 90-180 days between the utilities, the Transports and ultimately the Dow industrials. The charts below reveal that the Utilities have already started to pull back after putting in a series of new highs; though we don’t think they will correct seriously yet as they already experienced a rather hard correction after putting in a new high back in Oct 2005.
The really interesting development is that the Dow transports have started to break down while the industrials are putting in new highs. As the Utilities corrected rather strongly after putting a new all time high back in Oct 2005 the Transports and the Dow have to play catch up. The Dow utilities went on to put another new all time high after Oct 2005 but they only did so after experiencing a rather strong correction. This means that the Transports and then the Dow need to first correct and then if the relationship holds rally one more time. To put it simply the pattern appears to be holding as the Transports were the next in line to correct and then the Dow should follow.
If you look at chart of the Dow transports (2nd one) you will notice that they put in a new all time high back in April of this year. Based on this relationship the next move was for the Dow to follow suite and in early November it finally put in a new all time high. Just for reference purposes the Utilities put in a new all time high back in Oct 2005. This clearly illustrates this relationship is still intact ( if you need to refresh your memory go back to the October issue where we conducted a very in-depth study of this pattern). Thus until the Dow put in a new all time high the Transports could not go on to put in another new high and that’s exactly what happened; they trended upwards but did not put in any new highs. In addition before putting in another new high if this relationship is to remain valid the Transports would have to experience a pretty hard correction just as the utilities did after putting in a new all time high back in Oct 2005.
So we can clearly see that the Dow transports have broken the main up trend line and are actually trending lower while the Dow is trading in record high territory. Notice also that even though the Dow is in record territory it’s barely trending above its main up trend line. Since there is a lag time between the Dow transports and the Dow industrials just as there is a lag time between the Dow utilities and the Dow transports we feel that the main move will not begin until next year. Market tops and bottoms are now taking longer and longer to form but by the same token the pay offs are even greater for those who sit and patiently for the trend to change.
Now let’s add in some other interesting facts
NYSE specialists continue to build up their short positions, the dumb money continues to lighten up on its short position and they are actually getting more bullish now and finally our Smart money indicator has issued a sell signal on the daily charts. It never really confirmed the current rally at all. If we add these factors to the first two factors we mentioned it becomes all but obvious that the markets are topping and that the correction could begin anytime. Since this market took so long to correct we feel that the coming correction is going to be rather hard and it would not be out of the question now to expect a correction in the 9-12% ranges. This would translate to a move down of 1200-1400 points; as stated before the main move will not begin till we break decisively below 11970.
It has been somewhat frustrating for those that took part in the put option plays; remember we did warn everyone that this was a higher risk trade. We also stated that we have been rather successful on all our short-term index trades (winning almost 90% of the time) and so it’s just a matter of time before we experience a loss initially; no one can win 100% of the time and even wining 90% of the time is not an easy feat to maintain. When one takes part in higher risk trades one must understand that one cannot win all the time.
We still have time on our options and we are still holding a third of our funds in reserve waiting for the right time to deploy them. Traders that are patient and disciplined will definitely be rewarded. There are just too many factors converging against the market right now and it would be foolish not to pay attention to them. For the first time in very long time the Smart money (NYSE specialists and NYSE members) is building up a short position, we also have a new sell signal from our smart money indicator, the main up trend line is very close to being violated on the Dow, it has already been violated on the transports, the Dow pattern is indicating that a correction is in the works, Standard deviation analysis is indicating weakness in the markets, the number of new lows have spiked to their highest levels in months and finally we have several sell signals on the hourly charts from our psychological indicators. We also re examined several ETF.s, power shares, indices, etc and almost all of them have now flashed a series of negative divergences on the hourly charts; several of them have flashed them or a very close to flashing them on the daily charts too. All this means that now is definitely not the time to be bullish.
Dow and overall Market ready for strong correction
We used the above chart with our other indicators to help us determine that the markets had put in a bottom and were ready to take off in the June, July period. The above chart is simply a ratio of extreme bullishness/extreme bearishness. ULPIX is a very aggressive bullish fund and URPIX is a very aggressive bearish fund; hence we are using two sets of extreme values. In June and July of 2006 we can see that the bears were in charge as the bullish fund was getting hammered. Take a look at how things have changed now and it appears that this chart is topping which means that a correction is in the works. Notice also how extreme the move upwards has been since June 2006. We have one negative divergence signal here and several on our own indicators. Based on last weeks analysis and this new development risk takers can short the markets via the leveraged fund URPIX or buy additional puts every time the Dow trades above 12595-12655. Note we are still holding onto a 1/3 of the funds we split into 3 lots when we started buying puts; this play is for those individuals that are willing to take on additional risk. We are not ready yet to deploy the last lot.