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THE DOW REPORT
I No Longer Trust the Summer Rally

This was not a bad week for the markets. The Industrials were up 168.66 points or 1.48%. The Transports were up 208.64 points or 4.97%. The S&P 500 was up 20.95 points or 1.61%. As a result, many have e-mailed me this week asking if the Dow theory non-confirmation is really still relevant or valid. Others have asked me if it has been corrected with this week’s advance. I also received e-mails this week informing me that lack of confirmation by the underlying internal strength indicators is no longer applicable. Additionally, I’m receiving a number of e-mails on the 4-year cycle. Some are asking me if it was possible that the June/July lows marked the 4-year cycle low, while others are informing me that the June/July lows marked the 4-year cycle lows and that the markets are now off to the races.

The signal that these e-mails send me can be summed up in one word: Complacency. Of course, the non-confirmation is still valid. One-hundred and ten years of market history has not been nullified in the last few days, the last month, the last year or even since 2002. In the first chart below you can see that the dual non-confirmation between the Industrials and the Transports still exists. The first non-confirmation is marked in blue and occurred when the Transports fell below their June low, while the Industrials held above that level. The second non-confirmation is noted in red and came when the Industrials bettered their early July high, but the Transports failed to follow. As a result, both non-confirmations still exist, and to say that they are no longer valid is to say that the Dow theory and its one hundred and ten years of history is no longer applicable.

Next, I want to follow up on the internals. In the chart below I have included my intermediate-term Total Market Volume Differential. This indicator is a composite of the NYSE, AMEX and Nasdaq Advancing and Declining volume. I want to draw your attention to the non-confirmation that began developing in 2003 and lead up to the temporary top in February 2004. This non-confirmation is indicated in black. Here you can see that it warned of the decline that carried the market down into October 2004. Note that as the market began moving down into these lows, this indicator began to form a positive or bullish non-confirmation. This positive non-confirmation represented that an accumulation was taking place and warned of higher prices. Then, as price moved up out of the October 2004 low, this indicator moved up bettering its 2004 levels, but wasn’t quite able to better its 2003 level. Note that this indicator confirmed price as the market approached its December 2005 highs. Then from the December high, notice how this indicator began to lag once again as the market moved up into the March 2005 high. This divergence was followed by the decline into the April 2005 lows.

Now I want to point out the non-confirmation between price and this indicator that began in January of this year. This non-confirmation lead to the May high and the decline into the June/July lows in which the summer rally was born. Thus far, this non-confirmation still exists and will remain intact until/unless both price and this indicator can move above their 2006 highs.

In the next chart below I have used the same logic, but with the Advance/Decline data. Here too, we find that these very same non-confirmations exist.

In the next chart below I want to point out that we have a very long-term divergence between price and this intermediate-term Total Market Advance/Decline line. Let me add that this sort of non-confirmation can be found at important market tops since the 1970’s. This is not to say that such divergences didn’t occur further back, but that I do not have the data on all of these indexes beyond that point. Also, understand that divergences alone are NOT signals to buy or to sell. My actual signals come from my statistical model and my Cycle Turn and Trend Indicators. Divergences are simply clues that something is wrong. Sure, the Secondary Trend, according to Dow theory, is actually still positive in that the non-confirmation serves merely as a warning at this point. On top of that, my indicators have yet to tell me that the summer rally has ended. What these divergences are telling us is that the market is spitting and sputtering and just as I said back in January, I expected the gain to occur in the first part of 2006 and for the pain to occur in the latter part of 2006. I continue to believe that we are seeing the setup for the pain. The complacency is merely a sign of the times.

Thus far, nothing has happened to cause me to change my view on the market. Based on my trend quantification work and my intermediate-term Cycle Turn Indicator, I looked for and called the market top in May. I then looked for the summer low and when it occurred I said, “the Summer Rally has begun.” At present, I no longer trust this advance. I still believe that Dow theory is every bit as relevant today as it has been in the past and we still have a Dow theory non-confirmation in place. Furthermore, I still believe that the underlying internals are relevant. Sure, the market can be manipulated in the short run, but manipulation only serves to make matters worse in the end. This is a time for caution and skepticism rather than complacency.

If you are interested in a statistical and technical based source that also utilizes Dow theory and provides statistical probabilities as to what should occur, then Cycles News & Views may be for you. I also provide web-based updates giving specific short and intermediate-term turn points on the stock market, gold, bonds and the dollar, utilizing my Trend and Cycle turn Indictors. The Trend and Cycle Turn Indicators keep us on track with specific turn points and guides us in regard to our longer-term forecasts. The September issue is now available and in it I give all of the updated statistical probabilities and specific expectations for the stock market for the rest of 2006 and into 2007. A subscription also includes short-term updates three nights a week. Please see www.cyclesman.com/.

Tim W. Wood

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