Coming into the year there were two dominant themes regarding investors expectations for 2005. The first and one that stands out the most was the fact that this is the fifth year of the decade and that fifth years of a decade have seen the market end higher for the last 120 years. The second was that the majority of analysts and strategists expected to see a major shift from small and mid cap stocks to big cap blue chip stocks, those that make up the S&P and to a larger extent the DJIA. With last week came the end of the first half of 2005 and has left some interesting results
The strong rally expected in the fifth year has resulted in modest losses so far in all of the major market averages. We know that there is a second half of the year to go but so far this has to be a grave disappointment to the multitude of investors, traders and market commentators who had expressively focused on this phenomena as a reason to be bullish for the year. We had pointed out in January that the market rarely accommodates the crowd and if there was to be a fifth year failure this was certainly the year to see it happen. This also coincided with a down January, something that has not occurred prior in a fifth year of a decade, at least as far back as our data just prior to 1920. Of course the year is only half over and the fifth year fans still have a chance to pull it out but the first six months is not what they had expected at all.
As for theme number two, a shift into big cap stocks, well that too has failed to materialize. The DJIA in fact is lagging the S&P for the first six months by nearly a three fold margin and versus the Russell 2000 by nearly a 4 fold margin. This is also evident in the NASDAQ as the Composite is off fare less than the NDX, the latter comprising the largest 100 stocks in the overall composite. The disparity here is not as bad as it is between the DJIA and S&P with the NDX off about 50% more than the composite. But the story is the same. This also goes to show that the majority view when it comes to the stock market tends to be wrong more often than not. And when that view is excessive it is wrong considerably more often than not. Meanwhile, we are also faced with a down January and according to the January barometer "as January goes so goes the year". This is not close to 100% but does have a fairly good record for whatever reason and we should be aware of it and not dismiss it off hand. The fact that this is also coinciding with a peaking four year cycle suggests the strong likelihood that the January barometer will have a fairly good chance of being correct this time around. We had said early in the year that 2005 was to be a shift from a cyclical bull market back into the secular bear market that began in 2000 and from what we have seen so far this year the market has given us little reason to change that view and a lot to confirm that view.
The month of June left a number of divergences in its wake. Not only in regards to the momentum indicators, of which there were plenty, but also among the various market averages. The most notable is the divergence between the DJIA and DJTA as the latter fell short of its early June peak in mid June and setting up a Dow Theory non confirmation, the initial step to a Dow Theory sell signal That signal has not been confirmed (the sell signal) but it is close and raises a big caution flag. Keep in mind that while both averages went to new joint highs in March, the DJTA had made new all time highs above its 1999 high which was not confirmed by the DJIA. This sets up an even bigger non confirmation the likes of which we have not seen since 1999-2000. Other, not as noticeable divergences include the failure of the DJIA to confirm the S&P on June 22 and the NDX to fail to confirm the NASDAQ Composite on June 23 having peaked on June 2 and recording a sharply lower low on June 22. There is even a smaller divergence within the post June 2 divergence as the NDX made a lower low on June 23 versus June 17. Since the stocks comprising the NDX are nearly 80% or more of the overall NASDAQ composite at least in market value and to a degree trading volume as well we see periods of relative strength in the Composite versus the NDX as more of a negative as it suggests a lot of small, highly speculative stocks are leading the way.
The leadership in the post 2002 rally has been small cap and mid cap stocks, which in June recorded new all time highs. At the same time both weekly and even longer-term monthly momentum are seriously diverging showing a huge loss in upside momentum. This is based on 13 period RSI, which shows a pattern typically seen at or near the end of a bigger rally of two lower highs in momentum versus two higher highs in price. The monthly divergence does not show two lower highs but does show multiple divergences dating back to 1997-1998. These divergences have not been confirmed. And until they are confirmed by price they will remain as always, potential divergences They do, however, add to the myriad of developing long-term negatives that add further to our view that the cyclical bull market is in its latter stages.
Speaking of divergences, the break in price in late June finally confirmed the series of negative divergences that had been building in an array of indicators since late May-early June. These indicators have corrected to neutral but at the same time the daily trend oscillators are now negative and beginning to accelerate. They have also come off a very negative signal. This was coupled with a sharp rise in acceptance of the rally from the majority of our sentiment indicators. The two exceptions were the Rydex ratios which were only neutral and the CBOE put to call ratio, which is still at the low end of bullish. The polls on the other hand have continued to slip with Investors Intelligence showing the most negative bull/bear ratio since early January and not far from a multi decade high. Consensus and AAII have eased the past week but Market Vane remains in the stratosphere with the four week moving average above its March 2004 peak and the highest since March 1998. The sentiment combo, which is comprised of all four polls is not as excessive as it was in late December but is not that far away either and other than the past two years it is at its most negative level in its 18 year history.
Our short-term indicators are bearish and the wave structure from late June does not look complete. Our expectation is for another wave down to carry the averages below their late June low. However, what we are not sure of and what the indicators and wave structure cannot confirm is whether or not we get another small rally above last weeks late high prior to that next wave kicking in or if what we saw last Thursday was it. This should be confirmed today but in either case a move below last weeks low is expected.
