While on the surface the Dow’s break out was impressive, the underlying weakness in the index itself and the rest of the market was glaringly unimpressive. In fact, at this moment in time, the US stock market is in a very precarious state and I would strongly encourage all “do-it-yourselfers” to tighten up your stops and pay close attention to current holdings this week. I’ve seen this situation before and I have to say it’s got me pretty nervous. In recent history, the break out last week looks a lot like the break out (fake out) that we saw in the S&P 500 last March. The situation then and now are almost identical. Specifically, our system had already moved to an intermediate term sell signal (as it is now) and refused to give the green light even as the broad market made a new high on March 4, 2005. It was as frustrating then as it is now to see prices move higher while the technical foundation of the markets was getting weaker and weaker. By a weak technical foundation I’m talking about sluggish buying pressure, volume and breadth. Last week was no bought as much as it was not sold if you can stand any more double speak. Markets can and do move higher on the back of short covering or simply an abatement of selling pressure. The fake out in March of 2005 proved to be the high point for the US market and prices fell dramatically lower by an average 8%. I don’t know if we’ll see a similar outcome this time around but the stage is set.

Let’s get into some concrete numbers and I’ll give you an example of what I’m talking about. Let’s look at the mighty Dow. Of the 30 stocks in the Dow Jones Industrial Average, last week we find that only 4 actually made all time new highs from the peak in 2000. 2 of the stocks are at a break even. 15 of the stocks (50%) are still down over 20% from 2000 and 9 (~30%) are still down over 30%. From the high in 2000, the average price move for the 30 components of the Dow is still down 21.5%. And yet the capitalization weighted index itself gives investors a false sense of achievement by moving out to a new 4 year high. Quite frustrating and quite a precarious situation.

Beyond this failing participation, volume in the last week was suspiciously light and one of our key price oscillators (Russell 2000) was just barely able to turn positive. If the Russell 2000 index is down virtually at all, close below 730, the oscillator will turn down again and form a very bearish pattern. The price oscillators for the S&P 500 and the Dow will similarly turn down with a close below 1278 and 10,984 respectively.

Energy, Gold and emerging markets are in a recovery mode from the brutal selling of the last 3 weeks and none have made new highs from their peaks in late January. At this point, the volume patterns suggests we’ll see at least another round of selling in these sectors before a more sustainable move higher can begin but I’ll be keeping a close eye in these areas.

News Flash – As I write, the SOX semiconductor index is currently taking out the February lows while the broad market is still sitting close to the highs of the year. Semiconductors, like any conductor, are often a leading sector for the broad markets. Like all the above, this doesn’t bode well for the future of stocks but we need to let the rest of the market show real selling before taking any action.

While I have absolutely no reason to doubt the current price action in the markets, I have plenty of technical concerns and lot of gut concerns about the current situation. As usual, adjustment will be made based on actual price action; I just don’t like the prospects in the short term.

Overall, our strategy as of the end of January has been one of good defense and will continue to be as long as the technical background for the markets continues to deteriorate. Our sector models (Worldwide Sectors, New Power, Skandia annuity) are getting some good traction as of late but our more risk managed models (All Season and High Income) are broadly diversified and generally holding out for more confirmation of an uptrend before becoming more aggressive. I realize that these moments are some of the more frustrating for anyone invested in any risk managed model. As a matter of psychology and behavioral finance, it takes a lot of courage to be disciplined about investing. Most investors don’t have a system of any sort and lack any form of discipline when it comes to buy and sell decisions. They look at shat has already run and they buy more. When prices fall and the pain of loss becomes real, they sell. In the current situation it takes more discipline to avoid buying than it does to sell. Back at the lows in late October and early November of 2005, it was just the opposite situation as it took a lot more discipline to buy than to sell. Remember, the markets have a crafty way of frustrating the greatest number of investors. Stay tuned; market action this week is pretty critical.

Sam Jones