LAGGING TRANSPORTS SUGGEST A DOW THEORY DIVERGENCE IN THE MAKING -- THE SAME IS TRUE OF LAGGING FINANCIALS AND SMALL CAPS -- GOLD APPEARS TO BE CONSOLIDATING IN UPTREND AS EURO RALLIES -- FED EXPECTED TO LOWER RATES A QUARTER POINT TOMORROW

DOW THEORY DIVERGENCE... One of our readers asked for an update on Dow Theory, which is the oldest of technical indicators. Simply put, the Dow Theory holds that a new high by either the Dow Industrials or the Dow Transports should be confirmed by the other. When one hits a new high, and the other doesn't, a Dow Theory divergence exists. Charts 1 and 2 show the diverging trends between the two Dow averages since the summer. The Dow Industrials in chart 1 bounced off its summer low and appears headed back toward its old highs. The Transports in Chart 2 broke their summer lows. Although it's in a recovery phase, the Dow Transports is still trading below its October peak and is still 12% below its July peak (compared to 3.6% for the Industrials). At the moment, both are rising. The fact that the Transports are so far behind the Industrials, however, leaves open the strong possibility that the staying power of any yearend rally is suspect. The October high in the Dow Industrials was "unconfirmed" by the Dow Transports which didn't even come close to a new high. The market subsequently fell 10%. Since the Industrial high in October was slightly higher than the July peak, there's a possibility that the current Industrial rally could be a "right shoulder" in a topping pattern. That would put major resistance at 14,000. I recently suggested that I viewed any yearend rally as part of potential topping pattern. I still hold that view. The current divergence between the two Dow averages only serves to strengthen that view.

Chart 1

Chart 2

MORE NEGATIVE DIVERGENCES ... The chart of the S&P 500 in Chart 3 is similar to the chart of the Dow Industrials. It too looks like a potential "head and shoulders" top in the making. That would put major resistance at 1555. Two other areas that are lagging far behind the S&P 500 are small cap stocks and financials. Both are rallying at the moment along with the rest of the market. While the large cap index is only 4% from its old high, the Russell 2000 Small Cap Index in Chart 4 is 8% off its 2007 peak. The Financials SPDR in Chart 5 is 18% from its summer high. That suggests that any test of its 2007 highs by the S&P 500 would take place with those two groups still way below their old highs. That sets up the possibility for a lot more "negative divergences". To me, that's another warning that any yearend rally will be on thin technical ice. Shorter-term traders can still expoit a yearend rally from the long side. Longer-term investors, however, should maintain a more defensive stance. That could include doing some selling into the rally. Or, concentrating in more defensive market sectors. One of those is gold.

Chart 3

Chart 4

Chart 5

GOLD IS BOUNCING AGAIN ... On November 30, I used a point & figure chart to show that the streetTracks Gold Trust (GLD) was in danger of slipping into a corrective mode. I warned that a close at 76 or lower would trigger a "short-term" sell signal. Chart 6 shows, however, that GLD bounced off p&f support at 77. That makes the gold pullback look more like a consolidation than a correction. The daily bars in Chart 7 seem to confirm that view with GLD having bounced off its 50-day moving average. It still needs to clear a resistance line at 81 (and then the late November high near 82) to resume its uptrend. Gold is continuing to draw strength from a falling dollar and a rising Euro. Chart 8 shows the Euro jumping today and remaining above its 50-day moving average. It will be informative to see how the dollar and gold react to any Fed move tomorrow afternoon. That's true of all the markets.

Chart 6

Chart 7

Chart 8

FED TIME... The Fed is widely expected to lower the Fed funds rate by a quarter point tomorrow afternoon. Any deviation from that belief (either by a bigger cut or no cut) would probably have a dramatic impact on the market. I'm not sure that a quarter point cut will change things much. While it's generally not wise to "fight the Fed", it's also true that the market fell sharply after the last cut. Rather than trying to read the mind of the Fed, I'd suggest trying to read the message the charts appear to be telling us. Right now, they're suggesting that things look better for the time being but could get a lot worse in 2008.