Option Investor
Index Wrap

Correction time

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Not Miller Time! This past week's correction to the several week rise in the indices looks set to continue with another downswing ahead. The typical pattern is for a sharp 1-2 day drop, then a rebound that might retrace 50-60% of the fall, followed by another decline that will typically take out the prior correction low.

This view fits with the current fundamentals. The rebound off the Fall lows was in response to a possible better economy after the Iraqi conflict. And, earnings were not too bad, based on continued tight control of costs. Now, the market is waiting for a further improvement and a trend of better numbers. With the next round of earnings reports still some way off and with the move into summer, we're into the doldrums for a while. Absent new bullish news, the market is prone to fall some more.

Except for a strong utility sector that pays the biggest stock dividends, stocks ended mostly unchanged - the boost in the utilities was of course due to the passage of the new tax bill, with its centerpiece tax break for stock dividends.

The benchmark S&P 500 and the Dow Industrials broke a 3-week winning streak. Some blame was laid to nervousness on Monday and Tuesday over a string of terrorist attacks in Morocco, Saudi Arabia and Israel. Lets not forget our Moo faced friends in Canada who went a bit mad. Yes, Mad Cow disease, really no laughing matter, was afoot in Canada.

For the week the Dow fell about a percent - for the day on Friday, ahead of the 3-day Memorial Day holiday, the Industrials were up some 7 points and climbed back above 8600 - just barely at 8601. The Nasdaq composite also rebounded slightly, gaining 2 and 1/2 points to 1510, just above near support in the 1500 area. COMPX was down a bit less than 2% on the week.

The $350 billion tax-cut package that was passed by the House and the Senate reduces the top rate on dividends and capital gains to 15% and was the prime driver for utilities. American Electric Power (AEP) was up over 4%, Southern Co. tacked on 5% and Public Service Enterprise was also up close to 5%.

Individual investors tend to buy these stocks for their safety and predictable dividends and the companies are of greatest interest when their costs fall, the biggest part of which is energy costs which are falling of late. Also, other interest rates have been declining in a significant way. Yields of 5%, with only a 15% top tax rate are looking pretty attractive versus the 10-year government Note priced to yield 3.3% at Friday's bond market close.

The other big news was the continued fall of the dollar - I commented last week on the bullish gold charts and bullion rallied even more sharply this week in reaction to the dollar's fall. With gold still mostly priced in global markets in dollars, its price will rise if its going to maintain its value in dollar terms.

The Euro ran up for week to a 4-year high, closing at 1.1837. I can't believe this bit of minor good fortune as I keep getting distracted from converting (to dollars) a yearly rent that I get paid in Euros - my resolution at the moment is to, without fail, get that done in the coming week. Hey, I was happy with $1.10!

Recent comments were made by some key United States officials that they wouldn't try to prop up the dollar, which led to accelerated selling of the greenback. Moving to a still further price extreme is not atypical in the currency markets. The dollar was quite overpriced last year and these markets like others - think stocks - tend to move from one extreme to the other over time. Fundamentally, much of the pressure has stemmed from all the recent concern of a possible U.S. deflation trend and the possibility of a double dip recession because of it.

After this correction runs its course, I think we will work higher in stocks - multinational earnings looks like they'll rise partly due in fact to a weaker dollar and the Federal Reserve's increase in the money supply due to falling interest rates. Fed funds, now at 1.25%, could fall by late-June to .75% - this is the current expectation, for the Fed to push its benchmark rate down by a 1/2 percent.

Hey, if you're a gold bug, it's a great looking chart! The reaction low held right where I would have looked for support - at a level line from the apex of the triangle. Better to have owned calls on gold itself, as the XAU or Philly Gold Index has not done as well as the metal itself.


S&P 500 Index (SPX) - Weekly, Daily & Hourly charts:

Don't say I didn't warn you - about technical resistance in the 950 to 960 area that is. It became a showstopper in the S&P 500 (SPX) by the Monday opening last week. What now? You got another chance to buy puts from my reading of the charts. 935- 940 looks like the area - perhaps the hourly chart "gap" will get entirely filled in by a move up to about 945. Anything over 940 is a "gift" in my book and a good entry for put purchases.

What would suggest that SPX was back on a bullish track? - simply to clear a well-defined "line" of resistance by closing over 948- 950.

On the downside, as discussed above, I think we'll see a dip to below this past week's (down) swing low around 915. Perhaps SPX will not re-test 900, but it could get close, say to 905, at least once between now the June expiration.

While I am not a strident bear and am mildly bullish for the longer term, I still point out that the end of the current bear market isn't really "confirmed" until we see SPX close above 960 on the week and then maintain that level, as support, on subsequent pullbacks. While institutions will bury significant money in key COMPX biggies, the S&P 500 is the biggest draw for money managers to put the most money to work and they're not convinced yet.

S&P 100 Index (OEX) - Daily & Hourly charts:

Repeating the daily chart twice here, in order to show the OEX envelopes I use and the overall bullish upside momentum by the fact of the upside crossover of the 50 day above the 200-day moving average in the S&P 100 (OEX). There is a tendency for a move back below the 21-day average however, once there is dip below it - that's the center line on the lower chart.

Upper left shows two interesting technical patterns. One is the fact that OEX cleared its prior 475 peak for the week - the fact that this was followed by a sharp drop was largely unpredictable expect for my (largely) unfailing indicator of "sentiment": the line that plots daily equities total call option volume relative to total equities put volume on the CBOE.

I got bearish prior to last week based on the chart patterns I highlighted, the overbought indicators and by a bearish price/RSI divergence. I have to keep up my favorite "sentiment" indicator - my Call to Put ratio - by manual entry. While I thought it was up to date last week, something went awry and the chart didn't show the jump in the "needle" to a bearish extreme of 2.5, as is circled below.

Friday the 16th saw CBOE equities call volume surge to 851 thousand contracts, versus put volume of 340 thousand. I'm glad to know that this indicator continues so reliably to predict downside reversals within 1-5 days of such extremes. Fortunately, many OIN subscribers have picked up the habit of checking this ratio and pointed out the extreme that can now be seen under the lower left OEX chart.

Another thing that I would point out about when you have overlooked some single factor is what I call the "Tree of Indicators & Patterns" concept. If you follow enough of the right things, you will rarely fail to see a correction coming even though a particular single indicator or pattern does not develop as expected or you just overlook seeing it.

Enough hindsight and on to foresight - I think OEX is due or nearly due for its next fall and would get ready to be in puts to capture this. 472-475 is my most favored price zone to enter into some (put) buying. If 475 is pierced, 480 looks to be the next key resistance.

My outlook is for new lows below 460, perhaps to around 445-450 again, support implied by the 200-day moving average. The lower envelope "band" relative to the 21-day average in the lower daily chart, intersects in the 440 area currently - however, I rate the chance of seeing OEX down this far as being slim. Note the prior recent trend of a decline RSI trend while prices were going sideways, as forewarning of the price break of early last week.

After the current correction runs its course, OEX could reach 500, but that would probably could not happen before the next earnings announcement window in July - and, of course, earnings would have to be good.

Nasdaq Composite Index (COMPX) - Daily & Hourly:

I highlighted in the daily Nasdaq Composite chart - left, below - my expectation for a common or "typical" corrective pattern that would see another downswing ahead, suggesting a possible move back down to the 1450 area.

1550 is resistance in the COMPX. 1480 is near support.

The Composite has retraced now about 50% of its decline from recent high to recent low. I don't envision the current rebound carrying much higher than 1525 at the most optimistic - the pattern says more correction or downside ahead in my estimation.

What would begin to convince me otherwise is a close back above 1530. Resistance and selling interest can be anticipated in the 1530-1540 price zone.

Both the daily and longer hourly oscillator indicators are suggesting either continued downside momentum (daily chart RSI) or another overbought extreme in the case of the hourly stochastic.

Similar to my suggestion last week, I again suggest bearish trading strategies by buying NDX or QQQ puts on further rallies in the Composite. On to the Q's! Wish I were sailing on the new QE2, but will have to settle for QQQ.

QQQ charts - Daily & Hourly:

QQQ could be re-shorted in the 28.5-28.75 resistance zone, anticipating a move back to below recent lows around 27.5, perhaps to the 26-26.50 area where the longer term up trendline intersects on the daily chart currently.

The daily chart has a bearish rising wedge pattern to some degree. A few such technical considerations are pointing to another downswing ahead that is tradable.

After further corrective action however, I could see QQQ reaching 30 again, at the top of its current hourly uptrend channel. The very next move looks to be down however. My expected maximum price range over the next 2-4 weeks is 26 or perhaps a bit lower on the downside, to 30 on the upside.

Knowing that any imagined outlook can be wrong, a move to 29 or above, especially on a closing basis in the upcoming 4-trading day week, seems the least likely next move in the Q's. But a rally to this extent would suggest an upside "breakout" and renewed upside price momentum.

The downside seems the path of least resistance just ahead as the stock has had a decent advance off its lows - some pause and a further pullback would be normal at this juncture.

Good Trading Success!

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