Option Investor
Index Wrap

If Fed had cut 50, things could have been worse!

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The Federal Open Market Committee decided to lower its Fed funds rate 25 basis point, but market participants seemed rather unimpressed as if they had expected more. I say, "if the Fed had cut 50, today's 98-point decline for the Dow Industrials could have been doubled."

To "understand" where I'm coming from, then look no further than Wednesday evening's Index Trader Wrap http://members.OptionInvestor.com/Itrader/marketwrap/iw_061803_1.ASP and comments regarding dollar/bond and housing sector to see what the market's response was to today's 25-basis point cut.

While we will never know for certain if the markets (bond and stock) would have reacted even more negatively than we saw from the 02:15 PM EST mark (when rate cut was announced), had the Fed cut 50, today's reaction action from the bond market, which sold off rather sharply, certainly looks to have been that it was expecting more, if not disappointed with what it got.

Earlier this morning, Treasuries started out higher (price) on the weaker-than-expected May durable goods order data, but began reversing those gains ahead of the 10:00 AM EST release of May housing data, which was much stronger than forecasted. That news had Treasuries relatively unchanged into the FOMC announcement, but the 25-basis point cut saw Treasuries extend their losses with YIELDS finishing at their session highs.

And here is where and index trader begins to perk up. Despite the stronger-than expected home sales data for May many of the homebuilders traded with fractional gains for the bulk of the session, but when Treasury YIELDS "shot" higher, it was the Dow Jones Home Construction Index (DJUSHB) 438.97 -2.46% and PHLX Housing Index (HGX.X) 283.27 -1.41% to end up as today's "sector losers."

Financials? How about the S&P Insurance Index (IUX.X) 264.23 -1.41% challenging the homebuilding-related sectors for sector loser. I think today's lower trade in the IUX.X is also tied to what took place in the bond markets today. We made note of this sector last Wednesday's wrap too. Comments were that this group buys, or has been buying debt instruments (bonds = Treasury, corporate, "junk", etc.) with money received from premiums. When Treasuries got hit today and YIELDS rose, insurance and homebuilders took the early hit.

For those of us that have ever wondered.... why the "fundamentals" released (housing data as an example) were much better than the sector/stock performance (DJUSHB/HGX.X) then perhaps some of today's unwinding in the bond market and impact on the homebuilders begins to build some clarity of what took place, and may have even "dictated" broader market equity action.

If there's one thing that should now stand clear in a trader/investor's mind, its that the Fed is most likely going to use their "jaw boning" and talk of buying back longer-dated Treasuries to try and keep mortgage rates low.

From here on out, the bond/dollar and homebuilders become a traders "best pulse" on the economy. At least, this is my opinion.

Let's face it. There was little in the May housing data to suggest a bubble in the housing market that could threaten an economic recovery. The biggest threat to the housing market and a "housing bubble" is if despite Fed talk of buying back longer- dated Treasuries, the bond market doesn't listen and YIELDs rise SHARPLY from here.

Emphasis is give to SHARPLY as it relates to RATE OF CHANGE, or "shock."

Let's talk quickly about the Treasury bond market. Here's a couple of notes I made in today's market monitor. I thought there was a good trade in the making for the 5-year YIELD calls ($FVX.X) 2.274 at 10:49:35 and I tried bidding this very thinly traded option call at $2.40, but had no luck in finding a seller in between the $2.00-$2.80 bid/ask. What got me thinking about this trade was comments late yesterday from PIMCO's Bill Gross (manages roughly $345 billion in assets) regarding just how little upside is left for bulls in the Treasury bond market.

Market Monitor

One "reason" I profiled and tried to get some action in a 5-year YIELD call was that homebuilders weren't really showing much bullishness after such a strong May housing report. Did the MARKET know that the Fed was "only" cutting 25, perhaps not cutting at all? The reason I looked at the 5-year was that the Fed hasn't said anything about buying back shorter-dated maturities in recent months (avoid potential buying) and if bond market was looking for 50 basis cut (50% chance earlier this morning) then anything less than 50 would be a "disappointment."

I sure wish YIELD calls were more actively traded and spreads narrower. I just didn't feel good taking the offer (20% spread?). By session's end, the July 20 call (FVXGD) finished bid/offer $2.80 x $3.60. Again... very little liquidity in these and to get filled "in between" takes some good fortune.

The main point of the above market monitor snapshot is Bill Gross' comments. Again... Mr. Gross' comments regarding the bond market's pricing in "Dow terms" is so that stock traders/investors can better understand what he is talking about.

Remember! When a bond reaches its maturity, you ONLY get the face value of the bond, or $1,000.00. With that understood, Mr. Gross is saying that Dow 10,000 is analogous to a bonds face value of $1,000 and that buying current MARKET YIELDS is equivalent to saying that the Dow can only trade as high as 10,000 and bond bulls are buying at a Dow equivalent of 9,600. What kind of risk/reward is that if somebody tried selling you bond at $96 and told you it could only appreciate to $100? I know my reward is $4.00, but what's my risk? $1 or $96 depending on where you place a stop right?

So now we're perhaps getting inside a bond trader's head (based on Mr. Gross' risk/reward comments) and looking at what the Fed is doing. 25 basis points? Sell!

Impact? Higher YIELD!

Impact? Higher mortgage rates?

Impact? Fewer home sales if mortgage rates rise?

Impact? Homebuilder stocks become more "risky?"

Impact? If Homebuilders weaken, could spread on macro economic scale if economy doesn't recover and main engine for past economic stability weakens?

My observations today are this. Fed cuts 25 basis, bond market sells (may have factored in 50, perhaps 25 basis points) YIELDS rise, raises concern that mortgage rates rise, and housing sector sees selling despite very strong May housing data.

Expect the Fed to take a stance that it is willing/able/ready to buy longer-dated maturities in order to try and keep Treasury bulls from selling their longer-dated bonds, which would adversely impact mortgage rates (have them moving higher.)

As a benchmark for today, according to www.realtor.com, the national average for a 30-year fixed rate mortgage is 5.29% (0.29 points), a 15-year fixed is 4.69% (0.31 points) and a 1-year adjustable rate mortgage (ARM) is 3.34% (0.36 points).

The 30-year YIELD ($TYX.X) finished up 9.4 basis points to 4.438%

Dow Jones Home Construction Index (DJUSHB) - Daily Intervals

Monday's trade saw Dorsey/Wright and Associates "building" sector bullish % (BPBUIL) reversed lower into "bear alert" status, and today's bond market action and lower trade in the DJUSHB below the 440.59 level now has the outward appearance of the DJUSHB exhibiting technical weakness. This is often a pattern of a "sick patient" where the internals begin to deteriorate (point and figure sell signals) and then the outward appearance of an index begins to reflect the internals.

I don't know the exact dates of when the building sector bullish % (lots of homebuilders are in Dorsey's building bullish %) reversed up to "bull alert," then "bull confirmed" as I wasn't monitoring this sector bullish % closely, but I do know that it was after Monday's trade that the sector bullish % reversed back lower.

Right now, I'd put resistance near the 460 area, with a moving bearish target being the 50-day SMA.

I've mentioned two stocks (there are probably others) in the group as short/put candidates. Centex (NYSE:CTX) $78.51 -3.69% gave a double-bottom sell signal at $82, fell to $79 on its PnF chart, reversed up 3 boxes, which then gave us a bearish vertical count of $70. If I were to take a retracement on CTX, similar to that shown on the DJUSHB (October low to recent high) then CTX's retracement bracket gives me a 38.2% retracement of $68.70, which may be equivalent to the DJUSHB 397.98.

Using this similar retracement on CTX, its 19.1% retracement is at $78.10, so the stock has not broken this level. However, PnF chartists will note that a trade at $78 in CTX would be a second consecutive double-bottom sell signal.

The reason I provide index trader's with a stock specific name, is that the DJUSHB does NOT trade options. However, the PHLX Housing Index ($HGX.X) 283.27 -1.41% does. But some index traders don't like the spreads or lack of open interest. For instance, the HGX.X Sep. $285 puts (HGXUQ) are bid/offer $14.80/$15.40, open interest is 0, and no contracts traded today.

Centex (NYSE:CTX) $78.51 -3.6% doesn't trade a September expiration, but the October $80 puts (CTXVP) are bid/offer $7.90/$8.20, open interest 172 and traded 0 volume today.

Moving onto the indexes.

I want to first cover the S&P 100 Index (OEX.X) 491.60 -0.98%. Session low was 491.40 and just shy of my profiled stop from Tuesday's

S&P 100 Index Chart - Daily Interval

I thought "tensions were high" just prior to the FOMC announcement, mostly because the bond market pits were loud and trading rather fast. I was also closely monitoring the OEX bullish trade as I thought a bull was really looking for a move into our "zone of resistance" to bring some action into the trade as the OEX had been stuck between 499 and 500 for the better part of 3-hours.

Just prior to the FOMC release, the OEX did pull back to 497.50, then came right back to 499.00. When the rate cut was announced, the OEX quickly fell into our "zone of support" from 495.11- 495.92, bounced back to 498 20-minutes later, but got "smacked" back lower to close right at our MONTHLY 19.1% retracement.

I view today's action as a negative for this trade and will now lower my bullish target from 507-510 to 500. Yes, maybe I should have pulled the plug just prior to the FOMC data, but I liked the still bullish nature and positive internals that were building up to the announcement.

In the above chart, I do say... "if not stopped out at 491 tomorrow, then sell the close if OEX hasn't traded 500." The reason I say this is that the "reason" I had target 507-510 was thought that we might get a "pop" to that level on the FOMC announcement. Now I see, based on observation, that that scenario is no longer in play. There is still a shot at 507-510, but only based on past Stochastic setup and trade at current level. The reason I need to see a trade tomorrow back at 500 by the close is this.

The Stock Trader's Almanac points out that Monday, the last day of the second quarter, shows the Dow Industrials trading down 8 of the last 11 years on that day. For a bullish "swing trade" in the OEX, if I'm still going to be targeting 507-510 area, then by golly, with more bearish historical tendency facing me on Monday, then I need to at least see a close above 500 tomorrow for any thought of achieving my target. Again... history is no guarantee of the future, but I don't like historical 8 loosing sessions out of 11 odds for a bullish trade.

I would also think along these lines for those still holding 497 and at a loss. If the OEX does trade back near 500 tomorrow, without triggering our stop at 491, then I would RAISE STOP to break-even. I had full intention of doing this today, but I was waiting for the OEX to trade into the 500.79-502.10 area to do it.

Today's trade saw no net change in the S&P 100 Bullish % ($BPOEX). Still holding at 81% bullish.

The S&P 500 Index (SPX.X) 975.32 -0.82% traded very similar to the OEX. Tonight, I want to try and "draw in" the commentary related to the DJUSHB and retracement used in that chart, with the SPX so we can perhaps tie in how that sector may relate to the broader S&P 500. All I'm doing is anchoring retracement from the October lows to recent high so we can try and tie the levels together.

Current observation is that the "building" bullish % is "bear alert" and has closed below its 19.1% retracement.

Today's action saw the S&P 500 Bullish % ($BPSPX) see a net loss of 2 stocks, so the bullish % slipped another 0.4% to 78.80%. There has been no reversal back lower in this broad bullish %, but we get the continued observation that some internal damage is being done.

Let's also remember the work we did with unconventional 6-point box size to establish a "finite" bullish stop at 972. Today's low in the SPX of 974.86 is getting close to that level.

S&P 500 Index Chart - Daily Interval

I'm going to profile 1/4 bearish position in the SPX for September expiration (same type for SPY). While target would be 921.09 as it relates to some of the work we just did with the DJUSHB and Centex (CTX), a "normal" and healthy pullback in the SPX in a longer-term bull market (remember higher high from December and higher lows from October is technically a longer- term bull market event).

If eyeballing the 460 resistance in the DJUSHB, then I'd begin to think SPX 1,000-1,010 as resistance too.

NASDAQ-100 Tracking Stock (QQQ) - Daily Interval

The QQQ didn't pass my bullish test of CLOSING above our upward trend. While the tendency is to "adjust" the trend a little lower to the May pullback instead of where I attached it to the April pullback, I tried to compensate for that potential error with the CLOSE below, which the QQQ hasn't done before.

Our "finite" stopping point from the unconventional QQQ $0.35 box chart is $29.40.

I did profile and take a QQQ short at $29.51 in after-hours trade. This was to provide some hedge to an OEX bullish trade in case we look at a "gap down" type of situation taking place in the morning in the indexes and OEX call option trade, where the gap takes us below 491 stop.

In last night's wrap, I also discussed a conversation with a futures trader friend of mine and importance of S&P futures 974.00. This futures contract looked to try and close 974.00, but by the end of its close settled at 971.90. This settlement below 974 had me concerned of a lower open trade in the morning.

Today's trade saw no net change in the NASDAQ-100 bullish % ($BPNDX). Still "bull correction" status at 76%.

Dow Industrials (INDU) - Daily Chart

The Dow closed right in our "last" weekly zone of support. Things were looking good for bulls until the FOMC data was released and market responded. While the indexes look near-term oversold, I would look to establish 1/4 bearish in the Dow on a break below 8,976 (10-points below WEEKLY S2 of 8,988). Keep some powder dry at this point if short/put at 8,976, as a more "ideal" short/put entry point would be up near 9,200.

Pivot Analysis Matrix -

While I spent some time again tonight on the DJUSHB and how traders in that sector may be responding to Treasury YIELDS, the financials are still important. Once again we see BIX.X 300.00 support in the matrix and this is also a sector away from the major indexes that traders should monitor.

If the indexes find selling at WEEKLY S2, the downside risk can be immediately assessed to either DAILY S2 levels and MONTHLY pivots!

OEX stop of 491 couldn't be more in between tomorrow's DAILY S1/pivot.

I've also highlighted the SPY and how it did trade and CLOSE below its WEEKLY S2. What is going on here I think is that cash SPX traders did see the S&P futures settle below 974 and may have come in short on the SPY as a hedge after cash close of 04:00 PM EST, while the SPY was still trading.

We're also noticing that the 10-year YIELD ($TNX.X) is DIVERGING in the pivot as it relates to levels and what stocks are doing isn't it? More to follow on this, but all ties back with last weeks Index Trader Wraps.

Jeff Bailey

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