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Market Wrap


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It was just a doji kind of day today. While the DOW had a swing of 90 points today it closed down almost 22 points. The SPX had a stellar day and closed up a whopping 1.26 points. The Nasdaq was down a little more than 4 points and the RUT was up almost 2 points. So much excitement and so little time to talk about it. After a big rally off yesterday's low, it was natural for the market to take a breather today. We often see this pattern of expansion and contraction where the market rests a lot and contracts in its daily range and then busts a move out of that range to only then repeat the cycle. There are a lot of mixed emotions about what the market will do from here, and that was before Katrina hit us. Now we have so many conflicting opinions about how our economy will feel the impact and this has only added to the uncertainty about what will happen in the last four months of this year. And with the historically scary months of September and October directly in front of us, there's a lot of jockeying for position in the markets right now. I think some of the buying and selling spikes we're seeing are simply the other side getting spooked out of their positions.


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Economic reports this morning included unemployment claims and showed initial claims rose 3K to 320K versus the consensus estimate of 315K. The 4-week average jobless claims were up 1,250 to 316,750 and the continuing claims were up 36K to 2.60M. The aftermath of Katrina should easily spike the unemployment numbers. The only thing that will hold the numbers down will be the inability to get these people entered into the system. I feel for these people who have lost so much and it will likely be a bureaucratic nightmare to get them the money help they desperately need.

Personal incomes were reported up 0.3% versus 0.5% expected but spending was up 1.0% (as expected). So it shows we're continuing to outspend our incomes. In fact the savings rate dropped to a -0.6% rate which is the lowest rate in the past 46 years, since 1959. Prior to that (when only quarterly data was kept) a negative savings rates was recorded for several quarters during the Great Depression. More recently the savings rate was negative 0.2% in October 2001 and was 0% in June. Negative savings rates occur when consumers sell assets, dip into their savings or take out loans.

The negative savings rate combined with rising unemployment claims would normally be bad news but it sparked rumors that the Fed would now see the need to cool it and stop raising interest rates. The meeting between Greenspan and President Bush only fed those rumors and the bond market rallied as it reacted in a way that said they were convinced the Fed will not continue to raise rates as much as had been expected prior to this week. The meeting with President Bush was presumably held so that the president could discuss the economic impact of Katrina. If it was up to Bernanke he would probably do nothing since the storm "wasn't that bad". Talk about a bunch of people running our banking system who couldn't be more out of touch with the real world...

Construction spending was unchanged from June, coming in at a $1.1 Trillion annual rate. The July ISM manufacturing index was 53.6%, lower than the expected 57.0% and lower than July's 56.6%. This slowing in the index added fuel to the speculation that the Fed does not need to continue raising rates. The front end of the yield curve (the shorter term maturities) saw the most buying which lowered their yields faster than the longer maturities and this caused a steepening of the yield curve. But even the 10-year rate dropped below 4.0% before settling at 4.02% today. This drop in the 10-year yield is what has excited the housing index as seen in the chart later. But the action in the 2-year served as the strongest indication that the market thinks the Fed will let up on their desire to continue to increase rates.

July core inflation (food and energy prices removed) was reported up 0.1% while year-over-year it was up 1.8% versus 1.9% expected. Since most of us need to eat and use energy I fail to see the value of core inflation. But this inflation rate has dropped from 1.9% in June and 2.2% earlier in the year. So it sounds like inflation is abating. How come it doesn't feel that way at the end of each month?

The market looks like it could be on the verge of a rally into September. While that doesn't make sense in a fundamental way, I learned long ago not to trade fundamentals, sentiment or personal opinion. I try my best to trade what the market is doing and right now it's breaking down trends. Therefore I'm thinking we have a rally on our hands. If the market falls back down, I'll give up on the rally idea. Let's see what the charts are telling us since that's what we trade.

DOW chart, Daily

If the DOW is able to recover back above its uptrend line from March 2003, it will be the 2nd head fake break in two months. If it can back above its 200-dma at 10,538 it will look like July repeating itself. And that's what I'm expecting. I'm looking for a rally into mid-September that will take the market to new annual highs. This view is being hotly contested throughout the market so be very careful here. If we do get a new high it could be a quick one with an even quicker reversal back down. If we get a new high it should mark THE high in the market and as such this leg up could end up being truncated (fail to make a new high) in some of the indices. In other words SPX could make a new high that's not matched by the DOW. That's all speculation at the moment. One leg at a time here and the first hurdle for the DOW is to stay above the uptrend line and get above its 200-dma. Any failure here could be significant and the drop could be very fast.

SPX chart, Daily

Like the DOW, SPX is fighting a broken uptrend line but it's more bullish in that it has not yet tested its 200-dma and today barely closed above its 50 and 20-dma's. I'm assuming for the moment that SPX will continue its rally and depict on this chart that it will top out near a Fib zone of 1263-1267. That's also speculation at the moment but it fits the current pattern. If we were to see a flare-up to a new high that was met with negative divergences on the daily chart, it would likely set up an excellent shorting opportunity. For the time being we need to watch the current rally to see how it develops. Longs should have one foot holding the exit door open at all times. Do not get complacent here as surprises will soon be nasty ones to the downside.

SPX chart, 120-min

A closer view of the August decline shows SPX has broken the downtrend from August 10th. The next downtrend line from August 3rd sits near 1230. I suspect SPX could hit this downtrend line, pull back, and then launch a higher rally. It might even pull back a little over the next day or two and create the right shoulder of an inverse H&S pattern with the neckline at 1227.

Nasdaq chart, Daily

I was looking for a pullback to about 2100 for a retest of the broken neckline at that level. It didn't quite get there and now looks like it's getting a fairly strong bounce. On the shorter term charts you can see that it too broke its August down trend. If the trend line along the highs since January 2004 gets tested again and price fails there, especially with a negative divergence on the daily chart, it will look like a double-top failure and would make an excellent shorting opportunity.

SOX index, Daily chart

I show the SOX also making a new high over the next couple of weeks but it needs to get in gear soon. The pattern to the upside is looking very choppy and corrective, as though it's about to fail at any moment. It may be one of the sectors that doesn't make it to a new high (which would be a truncated 5th wave (wave-(v) on the chart), a particularly bearish signal). This sector could be our canary in the coal mine.

VIX index, Weekly chart

I showed the VIX monthly chart last week and now I'm zooming in a little on the weekly chart, so "price" action since 2003. This index shows how you can't use it as a market timing tool. Ever since it dropped below 15 there have been many people trying to short the market based on this. One look at 2004-2005 shows how unsuccessful that would have been. But it is a huge warning and says we should be very careful with the upside. Play it for short term upside gains to be sure but understand we're in a riskier market than the one we saw in 2000. Currently, the weekly stochastics looks ready to roll back over and this while VIX is at the top of its descending wedge pattern. It looks like a pullback in VIX is on the way which would support a bullish equity run.

As mentioned earlier, it is very difficult to trade the market on your gut feelings. You need to understand that your gut feelings are not that much different than most everyone else who trades the market. When you're afraid, so are the majority of traders. When you feel elated and in a buying mood, so are the majority of traders. Its a lot more difficult to be a contrarian than most of us would like to believe. For you pilots out there who have been trained to fly an airplane on instruments, you can relate to the analogy of "flying" this market on instruments and ignoring what your inner ear and butt are telling you. I've been in many situations flying in clouds or dark dark nights where I swear my instruments are lying to me. The only way to successfully fly (read: live to fly another day) is to ignore your gut and fly the instruments. It's the same thing with the market. Our instruments are our charts. Ignore your feelings about why the market should rally or sell off. Ignore the sentiment, VIX, chat rooms, CNBC, and fundamentals. The charts already reflect what you need to know. Whether you use moving averages, trend lines, Fibonacci, Elliott Wave, Gann, oscillators or a hundred other indicators on the charts, use them consistently through all kinds of market conditions and you learn to trust these instruments. There's a reason it takes 3-5 years to become a successful trader. It takes at least that long to experience the multitude of market conditions to test yourself with your instruments.

As much as I malign Greenspan, even he got it right by saying investors should not be lulled into a false expectation that the good times will last forever. In his case he created the good times (bubble) and then warns everyone of their irrational exuberance. But his point is that we get lulled into a complacency that would kill anyone in a more dangerous environment, be it a pilot, iron worker or stunt person. Complacency in our business loses us money. There are many people who have been lulled into thinking that the current bull market will just keep on truckin'. There are too many warning signs that the bull market is ending, including, or most especially, the housing market. People can't fathom that it will end. And again, bubbles don't tend to end well and we're still in a stock market bubble which is now joined at the hip with the housing market.

Human beings have reacted consistently the same way over the ages and the bubbles of the past have all seen the same consequences and in the same reactionary pattern. We're about to repeat history and most people don't see it coming. But speaking of repeating past patterns, one of the biggest reasons investors want to be bullish the current stock market is because this is 2005. Since 1941 all years ending in 5 have been up years. There was a market analyst that declared in June or July that it was time to buy stocks because this is 2005 (he was just one of many to publicly state this). His reasoning was that the worst performing year ending in 5 was up only 9%. That sounds pretty good and a lot of people buy into this theory, literally.

But here's a little factoid that no one seems to be talking about: every year since 1885 where the year ending with 5 that was an up year was also up at the end of August. Every time. Except this year. The DOW started 2005 at 10,783 and finished August at 10,482. SPX started the year at 1211.90 and barely saved itself a similar fate by closing August at 1220.33 after closing at 1208 the day before. The COMP started at 2175 and closed August at 2152. So, by historical standards we're in trouble. The pattern of years ending in 5 being up in August has now been broken. And if that pattern is broken why should there continue to be an expectation that the end of the year will be up anyway? Because it's different this time? I'm sure we'll hear yea, yea, that's it, it's different this time. If we're in a major secular bear market, as I believe we are, and the past 3 years have been nothing more than a correction to the first leg down in this bear market (which is a cyclical bull market), then the "popping" of this decennial pattern would appropriately be done in a major bear market. And the popping of this pattern would likely signal a popping of the bubble. In other words the failure of this very long term pattern could be a spectacular failure in the market. The reason this could happen is because so many people trust that it will work, will be positioned for it and will wait until it's too late before they bail. And when they bail it will be because there will suddenly be a general recognition by the masses that it has failed and there will be a sudden rush for the door. And it's usually an outside shock to the system that sparks the exodus.

I do not believe we're close to this recognition point. In fact one of the reasons I'm thinking we'll rally into September, as hard as that is for me to believe, is because the August decline has set up a buying opportunity for the fund managers. Even with a late September/October swoon, most will believe this is a good buying opportunity. I think the rally this week is based as much on this as anything else. Why else would the market rally in the face of rising crude prices and the Katrina disaster this week? If the Elliott Wave pattern plays out as I think it will, we will top out by mid-September, whether or not that's at a new high, and then start down into October. We'll get a rally out of an October low with the expectation that it will mark the next buying opportunity (Octobers have many times marked important lows that then launch major rallies into the following spring) but it will fail at a lower high and we'll drop hard into the end of the year, ending the year negative for the first time since 1941. The realization of this will shock the players and unnerved they will start dumping big time in December.

That's all speculation obviously at this point but from a mass psychology standpoint, which EW analysis measures, it makes a lot of sense right now. Having a down year in August is just another piece of the puzzle that fits perfectly into place. A rally now into September that convinces the majority that we'll have an up year is the next piece of the puzzle that is needed so I'm waiting to see how that develops. As this picture puzzle changes I'll keep you advised. It could be a very interesting year and for players who are comfortable with the short side, it'll be a very good year coming up. Unfortunately it will also indicate our economy is in serious trouble and I don't want to see that. But we trade for a living and we have to learn to block our emotions and trade what we see. Trust your instruments. So, onto the rest of the charts to see what the other sectors are telling us:

BKX banking index, Daily chart

The banks got a strong bounce over the past two days based on the theory that a steepening yield curve will improve their profitability. This is based on short term rates dropping faster than the longer term rates, which in turn has been based on speculation that the Fed will relax its stance on the need to continue raising rates. So we've got the banking index trying to get back above its broken uptrend line from October 2002. This is an important long term trend line and the ability to get back above the line, or not, should be telling for the short term direction of the market. The next hurdle will be its 200 and 50-dma's, again.

Oil chart, August contract, Daily

Oil continues to struggle at the top of two parallel up-channels, which intersect just above $70. While oil has pressed higher than its mid-August high, the oscillators are showing a negative divergence. If oil were to drop back down now, watch for support at its steeper uptrend line near $65 where I would expect at least a bounce. If that uptrend line eventually gives way, the lower one should provide support around $60. The oil stocks themselves are showing more bullishness and this might mean oil will break higher out of its two channels and I would view that as the blow-off top in oil.

Oil Index chart, Daily

I didn't expect to see a new high in the oil index after its high in mid-August. Whether or not this index is in the final stages of a blow-off top is too hard to know here. It certainly looks like it's not ready to be shorted! Some of the bullish factors behind this index today was the fact that the refiners got upgrades today. I don't like the stretched look of this index to the upside and therefore can't recommend buying it here but if still long this index just keep following it up with your stops.

Transportation Index chart, TRAN, Daily

The Trannies are getting hurt by the high oil prices. The airline index is getting creamed. As expected from last week's chart this index dropped down to its 200-dma and looks to be finding support there. The last daily low was met with bullish divergence. I show another rally leg to a new high which I'm not as sure about as say the SPX. However, if oil does in fact pull back a little more steeply, this index could get a nice goose to new highs. The next bounce should provide some clues in that regard.

U.S. Home Construction Index chart, DJUSHB, Daily

Last week it looked like this index was getting ready to bounce and I thought 940-950 would be logical support by its trend lines. The spike in buying of bonds and the resultant drop in the 10-year yield has this market all excited that the good times are still going to roll in. Don't get suckered in on this one. After the steep impulsive decline we should get a good bounce but I would look at it as a great shorting opportunity. An impulsive decline will be followed by another one and I suspect this index will continue down to test its 200-dma (which I expect to break soon thereafter). The coming bounce will be the one that typically pulls the bulls back in in force because they think the correction is over. Don't believe it.

U.S. Dollar chart, Daily

The US dollar broke its 200-dma today and did so with gusto. This is an important break and is likely telling us we're into the next larger leg down. It will likely find support just below $86 and give us a bounce that lasts a few weeks but the decline should continue into the end of the year. The large two-day decline was also a result of the slowdown in manufacturing activity, which had already reacted to yesterday's slowdown in the Chicago PMI data.

Gold chart, August contract, Daily

Sector action was mixed today, right down the middle and is a reflection of the flat day we saw in the major markets today. The green sectors were led by the gold and silver index, biotechs, energy, utilities, brokers and financials. The red sectors were led by the airlines, the SOX (semiconductor stocks got a downgrade by Prudential today to Unfavorable from Neutral), retail and computers.

Starting the day this morning we got several reports from retailers and they disappointed many even though there were some upside surprises. Wal-Mart (WMT 45.01 0.05) reported sales in line with expectations while Nordstrom (JWN 34.40 0.82) beat the consensus nearly two-fold. There were also good results reported by Dress Barn (DBRN 25.25 1.25), CVS (CVS 29.94 0.57) and Abercrombie & Fitch (ANF 55.41 -0.20). But Gap (GPS 18.56 -0.45) has continued to disappoint. So the consumer discretionary sector was down again today (-0.98%), dragged down by this underperforming retail group. But home improvement retailers were a bright spot within the red sector, helped by Katrina-induced gains in Home Depot (HD 40.62 0.01) and Lowe's (LOW 64.66 0.35).

The semiconductor's downgrade by Prudential this morning seemed to set the negative tone in that sector. But the energy sector received an extra boost after Lehman Brothers upgraded several refiners. Investors continued to favor utilities ( 1.38%) for its defensive attributes. And gains in diversified metals, steel, gold, and aluminum gave the materials sector ( 0.35%) a boost. The financial sector ( 0.31) benefited from the steepening yield curve.

Tomorrow's economic reports include the following:

Watch the pre-market reaction tomorrow morning to these 8:30 AM reports. Part of the reason for today's consolidation might have been some worry over tomorrow's numbers. But it's also a summer Friday and we've seen how boring these days can be. With the continuing light volume days we are subject to spiky price action and whipsaws. These days are usually best left untraded unless you see a really good setup. Just keep those stops tight, trade lightly and be quick to take your money off the table. Continue to make base hits until we're set up well for some longer term positions where a few fat pitches will be made available and you can point to the stands before stepping up to the plate and taking a swing. Good luck.

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