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Market Wrap

Just Another Opex Thursday

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This has been a busy week with economic reports and this morning's reports had the potential to really swing the market. But from the opening bell the swings were small and they got smaller as the day progressed. It was a typical opex Thursday where prices are pretty much pinned for the day as options are settled, especially since S&P options effectively stop trading on Thursday with settlement at Friday's opening print. Friday's tend not to be much different as the remaining options expire and again prices tend to get pinned to prices where we see high open interest.

This morning was busy with several economic numbers. The August inflation numbers were released and showed core inflation, which excludes food and energy prices, remained tame in August with the index rising 0.1% for the fourth straight month, slightly better than expected as economists were looking for a 0.2%. The 0.5% rise in the overall CPI was as expected. Higher energy prices pushed the overall CPI to a second-straight 0.5% increase. A "bigger whopper" can be expected in the September CPI, said Rick MacDonald, head of research at Action Economics.


Candlestick chart of the NASDAQ QQQQ

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In the past year, the CPI is up 3.6%, the biggest year-over-year increase since early 2001. The year-over-year increase is heading above 4% for the first time since 1991, MacDonald said. But the core rate is up a more modest 2.1% in the past year, the same as in July. It is generally expected that the core rate will increase in the coming months, especially if Katrina ends up boosting gasoline, food and shelter prices.

Energy prices increased 5% in August, the biggest increase in more than two years. The bulk of the data though was collected before Katrina hit so the impact of higher retail gasoline prices has not registered in these numbers. In August, gasoline prices jumped 8.3% and are now up 31.3% in the past year. Natural gas prices rose 2.7%; fuel oil prices increased 4.1%.

The Labor Department reported real average weekly earnings fell 0.5% in August, and in the past year, down 1.1%. Food and medical prices were unchanged in August. Transportation prices rose 2.2% on higher fuel prices and new car prices fell 0.5%, while airfares fell 2.2%.

The Labor Department also reported unemployment claims, which the market immediately discounted as grossly inaccurate since it obviously did not include the Katrina impact. It said new claims increased by 71K to 398K last week. As soon as the evacuees can find a computer and/or an unemployment office, watch that number skyrocket.

Then we got the Empire State index of manufacturing sentiment which fell to 17.0 in September from 23.0 in August, slightly ahead of the consensus 16.6. The new orders index fell to 13.1 versus 33.8 in August. The job index was 12.9 versus 10.2 in August and prices paid index was 53.4 versus 29.0, making it the highest since March.

The Commerce Department said business inventories fell 0.5% in July as auto dealers sold off their stockpiles.

Later in the day we then got the Philly Fed index numbers which showed a drop from 17.6 in August to 2.2, below the consensus 12.3. Philly new orders dropped to -0.5 versus 19.8 in August and prices paid increased to 52.7 versus 25.9 in August. One of the concerns about the increase in the prices paid component in the manufacturing reports is that it raises the prospect of inflation entering the picture. The problem for businesses is that it erodes the value of fixed-income payments and may force these businesses to pass along the higher costs (e.g., higher fuel costs) to consumers. This then provides the Fed with an incentive to keep raising rates in their effort to fight the inflation monster (which they're creating as I'll discuss later). The bond market reflected this concern today with a bit of a sell off which raised interest rates.

Lastly, we received some natural gas inventories which showed an increase of 89 Billion cubic feet (Bcf) last week. The price of natural gas dropped 1.9% to $10.95/million BTU's after an $11.37 high. This is from the EIA site: "Working gas in storage was 2,758 Bcf as of Friday, September 9, 2005, according to EIA estimates. This represents a net increase of 89 Bcf from the previous week. Stocks were 102 Bcf less than last year at this time and 98 Bcf above the 5-year average of 2,660 Bcf. In the East Region, stocks were 30 Bcf above the 5-year average following net injections of 58 Bcf. Stocks in the Producing Region were 28 Bcf above the 5-year average of 739 Bcf after a net injection of 22 Bcf. Stocks in the West Region were 40 Bcf above the 5-year average after a net addition of 9 Bcf. At 2,758 Bcf, total working gas is within the 5-year historical range." The bottom line is that inventories were up and prices were down. It would obviously be nice if that continues.

Whew, and after all that, the market did a "yea, so what" and proceeded to have a very boring sideways choppy day which makes it look like a pause before another leg down tomorrow morning. But I'm anticipating a bottom for the decline in short order and believe we'll get another rally leg started. Let's see what the charts are telling us.

DOW chart, Daily

The whole rally up from the April low looks like a big bear flag, and that's what I consider it. The only question in my mind is where the rally will finally top out, if it hasn't already. My preferred EW count says the current pullback will be ending soon, perhaps with another dip tomorrow morning, and then one more rally leg to a new high above July's. There's a Fib projection up at 10892 which seems awfully far away at the moment. The DOW needs to hold here though, at its 50 and 200-dma's, in order to maintain a bullish picture.

SPX chart, Daily

SPX has been hammering on its 50-dma the past 2 days so it too needs to hold in order to maintain its bullish EW pattern. Assuming it holds (perhaps one more minor new low tomorrow before a reversal back up), I'm looking for a rally up to a Fib projection zone of 1263-1268. I had hoped it would accomplish this in a Fib turn window of Sept 16th /- 2 days (which therefore includes the FOMC date of Sept 20th. But with Sept 16th being tomorrow, it's possible this turn date will mark a low instead of a high. This is speculation at the moment since obviously price needs to turn back up and make a new high.

SPX chart, 120-min

A closer view of the Sept rally and pullback, we see price stopping (so far) at the broken August downtrend line. A successful retest here will look like a kiss goodbye and would be very bullish. The pattern doesn't turn very bearish until the August low is taken out so anything could happen here.

Nasdaq chart, Daily

The techs are in a very similar pattern as the DOW and SPX. It needs to bounce now in order to maintain a bullish pattern. The daily stochastics certainly is not painting a bullish picture. A continued drop would likely take it right back down to 2100 quickly.

SOX index, Daily chart

I've been expecting one more rally leg in the SOX to finish an EW count that is looking for a 5-wave move up from the April low. The 5th wave could truncate and not make a new high so be alert for topping at any time. If the broader market and the techs rally I expect this one will as well. If we get a similar topping pattern at the last high in August, where the last high was met with a negative stochastics divergence, then the current pullback will lead to one more new high. If you see a similar divergence as the SOX rallies to a new high up near the top of its channel, it'll be time to get shorty.

Money will likely flow into this index and the rest of the market if investors begin to think the Fed is on their side (hold off on any further rate increases). One of the biggest questions/debates right now is what the Fed will do next Tuesday. Be flat going in but be ready to ride the direction it takes after that--it could be a big one.

I recently read an article by Paul McCulley at PIMCO, and an analysis of McCulley's article by Stephen Roach of Morgan Stanley. It was quite enlightening to understand from someone who's highly respected in the bond market what he makes of the Fed's actions versus what the bond market is doing.

Last week I discussed the rock and the hard place the Fed currently finds itself. The rock is the asset bubble--the stock market which has now been joined by the housing market, both of which are inflated to historical extremes. A popping of the stock bubble would hurt the economy. A popping of the housing bubble would kill the economy. The hard place is the inflation monster breathing down the Fed's neck. So the Fed governors need to figure out which one to fight since they can't do both simultaneously. Consequently the Fed has been slowly raising interest rates in hopes of cooling down the speculation in both markets but primarily in the housing market. For those who may have missed it, I discussed this in more detail in last Thursday's Wrap.

At September's FOMC meeting the Fed needs to decide to either stay the course against inflation (and the housing bubble) or to pause and let the Katrina impact register. The few Fed speeches and comments we have had since Katrina make it seem as if they do not sense this is a big national problem from an economic health standpoint. They seem clearly more focused on inflation (and without saying it, the housing bubble). If this view prevails, it means they will continue to raise rates at the September meeting. But while the Fed has been raising rates the bond market has been thumbing their collective noses at the Fed (and showing with hand displays how many friends the Fed has). This has resulted in a "conundrum" for Greenspan who is highly perturbed that the bond market won't play ball with him.

Relative to this "conundrum", Paul McCulley at PIMCO has theorized, based on the "time inconsistency" thesis which won the Nobel Prize in Economics by Professors Kydland and Prescott, that the market doesn't believe the Fed anymore. Very simply the Fed has made threats that are no longer believable, just as a parent might threaten a child but doesn't carry through on the threat, or more accurately who immediately rescinds the punishment. The child very quickly learns to ignore the threat. What the bond market has figured out about the Fed and its concern about asset bubbles is that first the Fed denies there is an asset bubble while they are creating it with their easy money policies (reduction of the discount rate and flooding the economy with money). Then they tighten against these inflating assets, justifying their tightening actions based on conventional inflation-pressure models and data. And then when the asset bubble is obvious to everyone (usually when the mainstream media starts reporting what a wonderful investment opportunity it is) and in danger of bursting, the Fed will begin vigorously dropping interest rates. The bond market now knows the Fed's modus operandi. This usually results in interest rates once again swinging too far the other way with the Fed dropping rates in hopes it will be able to reinflate the assets so that they can have another crack at letting it deflate more slowly.

This over-reacting by the Fed (and everyone knows they over-react because they take too long to react) results in a time inconsistency problem and the bond market has figured out the Fed and its reactions. As Stephen Roach described it, "In a nutshell the bond market is asking itself why it should bearishly discount an ever-rising Fed funds rate, if an ever-rising Fed funds rate will very likely burst property prices, which will result in a reversal to vigorous easing." In effect the bond market is anticipating the next round of aggressive rate reductions and is front-running them. The net result of this is that the market is attempting to smooth out the Fed's over-reactions. The market really is a lot smarter than the Fed. The conundrum for Greenspan is that he doesn't get it.

Therefore, what the bond market has figured out is that if Greenspan continues to raise rates slowly, it will eventually hurt the housing market, and it will likely cause an inverted yield curve and bring on a recession, which is what the Fed has always done. McCulley feels the market will anticipate this and invert the yield curve for him, perhaps aggressively, making long rates lower and doing the opposite of what Greenspan is trying to do. Mortgage rates would then drop and housing prices would be held up and possibly continue their increase. But if we get an inverted yield curve that would hurt bank profitability and they might then have to reduce their loans or tighten standards for loans. That in turn could cause fewer mortgages, or reduce the number of qualified buyers. That could then hurt the housing market. As you can see, this is a highly complex situation and all the computer modeling in the world really can't answer how the consumer will react to all this.

All of this makes the decision about what to do with interest rates next Tuesday even more difficult. It's not so cut and dried as one might think. On the one hand, Katrina, and high energy prices, could have a negative impact on our economy and therefore the Fed should pause in its rate increase. Sounds like a simple solution. But if the Fed continues on its rate increase path, we'll know there are much deeper problems that the Fed is worried about. I think the Fed is in a very difficult spot (hence the rock and a hard place) and frankly is in a no-win situation. The market will do what it needs to do and that's wring out the excesses. It will likely be a painful process but a very necessary one and one the Fed seems hell bent on avoiding. We'll see who wins that battle.

This brings us to a potential reason the market has pulled back in the last week. If the market is sniffing out the likelihood that the Fed will continue to raise rates, the market is spooking itself. It sure looks like the banks may be figuring this out--this index doesn't look so healthy.

BKX banking index, Daily chart

The banks' pattern continues to look bearish, and after the failure on a retest of the 50 and 200-dma's it looks even more bearish. It's close to potential support at an uptrend line from the April low, near 97, so watch that level. A break down there will not look good for the broader market.

XBD.X Securities broker index, Weekly chart

We looked at this index a month ago because it's one of the best indicators of broader market health. This is a weekly chart so the last few candles show the past month's consolidation and I had expected another leg up to the top of the ascending wedge. Price did an over-throw of the top of the pattern and dropped back inside. This is a typical ending signal for these patterns so I'm on bear alert on this index. I would look for a couple of shorting candidates in this index. If a new rally leg in the broader market is not matched by the XBD and the TRAN, that would be an excellent bearish signal to get out of long positions and into short positions.

Before moving onto oil I should add a comment about the M-3 money supply which continues to experience a very large increase as the Fed attempts to juice the market and provide a very liquid response to the jolts the economy is receiving. Forget what they're doing with discount rates--the real action is what the man behind the curtain is doing, and he's printing money like it's going out of style (and if they keep it up, it will go out of style with the rest of the world). Here are some M-3 numbers to chew on:
-- it is up $10.2B the week of August 29th (before Katrina)
-- it is up $69.4B over the past two weeks (an 18.3% growth rate)
-- it is up $109.3B over the past month (14.5% growth)
-- it is up $102.6B over the past six weeks (11.8% growth)
-- it is up $197.9B over the past 3 months ("only" 8.8% growth)

The method of injecting this money into the banking system is for the Fed to buy stuff. It doesn't matter what they buy since whatever they buy puts the money into the system. Their preferred method though is to buy the market--bonds, stocks and currencies. Their preferred method of buying the market is to buy futures contracts. We now have a government that is actively involved in our "free" market. Down right scary. On top of that, the growth rates given above are clearly well above the inflation rate, and in fact it's hyperinflationary. M-3 is growing at 6 times the rate of GDP growth, 5 to 10 times the rate of inflation. And yet the Fed says they have to raise the discount rate to fight inflation. Greenspan is out of control and it's our children's and grandchildren's money they're spending.

OK, thanks. I needed to get that off my chest. Let's take a look at oil since it's near and dear to so many of us. While the core inflation rate might be tame, the fact that most of us depend on the use of energy in several forms, the price of oil is front and center with many of us, especially since its inflation rate has been quite high.

Oil chart, August contract, Daily

As expected, oil bounced off its uptrend line and 50-dma near $63. The 20-dma is just above at $66 so that's the resistance level to watch. If oil drops back below $63.00 it will look bearish, and a break back below $63 will likely mean it's headed to the lower uptrend line near $58-59.

Oil Index chart, Daily

We got the extra push higher in the past week which now gives us a completed 5-wave move up from the August low. This now calls for a pullback to correct at least the rally from August. Keep an eye on the uptrend line from May as I'm thinking it could break next. There's a decent chance this index has topped for quite a while. On a faster stochastics setting than what is shown on this chart, there is negative divergence on the last high. The weekly chart shows negative divergence against the March high. I'm getting a bearish feeling on this index, and if it starts to drop back, it could be forecasting oil's price drop.

Transportation Index chart, TRAN, Daily

This is one of the key indexes in that it's the one used for DOW Theory predictions for the broader market. New highs or lows in the broader market or in the Trannies that are not matched by the other is a huge warning flag. This year's earlier all-time high in the Trannies that was not matched by the DOW was a warning that something was amiss. Obviously this is not an immediate trading signal but instead is more of a warning shot across the bow. Now if the broader market rallies but the Trannies struggle to match it, which so far has been the case in Sept, then again that would be another warning signal. Eventually these warning signals will follow through and it's bearish for the market and for our economy. I do not see a major bull market run ahead of us, even if SPX rallies above 1250. Exceeding that 1250 level would pull in many fund managers but I think it would be one of the best bull traps the market has ever devised. Be careful if it happens.

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

The housing index is struggling to bounce back up to the top of its long term up-channel, which is also where the 50-dma and 50% retracement of the last decline all reside--right around 1025. The price pattern looks like it will press a little higher so it could be a tad early to short this index. A rally up to the 62% retracement at 1047 would have me watching very closely for a shorting opportunity.

U.S. Dollar chart, Daily

Sharp-eyed reader (thanks Joe) noticed that my chart did not have the correct locations of the 50 and 200-dma's. QCharts has a problem with some of the daily candlesticks and so I was using a 720-min all-hour chart to get the full candlestick patterns but unfortunately that does not give us the correct moving averages. So I'll use the daily charts from now on and we'll just have to deal with the candlestick gaps.
The U.S. dollar looks like it's going to make an attempt to bounce back up to its 50-dma again. A third failure there would be very bearish. If the dollar rallies above it then it will have its broken uptrend line to deal with up around 89.50.

Gold chart, August contract, Daily

With the strength of the recent dollar rally I'm surprised by the strength in gold. I had thought it was due a pullback but nothing doing. This chart continues to look very bullish and I would watch the daily chart for a pullback to buy gold.

The results of today's economic reports and tomorrow's economic reports are shown here:

Individual stock action was very quiet today. Earnings reports are essentially finished and it's too early in the cycle to start hearing about upgrades and downgrades. Bear Stearns (BSC 102.90 -2.46) got clocked even after reporting a better than expected Q3 earnings report but obviously not as good as expectations. This had a negative effect on the Financial sector's performance, especially on the brokerage index as was shown in the chart above.

Despite today's increase in bond yields, which typically diminishes the appeal of dividend-paying stocks, the rate-sensitive Utilities sector was one of the leading sectors today. Other green sectors were the gold and silver index, biotechs, oil service and transports. Leading the red sectors today were the airlines at the bottom of the pile and then the SOX, computer and software, and the financials.

Consumer Staples ( 0.3%) and Consumer Discretionary ( 0.2%) posted modest gains, with the latter getting a lift from Time Warner (TWX 18.50 0.58), a heavily-weighted component that increased 3.2% after divulging that Microsoft (MSFT 26.27 -0.04) may purchase a portion of America Online. McDonald's (MCD 33.45 1.09) takes much of the credit for the DOW's positive close, rising 3.4% today.

As I mentioned above, I'm looking for a little more downside tomorrow morning but for that to be quickly reversed to get a new rally leg started. I'm thinking the downside move should only be a couple of S&P points, perhaps to about 1222-1223 (20-dma is at 1222.75) and DOW to hold above 10,500. Any drop further than that and I wouldn't want to step in front of the decline. But if the above levels hold I'll be looking to buy it. If I've got the longer term EW count correct we'll get one more rally leg to finish this 3-year old bull market. It makes no sense to me why anyone would want to jump in long, considering all the negative factors facing this market. But there's a massive amount of Fed money coming into the market, and it will be put to work. There are many many fund managers who believe 2005 will be an up year, and they want to put their money to work. Disregard your bias and trade what price is doing. If price breaks above a downtrend line for this Sept pullback, buy it. Just remember that surprises in the market from now on will likely be nasty ones so always have your exit in mind. Watch overnight positions so you don't get caught in a situation where you stop is skipped over. At this point long positions should be considered short term. Hopefully we'll get some good longer term short plays that will set up soon.

I have mentioned several times in recent weeks a potential turn date of Sept 16th (based on Fib relationships between prior turn dates since DOW's January 2000 high). If the pullback finishes tomorrow then it will show that the Fib turn date is marking a low instead of a high. Lastly, a turn date can be a turn in the market or an acceleration in the market. Right now the longer term trend is up and therefore an acceleration of a move would be to the upside. I mention this possibility because of the possibility we'll see a blast to the upside. Why or how could that happen? If the FOMC pauses on their rate increase, and changes their language, you can bet the market will hit every short stop above 1250. It could be a blow off top or it could be just the start of a big rally that takes us to new all-time highs for the DOW. I seriously doubt that will happen but price rules, not me. We are in a very risky environment right now and emotions could cause some wild swings. Be very careful and continue trading lightly and quickly. Taking base hits is still the right way to go. No home runs available yet. Good luck in your trading.

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