Option Investor
Market Wrap

Getting Volatile

Printer friendly version

There's a good chance we're seeing topping action in the market and the volatile price action we've been seeing in 2006 supports this idea. Tops are rarely as clean as bottoms. Bottoms tend to form as a panic low with many investors unable to stomach it any longer and disgorge themselves of anything related to a stock. With no one left to sell, and short sellers covering, we then often see the classic v-bottom reversal. Then a retest usually follows which is followed by another strong rally. That's typical bottom behavior.

Tops are different. Tops are ugly. They're full of whipsaws as bulls and bears duke it out for control. Bulls are convinced life is good and that it will stay that way forever. Every dip is a buying opportunity. Bears on the other hand are flabbergasted at the stupidity of bulls. It's not that bears have a doomsday mindset but instead can't see the value of buying stocks where they are (or housing for that matter). When the music stops they don't want to be the one without a chair. Their feeling is that everyone knows stocks are overvalued and they can't fathom buying the stock market up here. So they sell every rally.

What we peons get caught in is the war between the titans. We're the little mice who scramble out of our holes to go steal a piece of cheese while the dogs and cats are distracted creating a fur ball in the middle of the living room. What we're seeing, I believe, is the fur ball. It's a classic topping process which I believe we're going through. The only question in my mind is whether we topped out in January or instead have another high ahead of us. There's little question in my mind that this market is topping out. While today's pullback at resistance looks bearish, it could be nothing more than just a pullback before it launches higher. It's all part of the battle going on.

So that explains the recent volatility and it probably won't get much better this year. Down markets are inherently less stable and the short covering rallies, helped by the bulls who believe we've found yet another bottom, create large buying spikes that then get reversed again. We've seen very low volatility for a long time and 2006 will likely start the swing back to the upside as measured by the VIX. If we're good and catch some of the swings, it stands to be a very profitable year. Catch the swings wrong and stay too long as the market goes against you and I can guarantee you'll be a hurtin' pup. I have lots of charts to review tonight since it's getting critical for direction here so I'm trying my hardest to nail down the pattern. Grab a cup of coffee and we'll work through them.

But first let's see what the economic reports were this morning. It's been a very quiet week as far as economics and earnings and that's another reason the market could flail around a bit as traders chase the latest rumor. Jobless claims data came out and showed initial claims rose 4K to 277K which was smaller than the 12K rise that had been expected. The 4-week average dropped to 276,500 which is the lowest it's been since April 2000. Continuing jobless claims fell 34K to 2.54M which is the lowest since March 2001. New claims are down about 13% vs. this time a year ago while continuing claims are down about 7% year-over-year. This is good news for those trying to find work. But I continue to be amazed at the parallels between economic numbers that haven't been this good since just before the stock market took a nose dive and today's market as looks to be topping. Maybe it's just me.

Wholesale inventory numbers came out at 10:00 and they showed inventories were up +1.0% vs. +0.5% expected and November was revised up +0.5% vs. the previous +0.4%. But wholesale sales also rose, up +1.0% vs. -0.7% expected so the inventory-sales ratio stayed the same at 1.15.

About the only other financial news worth reporting was the 30-year Treasury Bond sale today, which saw strong demand, after being absent for more than 4 years. The 10-year and 30-year bonds saw a brief price spike and dip around the time of the auction (1:00) and then settled higher on the day, the 30-year more so than the 10-year, so yields dropped a little today. The yield spread between the 2-year and 10-year remains very close, currently 4.65 for the 2-year and 4.54 for the 10-year which of course is inverted. The 3-month yield is at 4.51 and it is this yield as compared to the 10-year yield that is important to watch. If the 90-day average of these two show an inversion then a recession is virtually guaranteed in the next 6-9 months.

OK, onto the charts and let's see what's brewing in this pot of a market.

DOW chart, Daily

I see bearish signs all over this chart. I was trying hard to find reasons for this market to rally to a new high and I'm struggling. For almost a month now I've been thinking the DOW will rally up to about 11200-11300 before calling it quits but I'm beginning to think it might not happen. The top in January seemed "too cute" and I thought the bears would get one more spanking before rolling over. That could still happen and we're close to finding out. The DOW almost did it today by rallying above the downtrend line from January but then it immediately fell back below the line. Price is holding above the 50-dma at 10852 so if that holds tomorrow we could see this press higher.

And higher is where the DOW needs to go. As drawn on the daily chart, it appears we're hammering out a top in a bearish diamond pattern. This is a bearish reversal pattern seen at major tops. This next chart zooms in a little closer on this pattern.

DOW chart, 120-min

Here's a quote out of "Technical Analysis of Stock Trends" by Edwards and Magee, and how they describe a diamond pattern: "it is usually a reversal pattern...It could be described as a complex head-and-shoulders pattern with a v-shaped (bent) neckline...The overall shape is a four point diamond. Since it requires a fairly active market, it is more often found at Major Tops...The right side of the pattern should clearly show two converging lines with diminishing volume." Notice the volume pattern on this chart. Need I say more?

SPX chart, Daily

SPX bounced above its 50-dma at 1269 but couldn't hold onto it and that's bearish. It tagged its broken uptrend line from October at today's high and then dropped back, giving us the appearance of a kiss goodbye. Daily MACD looks bearish. It's hard to see but the daily candle is a shooting star at resistance. It is a particularly bearish shooting star with a long tail and a red head. Beware the red heads. About the only thing I can say when I look at this chart is that if it rallies back to new highs tomorrow it will be because the bearishness of it is too obvious and it will catch the bears flat-footed. Be careful here but I wouldn't want to be long.

SPX chart, 120-min

I'm showing a little closer view of the decline since the January high. First thing that's obvious is that it's holding to a parallel down-channel. This immediately suggests SPX might not find resistance until closer to 1283 at the top of the channel. The daily chart says otherwise but be aware of that possibility here. Second thing I wanted to show is the EW count for the current decline. This is for you EW followers, and understand there are alternate wave counts that portend higher prices not lower. But the significance of this count is that it is set up for a 3rd of a 3rd wave down and these are known as the screamer waves. If you're on the wrong side of a 3rd of a 3rd wave, you'll be screaming, trust me. The setup is there and now we'll just have to wait to see if we get follow through and if we do we're about to get a very strong and fast decline kick into gear.

Nasdaq chart, Daily

The techs have some bullish qualities to their charts, and of course some negative qualities as well. First, price holding above the trend line across the highs since January 2004 is bullish. Second, sorry there is not second. The bears win in this chart as well. Price was unable to hold above the 50-dma at 2266. Price came up to give its broken uptrend line from October (I'm ignoring the spike down on Jan 3rd when drawing that line) a kiss goodbye today. MACD continues to look bearish. This could be headed for 2200 next. Best case is that it might chug along sideways as we head into opex next week. Marc Eckelberry watches open interest on options very carefully and feels we have a lot of put support underneath us and I find it hard to argue with that logic. As I had mentioned on the Monitor, the only way I can see the market dropping, and dropping fast, when we have lots of put support (which is also true on the SPX), is if the market makers who are short all those puts have to sell the market short in order to protect their positions. That's when the bottom falls out.

NYSE chart, Daily

I'm showing the NYSE tonight because it's the granddaddy of the markets, along with the Wilshire 5000. It's a truer reflection of the market. The bullish thing I see is that the 50-dma is holding. The bearish thing is that it came up to its broken uptrend line from October and gave it a kiss goodbye. It too has left a bearish shooting star candle at resistance. Confirmation of that candlestick pattern is a red candle the next day so if we get a down day tomorrow and you're long this market, I wouldn't be. Just remember a receding tide drops all boats.

SOX index, Daily chart

First glance at this chart and I thought well we at least have one bullish chart. But then a closer inspection got me to think otherwise. The near retest of the last high is leaving a bearish divergence that will only be negated if price keeps rising. Bearish divergences at the last high already make this rally suspect. But if it somehow surprises us and makes a run for the roses, I see an upside target at 573. And if the SOX is rising while the broader market is sinking, I'd go with the SOX as it's usually a leader in the market, whichever way it's going.

BKX banking index, Daily chart

The banks are in a new parallel down-channel now and today's bounce stopped at the top of the channel. Daily oscillators look ugly as each bounce is knocked back at a lower high. This is potentially building up a very bearish wave count and suggests we could see a flush to the downside soon. Either that or it's pulling back correctively and getting ready for another rally higher. Take any break out of this down-channel seriously as it could be a heads up the rest of the market is going to rally to new highs as well.

Before I move onto the other charts, I said last week I'd finish up my discussion on contrarianism. In light of the bullish mood in today's market, it's a bit difficult to think bearishly about it. That's being a contrarian and it's hard. In fact we writers often get hate mail from the bulls and we're accused of being negative and pessimistic, baby killers even. Jim has shared that we've lost readers because they can't stand to hear bearish things in a bullish market. It's hard being a contrarian, but it usually saves you money and may make you a ton. Last week I had mentioned how painful it can be and that it registers in the brain the same way physical pain does. To go against the crowd means ostracizing yourself and you need to be prepared for emotional disagreements if not ridicule. For long term investors it's important to know when the market is set up for better than average returns and when it's set up for below average returns. One of the ways to help determine that is to look at investor sentiment.

Many studies have been done on this subject and the gist of them is that when investor sentiment is very bullish it's time to be worried about the market. When people feel good about the economy, their jobs and life in general they tend to view things in a bullish light. Measures such as consumer sentiment track very closely (albeit with a time shift) to the stock market. Equity prices are determined in large measure by investors' perceived risk in the stock market. Many will argue it's all about fundamentals but I argue the exact opposite. People's attitudes affect everything we do including the buying and selling of stock. The fundamentals of a company (its business) follow general consumer attitude. It's why we see completely opposite reactions to the same kind of news at different periods of time.

So equity prices are largely dependent on investor mood and as investor mood reaches a fevered pitch, where we see high bullish sentiment as compared to bearish sentiment, it's not a far-fetched idea to think that equity values are pumped up higher than when investors are feeling worried about the market. As people feel safer about the stock market as a good investment the riskier it becomes. As more and more people perceive the stock market to be low risk, the more they're already into the stock market. Once everyone is in, where does the new money come from? One of the reasons I like to use Elliott Wave analysis as one of my tools is because it measures the ebb and flow of investor behavior which in turn dictates stocks prices. The stock market is an excellent reflection of social mood. Stock valuations are less driven by fundamentals and more by the perceived risk in that stock by investors. And therein lies the reason to be a contrarian.


31 Closed Trades; 28 Winners

Jonas Ferris picks good companies whose insiders are buying, too. With this record, it's easy to see that tracking insiders works; now see how we make it easy.


There is a negative correlation between how comfortable people are about the stock market and its performance over time. As the majority turn bullish, which means the majority are now invested, the performance of the stock market underperforms the historical average. And just the opposite of course is true--as investors turn mostly bearish, meaning the majority have sold out of the market because of the perception that it's too risky, that's actually the best time to invest. That's when bottoms are found. But being a contrarian and buying the bottom can be a very painful experience. First, if you buy too early you'll likely regret it, and second, your trading buddies will think you've lost your senses. If the market is high and investor sentiment is high (think now), and you want to sell all your stock holdings, you will suffer ridicule (and maybe some lost profits).

It's interesting to note what investor sentiment is telling us right now. What are we hearing as the great places to invest? I hear we should be investing in Asia. Japan is especially hot, and it's mostly foreign investors in the Japanese market. Growth stocks and small caps are hot. Therefore as a contrarian where do you want to invest right now? Not in Asia and you want to move out of growth and small cap and into value stocks, those stodgy old boring stocks that pay dividends. Oh gag me with a spoon most of you are saying. If so then you're not being a contrarian. When consumer/investment sentiment turns sour and NYSE P/E gets back under 10 and the relative pricing of value vs. growth gets close enough to justify a switch then you rotate back into growth and small caps and you'll do it when it feels like absolutely the worst time to own ANY stocks. BTW, right Now might be the worst time to own any stocks.

Studies have shown that the difference between when you buy stocks can mean a 10x difference in results. When people feel comfortable about the market, and volatility is low as measured by VIX, the returns on equities is less than 1.5% per year over the next 10 years. But when people are horrified at the thought of owning stock, and volatility is high, returns on stocks purchased at that time then average over 15% per year for the next 10 years. We are in a period of excessive bullish exuberance about owning stocks. At best we'll be in a flat market (S&P 500 was at 1200 in 1998 and look where it is today). Index funds have been flat for the past 8 years, with a "dip" and a climb in between. When the market sells off long and hard and it feels like you must be nuts to consider getting into stocks, that's the best time to start building up your stock portfolio. When things are too bullish and valuations are high (as they are now), it's time to start paring back on your stock portfolio to protect your capital.

As for what to do now, excessive bullish sentiment that continues in this market is telling us to be looking elsewhere for our investment money. But don't put it in real estate. Talk about bullish sentiment!

Talk about Centex offering $75-100,000 discounts if buyers bought that Saturday. How do you suppose homeowners who recently purchased homes there now feel about lopping $100K off their equity?

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

After breaking down from its bear flag pattern the home builders are wasting no time on the next leg down. Price is currently stalled at the uptrend line from October 2004 and it's at about the right place to see a small sideways/up consolidation before it drops lower. The wave count in the leg down is shaping up for a low at the uptrend line from March 2003 at 824. This is also where the potential H&S neckline is located, shown more clearly on the next chart. We should see a bounce off that level, which might then find resistance at this trend line it's currently holding at, before finally breaking the neckline and heading lower into the summer.

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

This weekly chart of the home builders is to show the potential H&S pattern. On a weekly chart these patterns are significant since they're usually associated with major tops. The downside projection from this pattern would be down to the 500 level which is "only" back to the 2004 lows.

Oil chart, March contract, Daily

After briefly testing the January high, and leaving a negative divergence in its wake, oil has turned down hard. The 50-dma at 63.28 did not hold. The 200-dma at 61.70 and uptrend line at 61.40 will likely support the drop. After a bounce from that level I expect oil to break its uptrend and head lower.
Natural gas prices continue to nose dive. Price is now reaching down towards early 2005 prices. Yesterday's low was $7.30 while today's closing price (March contract) was $7.54. Bullish divergences on the daily chart though suggest this is getting ready to bounce. Today's report on NG stocks showed that inventories fell 38 Bcf which might have explained the small bounce today.

Oil chart, March contract, Weekly

The weekly chart of oil shows that it could be seeing a major turn here. The oscillators suggest a longer term turndown is in the works and why I believe its uptrend line will break. As I've mentioned in the past, a significant drop in the price of oil would be predicting a global economic slowing. A drop in oil price with a concurrent drop in equity prices makes abundant sense to me.

Oil Index chart, Daily

With a fast drop in the price of oil it's natural to see the oil stocks doing the same. Price has dropped to the 50-dma and could be setting up a bounce. It might only do a sideways/up consolidation as it works off some short term oversold conditions. Like oil I expect this index to continue lower.

Transportation Index chart, Daily

The Transports, thanks partly to airlines, liked the drop in oil but the bounce is so far looking corrective. The decline should continue and the 50-dma and uptrend line from October, both near 4200 would be the next downside target.

Transportation Index chart, 120-min

A little closer view of the pullback in the Trannies shows price dropped below the bottom of a parallel up-channel and today bounced back to test it. This chart suggests more downside tomorrow.

U.S. Dollar chart, Daily

The US dollar has stalled at its previously broken uptrend line from March 2005 and looks ready for a little larger pullback. It may press to a minor new high (it's being supported by its 50-dma currently) before it pulls back. Once it corrects the current bounce it should continue higher.

Gold chart, February contract, Daily

Gold has peaked, finally, for sure, maybe. Finding a top in gold has been a challenge but I think this one is it. By breaking the uptrend line from the December low, that leg up is done. With that leg up being done, the larger rally from last July is finished and that means we should now see a multi-month decline in gold. A typical retracement is back to the apex of the previous 4th wave which played out through last summer, and that's at $440. Obviously that wouldn't happen in a straight line, in fact far from it. It will probably be a volatile choppy decline. First support is at the 50-dma and uptrend line from November, both of which may coincide around 539 by the time price gets there. Today's bounce may have been a good opportunity to unload some of your long positions if you're a gold trader.

Results of today's economic reports and tomorrow's reports include the following:

Tomorrow finishes a week that has been quiet in terms of economic reports. We will only have Trade Balance numbers and the Treasury Budget numbers, neither of which will move the market. The market will just have to find its own catalyst.

Today's internals showed a very flat market which of course is not the way it started out. But the afternoon pretty much negated the morning session. Advancing volume and issues as compared to declining volume and issues came in virtually tied. It's interesting to watch what's going on with NYSE new 52-week highs vs. lows. Yesterday's rally was met with fewer new highs than previous days. In fact the number of new highs has been dropping since it peaked on Jan 27th but price didn't peak until Jan 31st/Feb 1st. New annual lows have been slowly increasing in number since the spike low on Jan 3rd. So even though NYSE was rallying during January to new all-time highs, the number of new annual lows was increasing. This was negative divergence and did not support the new price highs (which can also be seen in the bearish daily MACD and RSI readings). But today the number of new highs took a jump while new lows dropped. If that kind of behavior continues, don't trust any decline that we might get. It will indicate potential accumulation to be followed by a ramp-up in the market.

Sector action was also mixed today. Leaders to the downside were the energy indexes, computer hardware, disk drives and biotechs. Leaders to the upside were the gold and silver indexes, Transports, airlines, internet, utilities and healthcare.

As for tomorrow, if today's high was the end of the correction to the decline from Feb 1st, price should continue lower. Any bounce should not exceed a 62% retracement of this afternoon's decline otherwise there will be a good chance the rally will continue. We hit some firm resistance levels today and tomorrow's price action will tell us if it's just a pullback or something more significant. If it's to be something more significant we could see an acceleration lower as the potential EW count suggests we could be perched at the edge of the cliff, about to take a beautiful swan dive off it. But the market could chicken out and not dive off the cliff and continue climbing higher. The climb higher will only mean a longer dive to the ocean below but that would be another day. Be careful since it could get even more volatile in the near future. Good luck and I'll see you on the Monitor.


Market Wrap Archives