Option Investor
Market Wrap

Distribution Day

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Today's market had distribution written all over it. The Boyz are good at what they do. They want to unload their inventory without panicking the herd. In fact they need the herd (the retail crowd) to take their inventory from them. We can't have any scary sell offs otherwise we end up with a no-bid situation. So they hold the market up with one hand by doing some strategic buying in the indices while selling off their inventory with their other hand behind their back so you can't see them. Masterful. For example, why was GM up 2.4% today? Is it really a buy at these levels? Or is it more of an effort to prop up the DOW and keep it in the green? It would be fun to have the horsepower to do that.

Why do I say this? Take a look at the internal measurements of this market today in the chart above. You can't tell a book by its cover and you can't tell a market by its price. Look under the hood to see what that clanking is that's going on inside the engine. It may be obvious while at other times you need to use a stethoscope to listen carefully. The advancing volume to declining volume was hugely in favor of declining, almost 3:1. This follows yesterday's 2:1 advantage to sellers yesterday. I normally keep an eye on this chart to tell me when either the buying or selling is becoming excessive.

Advance-Declining Volume chart, 30-min

The horizontal lines at the top and bottom of the chart tell me when the market is at least temporarily overbought and oversold and to watch for a correction the following day. Typically price follows this indicator and I look for confirmation or divergence. The drop on February 28th and the rally on March 1st mirrored the internals. Today we had a major divergence and I consider it bearish for price. The chart shows we got into "oversold" today and yet price stayed flat. The DOW was even in the green. We had major selling going on behind the curtain but they were able to hold the DOW in the green. Shhh, don't scare the sheep...baaa.

Take a look at some of the other numbers. Advancing issues got swamped by declining issues nearly 3:1. New 52-week highs and 52-week lows are running neck and neck for the first time since last December. This kind of bearish action led to some quick selling into the end of December before setting up the new-year rally. March is known to be a "turn" month so it's got me wondering if we'll see a flush into the tail end of this month to clear out the trash to end the 1st quarter and then set the market up for a rally into Q2. Or we could be setting up for a much worse and much longer decline. Too early to tell. But the immediate concern I have is what is happening to this market and today was clearly bearish in my opinion, despite what price did.

Reviewing the economic numbers before returning to the market and having a look at the charts, we received the revised Productivity report and it came in at -0.5% which was slightly better than the preliminary report of -0.6% but worse than the -0.1% expected. This is the first decline in productivity since the 1st quarter of 2001 which is when the last recession began. Hmm... For all of 2005 productivity experienced the slowest rate of growth since 2001. Unit labor costs increased 3.3% which was revised down from 3.5% but it's still the biggest increase in a year. For 2005 the unit labor costs rose 2.6% which was the fastest increase since 2000. This is not a trend the Fed wants to see and will be worried about inflationary pressures resulting in this trend.


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I'm noticing a pattern here where reports of economic strength are starting to come in worse than most economists expect. This is the same pattern in all other previous slowdowns. They, who we supposedly depend on for guidance, typically are the last ones to know. As I've mentioned before, 50 of 50 leading economists were still predicting we would avoid a recession after we were already 3 months into it in 2001. We need to send Dick Cheney out bird hunting with some economists instead of lawyers. Either that or give him shot gun shells with a wider shot pattern. OK, that was cruel, sorry.

Retail sales were reported to be down 2.5% in the first week of March as compared to February, which was below the expected 2.3% decrease. One week does not a trend make but in light of the other signals we're getting, including a drop in consumer credit (see next paragraph), consumer spending may be slowing more than had been expected. That would of course have a negative impact on the economy and the stock market.

The productivity report barely registered on the futures and this afternoon's Consumer Credit report also barely caused a ripple. It showed consumer credit of $3.9B, up only marginally from December's $3.4B and lower than the market expected ($5.0B). The whisper number had been as high as $10B so the lower number means consumers have been less willing to take on additional credit which is a good thing. The only problem is that that means the consumer is spending less and of course that's not good for our economy. A little later I'll show a chart of Consumer Sentiment overlaid on top of the DOW's chart and discuss the link, and current disconnect, between these two. Consumer sentiment, housing, spending and the stock market are all tightly linked, or at least they should be. And when we see divergences we need to pay attention.

But first let's see what changed, if anything, from yesterday's charts.

DOW chart, Daily

What's up with the DOW, literally? When the SOX sells off hard, along with a lot of other high beta stocks, and the DOW is in the green, you should think only one thing--Defense. The best defense in a market like this, if you're long, is to protect yourself because it is apparently what a lot of large funds are doing. They want out of the less liquid stocks and into the mammoth highly liquid stocks so they can get out in a hurry if they need to. If I were looking at just the DOW I will admit I'd be looking to get long the market. This chart is actually bullish looking. The decline from the February high looks corrective, support hasn't been touched yet and oscillators are working their way down to oversold. This looks like a nice setup to get long. Too bad it's not the only index. But its strength needs to be respected even it's only for a short term basis. It still has the ability to drive to a new high, even if it leaves everyone else in the dust while doing so.

SPX chart, Daily

The SPX, as usual, is in the middle and between the DOW and the techs/small caps. It came down and tested the 3 supports and all of them held--the October uptrend line and broken January downtrend line intersect today at about 1272.50. The 50-dma is at 1276.13 (depending on how you set up your moving average) and SPX essentially closed at its 50-dma. Needless to say it must bounce or perish. Any break and close below 1270 would be bearish. Until that happens, SPX still has a fighting chance to make its way higher with the DOW.

Nasdaq chart, Daily

The COMP could not recapture its October uptrend line drawn through the January 3rd low and today could not hold onto its 50-sma at 2277. However it almost held onto its new October uptrend line drawn through the February low, currently at 2271. But even price action around the break of that trend line this afternoon looks bearish. After dropping through it, the COMP came back up and gave it a kiss and dropped back down. If the COMP is unable to recapture its uptrend line and the 50-dma tomorrow, so closing above 2278, I would say 2250 is next on the agenda.

SOX index, Daily chart

You know when you lose your socks in the drier? I think traders lost their sox today. This is looking nasty (unless you own some bearish positions on SMH or something similar). The October uptrend line held price yesterday but price gapped below it this morning and ran down hard. the 50-dma at 524.72 wasn't even a speed bump to slow it down. The December high and January lows around 510 and the trend line along the lows since February at 508 are the next potential support levels. Maybe the SOX will be able to hitch a ride on a DOW rally but it's usually the other way around. The SOX is often our leader and leading indicator in both directions.

BKX banking index, Daily chart

Like the chart of the DOW, if this was the only chart I was looking at tonight, I could be sorely tempted to buy the market tomorrow. This is especially true when you consider the banks are often the leaders--follow the money so to speak. Today's outside up reversal is bullish (bullish engulfing candle) and it did it above its 50-dma. I went looking for reasons why the banks would have rallied but frankly came up dry. We got a small reversal in today's bond yields but nothing to spark a bank rally. The yields remain firmly inverted. So I looked at the securities brokers index since you like to see this index bullish at the same time. Nada. In fact they were one of the leading indexes to the downside today. All of this makes the banks' rally suspicious, the same as the DOW. This one needs follow through to prove it's doing something bullish here. I looked at the intraday chart to see if it's telling me anything and what I see is a potential reversal tomorrow

BKX banking index, 30-min chart

The decline in the banks from the February high has formed a nice parallel down-channel. Today's bounce took it up to the top of the channel and at the same time within pennies of a 38% retracement. Now we'll see if this resistance holds tomorrow or if instead something more bullish has indeed begun.

I showed the following chart several months ago to highlight the tight link between consumer sentiment and the stock market. At the time it had been diverging for quite some time and portended a large market correction on the way. Here's an updated version of that chart.

DOW vs. Consumer Sentiment chart, courtesy Dr. Robert McHugh, Ph.D.

I drew in the pink lines starting from around the beginning of 2004 in order to show the divergence between the trend in consumer sentiment (down) and the DOW (up). This is a major divergence and it's really only a question of how long it can continue. The last time a "consolidation" in CS broke down was at the tail end of 2000 and into 2001. The DOW followed with a steep decline in 2000, right after the break down in CS, rallied back up and then broke hard into September 2001, so let's say the market delays from about 3 months to a year following a significant drop in CS. The most recent break down in CS was in the fall of 2005 with a recovery since but to another lower high and rolling back over. This means the market is on borrowed time now before it too will probably follow.

I showed a chart recently (see February 20, 2006 newsletter) of real hourly earnings vs. real consumer spending (PCE) and compared it to the stock market. No surprise it showed when PCE slowed down, the market corrected. When earnings slow down, PCE slows down and the market pulls back. Seems like a logical connection. But what the chart showed was a split since about 2003 between real earnings and PCE and I attributed this to the massive amounts of money being extracted from home equities. On Thursday I'll provide an update on what's happening in the housing industry and its potential impact.

So we now see a divergence between real earnings (which have been dropping since 1998) and PCE and a divergence between consumer sentiment and the stock market. It appears to me that while the consumer has been pulling boatloads of money (since that's what they were buying--boats) out of their houses over the past two years, they haven't been feeling terribly good about doing so. It's that nagging feeling that maybe they shouldn't be going into long term debt to pay for short term pleasures that depreciate in value. So consumer sentiment appears to be registering a deeper concern about the economy, jobs and their financial status but the money has been there for them to spend so PCE hasn't taken a hit, yet.

On top of this, we have a Fed that is mass producing money out of free electrons. The Fed decided they liked the idea of free money out of free electrons and feel all is right with the world. This newly created money makes it into our monetary system through various means but buying equities and bonds is an easy way to do it. The price of bonds has stayed higher than even the Fed wanted (their "conundrum") and the stock market has stayed higher than appears normal. The lack of even a 10% correction in the stock market for more than 3 years now says something is out of whack. Between the Fed's new money and the home equity extraction for consumers, there's been a gush of liquidity in the market (Japan has helped in this regard but that's for another day).

The net result has been a stock market that won't correct while both consumer sentiment and earnings have been dropping. As I've discussed in the past, the lack of equity extraction in the coming year will likely have a negative impact on both spending and sentiment and then the only thing holding the stock market up will be the Fed. Since they'll stop reporting M-3 at the end of this month we won't know how much money they're creating and therefore making it into the market. I'm going to assume it's going to be in the billions. We have a lot of debt to monetize.

However, all these divergences that I've been showing are not healthy. Normal corrections have not been occurring and that's simply not healthy. Business and economic cycles are important to flush out the wastes and bring in new vibrant systems and products. It helps competition by weeding out the weak. Stock market cycles help long term investors buy their stock more cheaply through dollar cost averaging. None of this is happening and it's not healthy. When it corrects, and it will, it's likely to be more severe than had it corrected in smaller moves on its own. Unless of course the Fed really goes to town and buys up the whole market but somehow I think that would be a challenge for even the mighty Fed.

Consumer sentiment is going to be closely linked to the housing market. It's not just the money that's been made available to so many homeowners but it's the feeling of wealth that so many people have enjoyed the past few years. Take that away and people are going to become sour, angry, frustrated, scared (about retirement) and sellers.

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

They made it. The housing index made it down to its H&S neckline at 835. After building the right shoulder since the October low, it's finally here. We finally will get a chance to see if it indeed is a right shoulder. But we may have to wait some. This is the same place as the longer term uptrend line from March 2003. To say that the 835 level is an important support level is an understatement. I would expect a bounce now to relieve the oversold stochastics and watch the downtrend line from January and the broken uptrend line from October 2004. Both are located near 895. For a weekly perspective, here's the H&S pattern:

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

This weekly chart gives some longer term perspective of where this index is. It shows the importance of the 835 level as I'm sure there are multiple sell stops just below. Notice the failure at the 50-week moving average (blue) at the February high. This was a significant failure as this average has supported the housing index during its rally.

Oil chart, April contract, Daily

Oil pulled back only marginally today but the oscillators look like they're ready to tip back over. A drop to its H&S neckline just above $60 looks in the bag. Being rejected at both its 50-dma and broken uptrend line now looks bearish. I would expect a bounce off $60 but I would be surprised if it held onto it for long. A drop to $57 should happen fairly quickly after that.

Oil Index chart, Daily

The oil stocks can usually sniff out changes to the price of oil and therefore usually lead the way. The fact that it has now broken its October uptrend line today, which could be considered a H&S neckline, makes it look like this index will make a beeline for its 200-dma and longer term uptrend line from January 2005, both near 530 and climbing. We should certainly see a bounce off that area, and maybe even back up to the broken uptrend line (neckline). But I expect this index to keep on truckin' in the southbound fast lane.

Transportation Index chart, Daily

Everything I see in this index tells me a top is in, maybe. This one has had an uncanny ability to show a top and then turn around and make another one. But the EW count for the move up includes a final ascending wedge (ending diagonal) for the final small degree 5th wave inside a larger ascending wedge for a larger degree 5th wave and has all the bearish divergences to support this wave count. If the Trannies manage to turn around and make yet another new high it will only mean the wave pattern is morphing into a larger ending diagonal but the outcome will be the same--this one is either done or very close to being done. And I mean this in a major way. The high that it's making (either here or slightly higher) should be THE high that lasts for years and years to come.

U.S. Dollar chart, Daily

The US dollar rallied strongly the past 2 days and it's now up against its downtrend line from November. The oscillators support a full scale attack on this downtrend line and it's looking like it's about to break. That would support the current wave count and Fib projection to see the dollar make it up into the mid-90s before the dollar bull market is finished. If the downtrend line continues to hold the dollar back, we could continue to consolidate a little longer in its triangle pattern. At this point that's not what I'm expecting.

Gold chart, April contract, Daily

Gold looks ready to roll back over after yesterday's strong down day. Its uptrend line from November is currently supporting price near 552 which is also where its 50-dma is located. A break below 550 will probably trigger sell stops. Now is when we'll find out if gold will consolidate sideways (which would be bullish) or continues lower as it heads for $500. Keep an eye on the US dollar as well since these two are back in synch (counter to each other).

There are no economic reports tomorrow but this shows the reports for the rest of the week:

Thursday's reports have the potential to move the market but most everyone is anxiously awaiting the payroll number on Friday to help give some clues as to what the Fed might do. With lower productivity and higher wages (inflationary), a high payroll number might show the Fed will need to continue aggressively raising interest rates. That would of course choke off the housing market. The Fed is in a tight spot, something like a rock and a hard place.

Sector action was mostly in the red again today, like yesterday. The difference today is that the major indices didn't reflect that. Masterful. The green sectors today were the healthcare index (HMO), banks (BKX), drugs and pharmaceuticals. These by the way are considered defensive. Except for the banks, keep an eye on any continuing rally in them since it could be a heads up that something more bullish may start. The leaders to the downside were gold and silver, disk drives, SOX, energy, biotechs, telecoms (profit taking from yesterday), securities broker index, transports and internets. Some of these groups are your higher beta and riskier stocks and selling these while jumping into the larger defensive stocks is just another sign that the market may be setting up for a stronger decline.

The fact that the banks closed in the green today while the securities broker index was one of the leaders to the downside is a mixed signal. You like to see the brokers (XBD) leading the charge in a rally. It shows strong trading, mergers and acquisitions, and other signs that we have a healthy market. Without the brokers I don't trust the banks being in the green today.

Price says today was a draw with the bulls and the bears fighting it out with no clear winner yet. But as the fighters head back to their corners of the ring, unbeknownst to the bull fighter, someone just removed his stool and he's about to sit down. We have something cooking here and while I can't put my finger on it, it's giving me a bearish feeling about what's happening. We have the market at obvious support levels and many traders are coming into the market buying this support. And those support levels held for the most part today. The flat finish on the day will convince many it's safe to buy this pullback as so many bulls continue to do.

My recommendation at this point is to be very careful. Maybe it is accumulation instead of distribution but the internal breadth tells me that's not what's happening. Wait for confirmation that support is going to hold before getting long (unless you're scalping day trades). And if you want to short the market wait until we get a confirmed break down. I would say a break below SPX 1270 and DOW 10900, that closes below, would be your signal that support is not going to hold and I would look to short the rallies. If we do get a break down then the current support levels would likely become resistance. As one reader wrote in today, SPX 1275 may be the number we get pinned to for opex so a drop below and rally back up to this number as we head into next week is a very plausible scenario.

And if we drop down, keep an eye on the lower support levels that I pointed out in the charts above. I don't see any pending crash but I do see weakness and until that picture changes I think shorting the rallies could be more effective than buying the dips. Good luck and I'll see you on the Monitor.

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