Option Investor
Market Wrap

Hissy Fit

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What happens when the market doesn't get what it wants? It throws a hissy fit and sells off. The market didn't get what it wanted to hear yesterday, that being that the Fed was likely to pause in June, and the reaction should have been predictable. The market had rallied up into the FOMC announcement so it was clearly a sell the (disappointing) news event. I was looking for a pullback to buy today, and tried twice, but it turned out to be a lot more than a pullback. It was more like a temper tantrum in the middle of the shopping aisle. The end result was that all three major indices posted their biggest down day since January 20th. We had what you'd call one of them there distribution days.

Today's price action was damaging to the bulls' cause, no question about that, especially in the techs. The techs have been weak while money was clearly rotating into the larger than large caps (the DOW) and that was a bearish sign. The techs broke all kinds of support levels today, which we'll review in the charts, so we've got a big heads up that something more bearish could be starting here. But we also know we are operating in the land of no follow through. Big moves in this market have been followed with strong reversals the next day, and this has happened in both directions. Every time you think there's a new trend developing, and try to trade it that way, the market whips around and slaps you silly for even thinking that. So we're left tonight wondering if this is it, are we really going to start an honest to goodness pullback. Well, maybe.

One of the concerns for the market now is that for all intents and purposes we've finished the earnings announcements (450 out of the S&P 500 have reported) and now the market has to focus on the "data" that the Fed will be using to decide the fate of their interest rate policy. We can expect to see a twitchy market, sometimes violently so, if new data suggests a different scenario than the majority of participants have been expecting. In many respects we will have a more difficult time now, as we supposedly near the end of the rate-increase cycle, than when we were in entrenched in the middle of the cycle. Plus market participants know that the market is reaching some critical levels and sees the techs and small caps lagging now. This makes everyone nervous about potential selling at any time.

The other concerns now are the high commodity prices. With gold and silver continuing their parabolic journey to the sun, hitting new 26 and 25-year highs, respectively, there's fear starting to creep in that inflation may be enough of a worry to keep the Fed on a rate-tightening path for some time to come. Other precious metals are doing equally as well. Oil is back up near its highs, closing at $73.25 today, and copper continued to new historic highs, up 9% at one point today. The US dollar continues to sink lower.

Treasury yields continued higher today as bonds sold off. The yield on the 10-year Note (TNX) hit a 4-year high of 5.17% and closed at 5.15%. This has a depressing effect on the economy and certainly the home builders felt the heat today. There was a $13B auction for the 10-year today and it did fairly well, receiving a 5.14% bid which is the highest since May 2001, and saw a strong 2.53 bid-to-cover. But the bond market telegraphed today the concern about inflation and worry that the Fed will continue to raise rates. That spilled over into the equity market, along with inflation fears as indicated by a declining dollar and rising commodities.


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As long as the Fed continues to pump money into the monetary system, which we don't know for sure since M-3 is no longer reported, it will have an inflationary effect. When M-3 was being reported money was being stuffed into the banking system at a hyperinflationary rate and there's little reason to believe they stopped just because they no longer have to report it. But I think it's safe to say that the declining dollar and rising commodities tells us what we need to know. But today's sell off looks to me more like just part of the choppy price action we've been in, and will continue to be in, as the market hammers out a top. I'm not convinced that we've seen the highs yet and I'll explain more in the charts.

There were a couple of economic reports this morning, none of which were market moving, those being the Initial Claims, Retail Sales and Business Inventories. The initial claims didn't change much for the past week--down 1K to 324K from the previous week's upwardly revised 325K (revised up by 9K). This was higher than the consensus estimate of 316K. This was also the highest level we've seen since last October. The 4-week average of initial claims was up by 2,500 to 317,250 which is the highest level since December. Continuing claims fell 49K to 2.39M and the 4-week average also fell by 7,250 to 2.43M.

Unemployment data is one of those rearview mirror pieces of data as far as figuring out what's happening in the market but the disturbing thing I see from the numbers is that unemployment claims are on the rise while job creation is declining. Our economy, as healthy as it's reported to be, can't even produce enough jobs to keep up with new people entering the job market (assumed to be about 200K per month). The combination tells me that we could be seeing the early signs of the slowdown that so many don't want to talk about.

Retail sales showed an increase but unfortunately most of it went out our cars' tail pipes. Sales were up a seasonally adjusted +0.5% but only +0.1% without gasoline sales. With consumer spending making up more than 2/3 of GDP (some estimates are as high as 80%), this lack of spending by the consumer is worrisome. This is where the impact from high oil prices will have negative consequences. Seems pretty clear to me that higher interest rates and higher energy costs are going to slow down the consumer. This will in turn slow down our economy. And I don't have an economics degree! But the Fed will wait for the "data" to tell them that and of course by then it will be too late--the stock market will have already figured it out.

April auto and auto parts sales dropped by 0.4% after being up 1.0% in March. Removing that component shows all other retail sales were up 0.7%, less than consensus for +0.9%.

March business inventories were up 0.7% (consensus +0.5%), retail inventories were up 1.0% (from a jump in auto inventories), manufacturers inventories rose 0.7% and wholesalers inventories were up 0.2%. The inventory to sales ratio held nearly constant at 1.26 months after a record low of 1.25 in January. Less inventory building than expected will probably lower GDP a little more than expected as well.

It was quiet on the earnings front. American Int'l Group's (AIG 63.15 -3.39) earnings last night set a negative tone this morning for the DOW but there were likely greater reasons for the market's sell off today. And not helping the healthcare industry was a report that UnitedHealth Group (UNH) released information that they were going to have to restate previous years' earnings in order to properly account for stock-option grants. They were looking at a potential hit to the bottom line of $286M. The SEC is also looking into their stock option granting practices. The stock dropped down at the open but then pretty much ran flat for the rest of the day, closing down -1.86 or -4.2%.

Let's see what the major indices and sectors are telling us after today's nasty spill.

DOW chart, Daily

After shooting above the trend line across the highs since November, the DOW has come back down for what could be a retest. But if the pullback continues, even if first preceded by a bounce from here, it should find support at or above its 50-dma. But if it breaks below its 50-dma at this point there's a good chance the high will have been put in and that's the EW count I currently show. I'm not ready to buy (sell) that yet but it's a distinct possibility and therefore protect long positions now--a drop below 11200 would be a bearish sign in my book.

SPX chart, Daily

As opposed to the DOW, I'm showing an EW count here that calls for a pullback to be followed by a choppy move higher. This is a little bit of a change from last week's wave count and that's because the choppy pattern for this whole year is making it very difficult to figure out where the wave count belongs. As long as SPX stays above 1280 the bulls are hanging on. A drop below that level and I'll be looking to sell all rallies.

Nasdaq chart, Daily

Where's the love? Those 4-letter stocks have been ignored for months now as the blue chips rallied. They're also now the first to break significant support. No matter how I draw an uptrend line, it's been broken. The 50-dma has been decisively broken. There's just no way a bull can like this chart. Last ditch defensive line is the trend line across the highs since January 2004 which is where the COMP was finding support earlier this year. If that breaks (below 2250) then the 200-dma at 2228 is a must hold but by then I think it will be too late. I'll be into shorting all rallies by that point.

QQQQ chart, 240-min

From a slightly shorter term perspective, the Q's show possible support at the bottom (slightly broken here) of two parallel down-channels. As Marc has commented on the Monitor, there are a large number of May 41 puts to calls (4 to 1) so this could/should provide support going into next week's opex. But if this continues lower there's potential Fib support at 40.13 which coincides closely with the previous lows in February and March.

SOX index, Daily chart

The SOX fell off the high wire but fortunately had the safety net to fall into. The break of its coil is bearish but the catch by the 200-dma should be good for at least a bounce. The 50% retracement of the October-January rally is also just below that at 486. I wouldn't expect these support levels to be sliced like a hot knife through butter but if that happens, you don't want to be long the semis. The tech stocks of course have the highest valuations and they're the first ones to be ditched when bulls get scared.

Stock Market Valuation
Speaking of stock valuations, I last discussed the subject in the April 27 Market Wrap and I recently read a good piece by John Mauldin that I thought would be worth passing along since it's very important information for both traders as well as longer term investors to not just think about but to act upon. As the market climbs to new multi-year highs (excluding today's blood bath) we're hearing more and more about market valuation. Those who are bullish will talk about how the market is fairly valued and that it has a lot of headroom above us to see a strong bull market. The bears argue just the opposite and say we've never fully wrung the excesses out of the market.

Each side uses statistics to back up their claims. John Mauldin's piece did a great job in explaining where we've been and where we're likely headed. The projections are based on an historical pattern which makes a lot of sense to me since we as human beings really don't change--we continue to react the same way as we have for millennia. This is why we see repeating patterns, and fractals (same pattern but on different scales), in the stock market

We can believe that this time it's different and that we're in a new era, or we can believe that we'll follow historical patterns. As one who studies EW patterns, which work because human beings have not changed, I go with the theory that history will repeat again. That's why a review of history is important here. Forget the hype on the Cheerleading Network of Buffoons and Clowns channel and follow the charts.

The gist of Mauldin's article was an answer to the question about whether or not the market is fairly or overvalued. Not many talk about it being undervalued for fear of being laughed off the stage. The question also has to do with whether or not we're in a secular bear market, especially seeing so many indexes hit new all-time price highs, with the DOW threatening to do the same. The bottom line in determining whether or not we're in a secular bear market has more to do with valuations than price. If the dollar's value is cut in half, the new all-time high for a stock at $100 is really only $50 so price alone is not a good measure.

The market always swings in a longer term pattern, a rhythm if you will, and it moves from overvalued to undervalued back to overvalued and back again, each cycle taking on average about 13 years (varies between 8 and 17 years). History shows that never before has the market swung from one extreme, stopped in the middle and reversed back up to the same extreme again. Never. The stock market has swung from overvalued in 2000 to at best fairly valued today. If we see a new bull market emerge from here, as many are calling for, we will see a reversal back to overvalued and it will be the first time in history. Could happen. But is that how you want to bet your long term investments?

It's important to review history and study stock returns following periods of expensive and cheap valuations. The data shows us that stock returns over 10 years that follow the cheapest valuations (typically around a P/E of 8) have been on average about 10% per year. The most expensive valuations, such as where we were in 2000 and where we still are today, show returns were 0% over the next 10 years. You're better off in bonds and bank CDs. You will hear many analysts predicting 6 to 7% returns over the next 10 years and what a wonderful investment opportunity it is now because of new technology, investments by baby boomers, sun spot cycles, and because by gosh we deserve it. It would have to be different this time for that to be true.

Starting from 1900 the average P/E is 14.8 (a point less if the years 1997-2002 are excluded) and it's a little higher if you look at the market since 1950. So the average is considered 14-16. Today's P/E ratio, based on the Standard & Poor's use of core earnings, is 19.6 (after reaching a high of 71.7 in December 2001 which today looks like an outlier on the chart). Therefore one could say that the P/E is slightly above fair value. And this brings back the question above about whether or not the market will now do a reversal back up to nosebleed levels, which would be the first time in history for that to occur.

For another look at valuations Mauldin showed a chart (too big to place in this document) that showed a measure of stock valuations done by Steve Leuthold from the The Leuthold Group in Minnesota. Leuthold normalized stock valuations to average out 5-year periods which smoothes the data. He also includes 3000 stocks in his database. His data shows stocks were at 86% of the most expensive periods as of the end of March. Considering the rally since then, we're probably over 90% today.

If we're that overvalued today, relative to the past, how much more upside can we expect? If we're at the most expensive end of the measurement, that means we can expect at best a 0% return over the next 10 years. And if we go back to the original question as to whether or not we're in a secular bear market, these high valuations would suggest, unless it's different this time, that we've got a lot more work to do to unwind the excessive valuations; i.e., we're in a bear market, or about to start one for some of the high flying indexes. The stock market has never ended its bear market when valuations got back to the middle, let along above the middle.

The following chart is from Ed Easterling at Crestmont Research and shows how the P/E ratio slowly dropped over time during the 1970s as the bear market proceeded.

DJIA vs. P/E, 1965 to 1981, courtesy Crestmont Research

Even as prices swung wildly, including a new high in 1972, and VIX ran from under 10% to 25% and back again, the P/E slowly worked off its excessive valuation over time, running from the mid-20s to about 8. And it took about 17 years to do it. Back in 1972, even with a new price high for the DOW, it was just a cyclical bull within a secular bear. We're about 6 years into the current secular bear and we should be completing a cyclical bull, with new price highs (and low VIX) included. Hence the note on the chart--deja vu? Considering the wildly excessive valuations we reached after 2000 one could argue that it will either take longer to work it off or we'll see a harder decline. With the Fed supporting the market now, it might be the longer scenario. That would mean peoples' retirement plans won't do so well over the next decade at least.

One other note on "deja vu". Notice the price pattern from 1969 to the high in 1972 in the above chart. Now look at this weekly chart of the DOW:

DOW chart, Weekly

For those who don't think we could drop lower than the October 2002 low for the next bear market leg down, look what happened going into the end of 1973/beginning of 1974. Didn't we also have some kind of oil crisis back then? For those of us who remember the odd/even days to fill up our tank, the comparison of price patterns and world events between then and now is uncanny, and scary.

On that happy note, let's see what the banks and brokers are telling us since we've been watching both to get an idea who might be leading the way here. By the looks of it so far, it appears the broker index was giving us a better warning about more selling. But the banks are nearing potential support now.

BKX banking index, Daily chart

Similar to the DOW, after springing above the trend line across the highs since November, price may be coming back down for a test near 383. Crossing the same level is the December 31, 2004 high. If that does not hold then the next test is its uptrend line and 50-dma near 376. Another break of that support would be very bearish. Until that happens though, the bulls still rule. Now if only I got the same impression from the securities broker index.

XBD securities broker index, Daily chart

After breaking its uptrend line, the broker index bounced off a test of its 50-dma only to run head first into its broken uptrend line and fell back away. It's the proverbial kiss goodbye and is bearish. It also closed below its 50-dma today. In order for the bulls to hang on here, it needs to hold above today's close and at least go sideways for a bit. That would set up another push higher. In the meantime this index is on the ropes.

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

After a brief consolidation it looks like the home builders are going to continue lower. There is potential support at a Fib projection of 725.74 which could coincide with the bottom of a parallel down-channel if it gets there in the next couple of days. From an EW perspective, the leg down from early April may soon complete (5-wave move) which would then set up a larger bounce, perhaps even back up to the 850 area to test the broken H&S neckline.

Oil chart, June contract, Daily

So far oil is doing what I expected it would--pulling back in a choppy fashion, although it's a lot choppier than I thought it would be. I'm still expecting it to continue lower. It found support at its 50-dma so obviously it needs to break below that (68.63 today) to make it down to its 200-dma.

Oil Index chart, Daily

As long as oil holds up, so too will the oil stocks. They're actually holding up a little better than oil and that could be indicating the pullback is over but that's not the way I'm currently leaning. I believe this has lower to go before the next rally leg.

Transportation Index chart, Daily

In the current EW count the final move up from its April low should only be a 3-wave move and that's what we currently have. Therefore the top could be in for the Trannies. Even got a little throw-over above the parallel up-channel and now price has fallen back inside. I'm going to be a Missouri man on this one though--show me the break below the 50-dma, at 4641 today, before I believe the bears are in control. This has reversed too many pullbacks which makes the current small pullback suspect. The other thing I'd like to see is a new high with negative divergences and I don't see that yet.

U.S. Dollar chart, Daily

The dollar is getting spanked. But never fear, John Snow believes in a strong dollar policy. I wonder if he has any idea of how little credibility he has. I've been waiting for the dollar to consolidate its sell off before continuing lower and I'm still expecting that. Short term bullish divergences are showing up so it could be close. But I think the target just above $83 is still the downside goal before we see any appreciable bounce back up.

Gold chart, June contract, Daily

I didn't think gold would bounce much higher than 703 which was a Fib target as well as a Gann number but a 2nd Fib and Gann level is at 729 and gold's high today was 728. The interesting thing about the EW pattern is that it now looks like we have an extended 5th wave in an extended larger degree 5th wave. Extended 5th waves are common in commodities and to have two of them like this is the very definition of a parabolic blow-off top. Whether it ends here or higher is tough to tell but I do like the EW count and the Fib projections now to call a high in gold, even if it pushes slightly higher tomorrow to finish it off. Shorting these parabolic moves is extremely difficult but I think we're just about there if today's high wasn't it.

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

Tomorrow's economic reports will probably not be market moving unless we get some numbers that were clearly not expected. Export and import prices and the Trade (Im)Balance numbers and then the preliminary Michigan Sentiment will be on tap. If the sentiment number takes a nosedive that could spook the bulls a little more otherwise I think it will be a relatively quiet day. Heading into a Friday, after a big down day like today, I suspect market participants are going to be a little fearful but tired. It's been a volatile week and I suspect there won't be much to move it and we will instead probably see more of a consolidation.

Looking at sector action, every sector on my list was red today. The leaders to the downside were many technology indexes, the securities brokers, airlines and the SOX. At the upper end, those losing the least, were the drug companies, healthcare and oil index (OIX). Technology has taken it on the chin lately. Microsoft (MSFT 23.22 -0.55) disappointed 2 weeks ago, Dell (DELL 24.51 -0.38) disappointed on Monday and Cisco (CSCO 20.05 -0.70) on Tuesday disappointed with their forecast for slower sales growth. The semiconductor group is heading into its seasonally slower months and the break of support in that group should be worrisome to tech bulls. In the DOW there was only 1 of the 30 components in the green today--Johnson & Johnson (JNJ 58.84 +0.52), which was upgraded to a buy rating from neutral at Banc of America. Alcoa (AA 36.02 -0.20) almost stayed in the green column until a late-day sell off. It was doing well as aluminum prices were hitting their highest levels since June 1988 and it hit a new 52-week high but couldn't hold it.

The internals didn't show much in the way of divergence with what we saw in price action today. Volume was a little light and that says we didn't have any panic selling today. That could be good or bad. Many times light volume leads to a stealth decline because participants keep thinking it's just a correction and not something more serious. So be careful about misjudging volume in an early decline. I'm not thinking we'll see much more but it's just a heads up not to use volume (except sometimes it's useful to identify a capitulation move). Declining issues and declining volume swamped those issues trying to swim upstream today. There were a high number of new 52-week lows but new highs still beat out new lows 376 to 264.

The big question of course is where this leaves us for tomorrow. I think we'll need tomorrow to help answer that question. If we get the typical no-follow-through that we've seen time and again in this market then today will look like just a nasty day of distribution. It could simply be part of the choppy price action I'm expecting to see over the next month or two if the top is that far away (if we chop higher like we did during the summer of 2000). I was thinking we had a chance to see a top get put into place before the end of this month, even next week but today's steep decline makes it look like the top is either already in (not the way I'm currently leaning) or we've got several weeks more of this stuff in front of us.

It could be very ugly to trade as the bulls and bears get more volatile in their struggle. I would expect trading to be extremely difficult since we'll see many reversals intraday as well as day to day. If and when we get the top, we'll see some impulsive moves lower (today Might have been the start of that) and they'll be much easier to trade. That would also be our signal to short the bounces. So don't feel the need to trade this stuff. Capital preservation is important while we wait for an easier time to trade. Sell some bear call spreads well away from market action (such as above SPX 1380) and let the noise continue without you. It will get easier than this. Good luck and I'll see you on the Monitor.

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