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Market Wrap

The Little Red Train That Couldn't

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After working so hard all year to chug its way up the hill, gaining almost 80 points from its December 30, 2005 closing price of 1248, SPX has disgorged nearly all those points in about 2 weeks. This poor little train couldn't even put on the brakes to stop itself from sliding back down the hill. As of today's close the SPX is only 13 points in the black for the year. But that's better than the techs--the COMP is now 25 points below its 12/30/05 closing price at 2205. When ascending wedges break they usually break hard.

This opex week has not been kind to the bulls and because it's opex week it probably was a catalyst to a harder sell off than might otherwise have occurred. Once the selling started it seemed to feed on itself and support levels gave way as if they weren't even there. There are probably several opex reasons for this but one example would be short puts. For a long time many traders, including the thousands of hedge funds, have been selling naked puts for income. As long as the market continues to hold up or go up, those sold puts expire worthless and the credit received for them goes right into the holders trading account.

The complacency that I've often talked about (including the story of the experiment with grains of sand and how everything appears stable, until it isn't) has been luring more and more traders to take greater risks than they would normally have taken in the past but the stability of the market and the relentless drive higher lulled people into believing it will just keep on truckin' that way. Enter opex week, the grain of sand that started the avalanche, or small dislocation. When the selling started there were many traders now forced to either cover their short puts (by buying them back) or they had to sell stock short as a hedge. Both actions add selling pressure to the market. This then fed on itself as more and more players are forced to do the same as lower and lower price levels were hit. Hence the support levels that were giving way left and right this week.

The relentless selling this week has a very good chance of getting reversed next week if not tomorrow. But Fridays of opex week tend to be boringly flat and I'm not expecting much in the way of fireworks tomorrow. I will be looking for an opportunity to buy the market, if not tomorrow then early Monday. Buying this "dip" though is not going to be a long term play. I do not believe, as the pundits on the Cheerleading Network do, that this is a golden opportunity to buy stocks. On the contrary, we are due a tradeable bounce but I would use it to lighten up my stock portfolio big time.

I will be a man of little words tonight (oh stop that, no cheering from the peanut gallery) and instead review lots of charts. I think we've had our market turn and a picture (chart) says a lot more than I ever could. Actually, I will discuss a little further down, just before the housing chart, some information about home owners and the fundamental change that's happening there as well. It's absolutely no coincidence that the housing market's slowdown will have a negative effect on the stock market. I've been preaching about this since last summer (OK, I was a little early on the stock market but that's when the home builders peaked).

But first let's get through today's economic reports. Initial claims data showed a big jump of 42K from the previous week's revised figure of 325K. Remember, this number was running under 300K not too many weeks ago. The bump higher was blamed on the government shutdown in Puerto Rico (46K) and it made the total the highest since last October, which was also a period of higher unemployment due to hurricanes Katrina and Rita. The 4-week average was up 15,750 from the previous week's revised average of 317,500. Continuing claims were up 8K to 2.39M. The 4-week average was down 9.5K to 2.42M.

Leading Economic Indicators was out next, at 10:00 AM and was down -0.1% vs an expected increase of +0.1%, and down from the prior +0.4%. This shows the economy is slowing down which prior to this week would have ignited a rally since the market would have interpreted that as good news since it would mean the Fed will pause in their interest rate hikes. Once again, this is why I do not trade news. The market drives the news (and fundamentals), not the other way around. Many economists came out to explain how well the economy is doing and that that "economic growth should continue moderately in the near term". What a surprise to hear that from them (cough).

At noon we got the Philly Fed index and it rose to 14.4 which was more than the expected 12.5 and higher than the previous 13.2. Again, the market didn't care. The prices paid index nearly doubled to 55.3 from 29.0 (inflation?) while the prices received dropped by a third from 15.4 to 10.3. This is not a good combination for manufacturers and spells trouble for earnings if that continues. The employment index experienced a large drop to 1.1 from 21.7 and the expectations index dropped from 28.2 to 22.5. All in all, not a good report.

So let's get on with the charts.

DOW chart, Daily

The DOW has been clearly one of the stronger indexes this year as money rotated out of techs and into the bluest of the blue chips. This chart makes it look like the spike up in May was a blow-off top. The spike above its ascending wedge and then drop back down inside the pattern was a sell signal. The drop below the pattern is a confirmation of the sell signal. This market has been doing some strange things (false propping by the Fed's printing press included) and therefore it's entirely possible for this market to turn right back around and head for new highs. But we play a game of probabilities, not possibilities. The probability here is that we're going to see a bounce soon and it should find resistance where support should have been this week--the 50-dma and October uptrend line nearing 11300. I would also watch for a bounce that retraces as much as 50-62% of this decline. The bounce, probably starting next week, should be a tradeable move. But longer term investors should look at any bounce now as an opportunity to move to cash. If you don't like playing the short side at least move out of your long positions or buy some insurance (LEAP puts).

SPX chart, Daily

SPX has struggled more this year to rally higher. What took nearly 4-1/2 months to gain has been given up in 2 weeks. SPX is showing typical ascending wedge behavior--the ascending wedge developed this year and had the negative divergences supporting the bearish interpretation of this pattern. When these wedges break we typically see a fast retracement of the entire wedge and that's certainly true in this case. Support is often found at the starting point of the wedge and that would be the February low in this case, or 1253. The 62% retracement of the 2000-2002 decline is at 1253. The 200-dma is at 1257. Two equal legs down in its decline from the May 8th high is at 1255. The uptrend line from March 2003 through October 2005 is at 1255. Starting to see some commonality in the numbers here? I think you want to buy this 1253-1257 support level and take it for a short long ride next week. Get long but don't stay long. Make sense? A bounce back up to its 50-dma at 1301 could make for an ideal short play. That's when you'll want to take a long short ride. Pay attention because there will be a test at the end. Here are the crib notes--buy 1253-1257 for a swing trade up to 1301 and then sell 1301 for a position trade to 1225.

Nasdaq chart, Daily

Even though the techs have been struggling more in the past month, and money was rotating out of them into the blue chips, that did not spare them for the selling that hit in the past week. The COMP sliced right through support levels. The 200-dma at 2229 will likely be resistance on a retest and then the trend line from January 2004, just a little higher at 2254 would be the next wall to climb over.

QQQQ chart, Daily

Even the gap fill at $39.35 didn't slow down the sellers in the Q's. There was some hesitation at the Fib projection where the pullback from January had two equal legs down ($38.83) but other than that it's been a strong sell. From an EW perspective this hard drop down looks like a 3rd of a 3rd wave down. That suggests we'll see a couple of stair-steps lower before this is ready for a stronger bounce. Resistance will likely be found around $40 at the most and the lower Fib target at $38 is probably where this is headed.

SOX index, Daily chart

The SOX has been even weaker than most techs in general and therefore could be closer to a tradeable bounce. Between a Fib projection at 465.52 (two equal legs down from January) and a 62% retracement of the October January rally at 469 I'm thinking that's where this index will find support. From there it could then bounce back up to its 200-dma before continuing its southbound journey.

BKX banking index, Daily chart

The banks dropped below their 50-dma today but it's done that a few times and then quickly recovered. How it acts around that important moving average this time could be important. Lending support here is the uptrend line from January at 374. This index has reacted to its 20-dma Bollinger Bands as well and the bottom of the band is at 372 now. So support is near and we could see a bounce start here. Whether it does or not will give some clues as to what's happening in the broader market.

XBD securities broker index, Daily chart

The broker index really did give us the heads up for what was coming. I started showing this chart shortly before it started selling off and we watched it test its broken uptrend line which forecasted a strong sell off coming. While this was happening, the banks and broader market were holding up better. Let us remember this and keep an eye on this index. It's due a little consolidation before continuing lower to support by its uptrend line near 206 (which is also where the 2nd leg down would achieve 162% of the 1st leg down) and then by its 200-dma at 200.

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Home ownership becoming a pain
Before we look at the home builders I thought I'd discuss some information in an article in the Rocky Mountain News (Denver paper) that was forwarded to me (thanks George). The article was written by John Rebchook and titled "Those ARMs Starting to Hurt", and led off the story with "As payments go up, so do foreclosures." I just moved to Seattle from Denver and so the news caught my eye. The gist of the article is about adjustable rate mortgages and the impact the rising rates will have on homeowners.

While the focus was naturally on Denver there are some statistics for other areas as well. The unique aspect of the housing boom that we've experienced this country (and other countries as well) is that it has been a national phenomenon. In previous housing bubbles they were localized. That meant the country was fine even if the localized bubbles popped. Houston in the 1980s or California after the various tech booms fizzled are examples where most of the country looked at what was happening and thought "poor bastards" and went about their normal lives.

This time it's different (yes, I really said that). We have a national housing bubble for the first time and a housing correction will hit nearly everyone. Even those who won't have to sell will see and hear about the housing correction and that will instill fear in the hearts of many. The rapid increase in home values has made people feel richer even if they didn't spend any of that equity. But many people not only felt richer they acted richer--they withdrew that equity and spent it, and it wasn't necessarily plowed back into their homes. The runaway consumer spending over the past few years has inarguably been fueled by home equity. There are now many people who now have loans on their homes, either primary mortgages or home equity lines of credit, at adjustable rates.

People were also buying more house than they should otherwise have been able to afford. The types of mortgages that many were getting have been "creative" financing taken to an extreme. Even worse, thousands of homeowners chose so-called "option ARMs," which gives people the choice to make minimum payments, minimum payments with interest, or payments with interest and principal. You can guess which one most chose so that they could afford the house or other things, especially since they believed home values would continue higher and they'd be able to just remortgage to cover the added loan value (from negative amortization). Now these people are finding they're adjustable rates are rising and they either can't get out of them without costly prepayment penalties or they can't afford to convert to a fixed loan now. They're literally stuck between a rock and a hard place.

As Rebchook with the Rocky Mountain News noted, "When you combine ARMs, 100 percent financing, negative amortization, seller-paid closing costs, rising rates, falling prices, rising inventory and a continuing sluggish Denver economy, you have a recipe for 1987 to 1990 revisited." That's when the local housing market crashed. This sluggishness in the housing market will not just hit pockets like Denver though. Particularly in the high-cost areas, such as the east and west coasts, the majority of new mortgages were ARMSs. Home equity loans are at adjustable rates. Credit card rates are being adjusted higher. This will all be a show stopper when it comes to consumer spending and that will of course put a major kibosh on economic growth (with consumer spending now accounting for upwards of 80% of our GDP).

Many home owners have very little equity in their homes. The numbers cited for Colorado are on the low end of the equity scale and is cited as a reason for the increasing foreclosure rate there. In Colorado, 28.5% of homeowners have 5% or less equity in their homes, and 47% have 15 % or less equity, according to a report released earlier this year by Christopher L. Cagan, director of research and analytics at First American Real Estate Solutions in Santa Ana, Calif. For those of you who live in Tennessee, your area was the only area that had even lower equity levels and therefore you will probably see higher foreclosure rates as well. But this is a country-wide problem now and it's going to get worse as these ARMs adjust higher.

But the largest negative impact will come from a depressed housing market. As these ARM mortgages have been ramping upwards (typically they can jump by 2% per year although there are many that have faster adjustable periods). There are many reports of peoples' mortgage payments doubling overnight. There are not that many households out there that can afford that kind of financial impact. The consequence is the home owner is forced to put the house on the market or face foreclosure by the bank. With foreclosures already hitting record levels, this is the last thing the banks want to deal with. They'll put the house on the market to sell as quickly as possible which usually means for less than market value.

As for new homes, we've already seen a significant slowdown in the home builders as they cut way back on building new homes. Once the market becomes flooded with resales, the number of new homes will be cut back even further. The bulk of new jobs in the past few years have been in and around the home building market. We will see massive dislocations for many of these workers, many of whom are independent contractors and we won't necessarily see their plight recorded in the government employment statistics.

As mentioned in the Rocky Mountain News, it's not all bad news for places like Denver. Dan Jester, a spokesman for Moody's Economy.com, said the Denver area is in decent shape because it didn't see the huge run-up in prices that other areas have seen, so it's unlikely to experience the big crashes that could occur on the coasts. "If you were Orange County, (Calif.), I'd be a lot more concerned," Jester said. And to that I'll add much of California, Seattle, much of the Northeast, and Florida. In other words, it's a lot more spread out this time than at any other time since the late 1800s I think it was when the country experienced a painful housing boom/bust cycle.

I'll give you my best guess for what I see coming down the pike in the next 1-2 years. If you're one of the ones facing the prospect of a rising mortgage payment because you have an ARM, you're probably struggling to figure out when you should try to lock in a rate. My guess is probably no better, or worse, than anyone else's so take it for what it's worth. I see interest rates increasing for a little longer but probably not by much. I think the bulk of the increase has already been completed. But once the economy starts to slow down (I think it already is slowing but it won't be reflected in the numbers for another few months) then we should see a reversal in rates. Stocks will sell off and investors will run for the safety of bonds. This will cause bonds to rise and yields to fall. Rates could bottom out as we head into the tail end of 2007, especially if the Fed gets on board with their "oops, we went too far again" reaction and starts dropping their rates quickly towards the tail end of 2006.

Now let's see what the chart for the home builders is telling us.

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

The housing index has now given us a 5-wave move down from its April high. All 5-wave moves are followed by a reversal so this index is ready for a reversal. At the same time it hit its Fib projection target at 725 and the bottom of its parallel down-channel. I'd be very surprised if this keeps heading south from here, but if it did, it would be very bearish and would likely mean a cascading drop lower (you wouldn't want to get in the way of that). Assuming we'll see this index get a bounce now, resistance would likely be the 800 area.

Oil chart, June contract, Daily

Oil is certainly chopping its way lower, more than I had expected. It may find temporary support at its 50-dma at $69.13 but the decline should continue once the bounce is finished. I'm still looking for mid-60s to set up the next rally in oil, just in time for summer driving. If we do get to the mid-60s, buy oil futures and that way you can fund your gas account if the price of oil heads back up and buying gas this summer is going to break your bank account.

Oil Index chart, Daily

Oil stocks had been holding up better than oil and started me thinking that oil might rally sooner rather than later. That was taken care of this week with the sell off in the oil stocks. This was an example of where the stocks don't always lead the commodity. Never trade one exclusively off the other because those rules are guides only. I'm not sure if at this point the oil stocks will drop straight to support at its uptrend line and 200-dma near 554 or if it will chop its way lower still and find support closer to 560. I still have a hard time reconciling a rally in the oil stocks if the broader market sells off but possibly a strong bounce in the broader market will mean a chance for the oil stocks to at least test their recent high.

Transportation Index chart, Daily

The might Transports have taken a mighty fall. That's a top. I'm sure of it this time (how many times have I said that?). Clearly the trend has changed with those big red candles. Now watch for resistance at its broken October uptrend line near 4800. If it does a kiss goodbye on a retest, find your (least) favorite transportation stock and short it.

As much as Secretary John Snow keeps reiterating his "strong dollar" policy, I wonder if the Fed is listening to him. They continue to create money out of electrons and that will continue to have a devaluing effect on the dollar. There are also many international currency issues at play here and I'm hardly an expert in the field of currency evaluation. That's why I stick with charts.

U.S. Dollar chart, Daily

The US dollar has come dropped hard over the past month and looks ready for some consolidation. It should stair-step a little lower and the Fib projection and H&S price objective just above $83 remain good targets for stronger support. A new low with bullish divergences should signal a strong bounce in the dollar is coming. Notice the dollar hasn't really bounced and yet commodities in general started one of their larger corrections this week. Again, these will often trade synchronously or asynchronously with each other but you can't depend on that.

Gold chart, June contract, Daily

Gold's EW count and Fib projections for extended 5th waves matched important Gann levels (off the Gann Wheel) and the 729 level held. The correction in gold is larger thus far than we've seen all year and that's probably a signal that the trend has reversed for now. But until its uptrend line from March, at $680, is broken to the downside gold is still in an uptrend. I just happen to believe it will break. If it doesn't break though, and instead forms a large sideways triangle, we could see gold consolidate for up to two months before it continues highe. If $680 gives way then I think there's a good chance we'll see gold pull back to $600 and maybe even $550.

Results of today's economic reports (there are no major economic reports tomorrow):

Other than possibly a reaction to the after-hours earnings report from Dell (DELL 23.92 +0.32), which was positive, it should be a very quiet morning with a lack of significant news from companies or the economy. Unless something wild happens in the overseas markets our market will be left to its own devices. Considering the blood letting this week, there will likely be scared/tired traders and we may see a very listless day. This has become typical behavior for an opex Friday anyway.

Speaking of Dell, it announced its fiscal Q1 earnings fell to $762M, or 33 cents a share, from $934M, or 37 cents a share, a year ago. The earnings results were in line with a revised forecast that Dell had given on May 8. But revenue was up 6% to $14.2B from $13.4B a year ago. Dell then said aggressive pricing late in the quarter would cause it to miss its prior estimates for earnings between 36 cents and 38 cents a share, on revenue in a range of $14.2B to $14.6B. Dell's shares closed in the after-hours session at $24.77.

Dell got investors in Advanced Micro Devices Inc. (AMD 31.35 +0.58) all excited after hours by stating that it would use AMD's chips in its high-end server product line later this year. This marks the first time Dell will use chips from AMD in its products. Dell has been an exclusive user of chips from Intel Corp (INTC 18.49 -0.01). In after-hours trading, AMD shares to $35.55. Intel shares fell to $17.75.

As for sector action today, it was mostly red but most of the selling came within the last hour of the day. We may be close to at least a temporary washout low. The leaders to the downside today were the energy indexes, biotechs, gold and silver, and the banks (BIX). There were only a couple of green sectors on my list--disk drive, retail, computer hardware (a run up in anticipation of Dell?) and utilities.

We're close, as in close to a tradeable bottom. I say tradeable because the longer term picture has turned bearish. Here are two charts I showed earlier today on the Monitor. They're both for the SPX with the top chart a weekly and the bottom chart a daily.

SPX chart, Weekly and Daily

Notice the similarity in patterns. The daily chart is a fractal of the weekly chart. The daily chart shows the rally from October 2005 and the weekly chart shows the rally from October 2002. Each shows a strong rally followed by a choppy rise higher in an ascending wedge. The importance of fractals is that they typical forecast what's going to happen. So the fact that the daily ascending wedge, as shown on the daily chart, has broken down, the same thing is likely to happen to the weekly wedge. The bottom of the wedge is near 1250 and is the level I'm recommending a long trade for a tradeable bounce. But the bounce will probably not last long before the decline continues. If we get a fast break down from the weekly wedge, we can expect a complete retracement of it, so back to the August 2004 low near 1070, relatively quickly. Relative quickly on the weekly chart would mean a retracement in 4-5 months.

That's the longer term picture for what I see coming this year. The short term picture, other than the support levels shown in the charts above, is starting to show evidence of bottoming. The short term charts clearly look oversold. We also see a spike in the new lows vs. new highs, down volume and issues vs. up volume and issues. The put/call ratio has hit a level that has always marked a bottom in previous declines. This chart from Stockcharts.com shows the ratio:

CBOE Options Total Put/Call Ratio, Weekly chart

If you look at previous peaks in the p/c ratio you'll be able to correlate them with market bottoms. If you look at the equity p/c ratio in the table at the beginning of this report you'll see that it was 0.80 today. Rarely will you see this higher than the mid 0.60s. We have too many people now betting on the downside and you can bet they'll get punished. It's now time to think about betting against the masses and that means start looking to get long and we'll see what kind of bounce we get.

Don Hays of Hays Advisory, a service with a strong professional following is generally regarded as a superbull. Even he has become medium term cautious as he writes, "The number of stocks making new highs and new lows is one of my favorite ways to 'feel' the internal action of advances and declines." He cites a study by Jason Goepfert at sentimentrader.com of the six occasions in the past four decades when the stock market indexes hit new price highs, but within the next five days experienced at least 5% of NYSE stocks making new 52-week lows, which occurred on Monday. In every case the market was lower one month later, for an average loss of 5.1%.

So the short term picture says get ready for a bounce, and traders who can watch the market can play it that way. But position traders will want to use a bounce to position on the short side (or cover your long positions). That's why I say play a short long position but get ready for a long short position. Good luck tomorrow and next week and I'll see you on the Monitor or back here next Thursday.
 

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