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Market Wrap

The Bulls Get a Reprieve

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We'd been short term oversold with bullish divergences at the new lows for so long it was beginning to feel like we'd never see the buyers step back in. But back in they stepped and gave us a nice 2-day bounce off of Tuesday's low, including a very strong rally today. That low on Tuesday/Wednesday broke several support levels and it was looking bad for the bulls but support has held this week as I'll show in the charts below. The trick now will be to hold this week's lows because a break lower would likely see last October's lows next. So it's not time for the bulls to relax yet but this bounce is letting them breathe again.

Volatility is clearly on the rise, and not just by the measure of the VIX. The price swings have been increasing dramatically and already are far greater than what we saw in 2005. This means it becomes more difficult to judge a 1 or 2-day move as having any more meaning than just a 1 or 2-day move. In other words the increased volatility leaves us wondering if the relentless selling into this week's low was the real trend and now the Wednesday/Thursday bounce is simply a correction before heading back down, or if this week's low was a bottom and now we've seen the beginning of a new move to the upside.

I showed some weekly charts last week with two potential EW counts that depicts future price action depending on which count is correct. I'll show updates to the SPX weekly charts (since the others look similar) at the end of this report. You can see the market dropped down to its decision level (actually a little lower just hit to hit a lot of stops for good measure) and has bounced hard since. Again that leaves us wondering if support will now hold. If it does we're looking at a choppy boring sloppy ugly-to-trade summer in front of us. If support breaks, hang onto your hats because the ride down will be swift.


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Today's rally is going to give the bulls lots of reasons to buy the market--the DOW has recovered its uptrend line and 200-dma. The pundits will be pounding the table about how undervalued everything is and what a wonderful dip-buying opportunity you had. But would you expect them to say anything differently? Of course not. My concern about a hard rally right after a hard sell is that it looks and smells too much like short covering. Sometimes that kind of short covering can go for days or weeks but it's often better to build a base from which to launch a rally. Whenever you see a v-bottom, like this week's, know in the back of your mind that we'll probably see a test of that low sooner rather than later.

We had a number of economic reports but I don't think any of them had much to do with the market's action. The market was deeply oversold and needed to come up for air. We don't know if the big bear paw will push the market's head back underwater. And with the increased volatility we won't know if a deep retracement of this bounce will continue to head for new lows or instead just be a corrective pullback. No one said this would be easy but we seem to have entered more treacherous waters than usual.

Jobless claims numbers showed some improvement as initial claims dropped 8K to 295K, making it the lowest level since mid-February and down 42K just in the past two weeks. Economists had been expecting initial claims to rise to 320K from the previous week's 303K so that was quite a surprise. The 4-week average dropped 12,250 to 315,750 which is the lowest in 6 weeks. Continuing claims rose 15K to 2.425M, the highest in 6 weeks and the 4-week average rose 10,750 to 2.42M. Over the past year the initial claims are down about 6% while continuing claims are down about 7%. These are all good numbers but it doesn't tell us what's ahead of us. The best unemployment numbers we had were seen as the stock market peaked in 2000.

The NY Empire State Index for June was 29.0 vs an expected 11.0 and a big improvement over 12.9 in May. But U.S. industrial production fell 0.1% and capacity utilization dropped 0.2 percentage points to 81.7 in May, making it the first decline since January and was an unexpected drop. Industrial production is up 4.3% for the past year. The jump in the Empire State Index is an indication that the ISM number that's due out in 2 weeks could increase after dropping in May to its lowest level since last August. New orders jumped to 25.8 from 16.2 in May. The prices-paid index rose to 52.9 from 43.1, indicating inflationary pressures. The factory job market weakened further though for the 3rd straight month, with the employment index dropping to 5.1 from 9.7. Optimism for the future remains high as the future general business conditions index rose to 62.5 from 59.4.

Capital flows into the U.S. fell sharply to $46.7B. Foreign private investors sold $7.4B in Treasuries while buying $3.2B in equities which is down from the $17B level for each of the previous two months. But foreign central banks purchased $10.7B in Treasuries which reversed March's sales of $6.3B.

As I mentioned above, the market didn't really pay any attention to these reports. It was oversold and there were reports out of several large trading houses this morning that they were going to be doing some buying today. Looks like they followed through on their word. Now we'll need to watch carefully for evidence that this is not just short covering that is so common during bear market declines. One of the reasons it's so hard to trade bear markets is because the "corrections" to the declines tend to be sharp and scary (to the bears). Playing the short side of the market is inherently riskier since your losses could be unlimited. If you're long a stock you know what your maximum loss will be--down to zero.

So when the market starts to rally against the shorts, they tend to cover a lot faster than those who are long the market and we experience a dip. We are naturally bullish and tend to hang onto long positions too long in expectation that the market will continue higher. But if we're short the market we constantly have a foot holding the exit door open and we're ready to bolt. Hence we typically see sharper rallies during a bear market decline than we would see otherwise.

And that brings me back to today's rally. Was that "normal" buying or was there too much short covering mixed in there? If it was real buying then we'll have a sustained rally and support will hold. If it was too much short covering the bounce will not hold and it will turn back down and head for new lows. Our job of course is to figure out which one is happening. Get it right and you'll make more than enough to live on. Get it wrong, and not use appropriate risk management and you'll bust your account in no time. Let's see if the charts offer some guidance in this respect.

DOW chart, Daily

After scaring all the longs out of their positions, based on the hard break down through support by its 200-dma and March 2003 uptrend line, the DOW turned around with a big raspberry and left those who stopped out standing at the bus stop staring at this in disgust. After smacking untold thousands of stops this came roaring back and recaptured those support level. This looks downright bullish from here. But the last low did not leave a bullish divergence on MACD or RSI and the sharp rally cries out "too much too fast". These v-bottom reversals look more like short covering and are suspect. But it could easily last a few weeks and therefore I don't recommend jumping in and shorting this. We'll need to wait to see how a pullback and subsequent rally looks.

SPX chart, Daily

SPX is threatening to leave a bullish divergence at its last low so that's at least a little better than the DOW. But now keep an eye on tough resistance at its broken 200-dma at 1261 and March 2003 uptrend line at 1267. That could be worth at least a short attempt to see what kind of pullback we get from there.

Nasdaq chart, Daily

This looks more bullish than the others, at least for a multi-week bounce, since it appears to have finished a 5-wave decline from the April high. From a larger wave pattern perspective I don't know if that leg down finished a larger pullback correction and now we'll see a run to new highs over the summer or if instead the decline was just the first wave down of many to follow. Regardless it should mean we now need at least a larger bounce and that could mean a choppy rally back up to the 2230 area.

QQQQ chart, Daily

Like the COMP the QQQQ shows a 5-wave decline could have finished at this week's low. That would at least set up a 3-wave bounce that could take the Qs back up to the $40 area, may be even up to its 200-dma near $40.50. If the decline has finished a larger corrective pullback from January then we should see a new rally (probably choppy) through the summer to new highs.

SOX index, Daily chart

The buyers liked the beaten techs and they piled into the SOX as well. But they'll need to continue tomorrow in order to beat it back through resistance by its 20-dma and broken uptrend line from April 2005, both basically where the SOX closed today. A failure here, a kiss goodbye, would look bearish and could mean another drop to hit its Fib projection at 422. A continuation higher could mean an eventual run up to its 200-dma near 490. The bad news here? The 50-dma is about to cross down through the 200-dma which is typically a longer term sell signal.

I've mentioned a few times recently that I'll be very curious to see how well the mega-banks report earnings from their trading operations. I've gone on ad nauseum about the collusion between the Fed, SEC and mega-banks and how the banks' trading teams have "removed risk" from their trading operations. The only way they can do that is if they can control the market. And if they're controlling the market then they should be able to continue making gazillions of dollars each quarter from their trading operations regardless of direction. But if they're trying to hold the market up (such as the PPT would want) then they'll get creamed by the sellers overpowering them. Well, we got our answer.

Bear Stearns (BSC 131.36 +7.36) reported today and showed strong earnings from their trading operations. Last quarter was up huge as compared to the previous quarter and year ago. Today's results showed trading profits up 81% as compared to a year ago, $2B as compared to last year's $1.4B. This follows Goldman Sachs' (GS 144.21 +5.62) report that they doubled their earnings from trading operations. Total trading and investments was reported to be $6.9B for the quarter, up from $2.8B (+147%) from the year-ago quarter. They were relatively flat against the previous quarter (up only 1%). Poor babies.

So these mega banks continue to trade well (tough not to) and they're obviously have been behind much of the selling we've been experiencing. Anyone have a way to bug their trading rooms? Just kidding of course, well maybe not.

BIX banking index, Daily chart

The banks have a nice reversal pattern off its 200-dma but I'm curious about why the oscillators haven't reversed back up. Is this telling us the buying wasn't that strong? For now I'd say the banks need to get back above potential resistance at the lows of its recent consolidation. Obviously a break back below its 200-dma would be a very bearish thing.

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

That green candle for the housing index looks pretty small as compared to its decline. If it can break out of its very tight down-channel we could see a larger sideways/up correction but the larger pattern calls for more downside and the target is still down near 500.

Oil chart, July contract, Daily

Oil is so close and yet so far from support in the $66-$68 area. I'm still expecting it to chop its way lower before setting up a larger rally. Oil stocks have been threatening to break down so watching them should give us some clues as to what's next for oil.

Oil Index chart, Daily

Oil stocks acted like the major indices and broke support at the uptrend line and 200-dma and looks to have recovered both today, but ran into its 20-dma at 571. So it's in a must-hold area now otherwise a break lower will likely see the March lows get taken out and that would mean the current EW count (looking for another high) is wrong and that we've probably already seen the highs.

Transportation Index chart, TRAN, Daily

The Transports got a bounce with the broader market but did so from an area between its major averages (with a pretty wide spread between them). A bounce up to just shy of 4700 will find resistance at its 50-dma and a continuation lower should find support at its 200-dma near 4240 (and climbing). But first it needs to break its downtrend line near 4650 so just above today's close.

U.S. Dollar chart, Daily

The dollar has continued a little higher as I thought it might. I thought the $86 area would be resistance by its 50-dma, broken uptrend line and a Fib projection for this leg up from early June. I expect this resistance level to hold and see the dollar turn back down to a new low. I also think it could find support in the $83 area which will set up a longer correction through the summer.

Gold chart, August contract, Daily

Ouch. Too bad it's not an easier task of identifying tops to parabolic rallies. They all end this way and obviously a short in this would have paid out handsomely. I'm thinking we could see a small consolidation here followed by one more new low before it sets up a larger bounce. The uptrend line near $550 and the Fib projection at $531 could be the downside target. Right now it's finding support at its 200-dma although the overnight low on the 13th hit 546.40 so it broke it briefly.

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

Tomorrow will be light on the economic reports--only the current account (deficit) number will be released and then the Michigan preliminary sentiment number. There aren't any expected surprises.

Sector action was all in the green on my sector list. At the lead were the airlines, securities brokers, energy, gold and silver, the SOX and Trannies. Down at the bottom of the green pile were healthcare, drugs and pharmaceuticals, utilities and financials. These were hardly weak though--they were up "only" 1% to 2% vs. 4% and 5% for the better performing sectors today.

Going back to the initial table at the beginning of this report, one look at the numbers will show that today was indeed very strong. Up volume was 20:1 better than down volume. That's huge and in reality too huge. That's panic buying and leaves a doubt in my mind as to its sustainability. Advancing issues had it over declining issues 4:1. Total volume was a respectable 5.5B. But 52-wk lows outnumbered new highs 230 to 102 so that raises an eyebrow. The equity put/call ratio was high and this normally would say we had too many non-believers in the rally (buying puts) which would be bullish (the wall of worry). The trouble with using this measurement this week is that opex can skew it.

Speaking of skewed, have you seen the VIX numbers? We've seen a 2-day drop in the VIX which hasn't been seen since July 2002 and September 2001 before that. One look at the daily charts will show you that those were the times we saw market lows followed by strong bounces. But after the bounce into August 2002 the market headed for new lows in October 2002. We have no idea what is setting up here but we could be seeing a similar setup for the summer.

This brings me to a review of the two weekly charts for SPX (similar for the others) that I showed last week and said we'd keep an eye on them to see if we can figure out which EW pattern will turn out to be the preferred count. The critical line is the trend line along the lows since August 2004 which is the line that got tested (and slightly broken) this week. It's a must-hold line for the bulls.

SPX chart, Weekly, More Immediately Bearish

Not much has changed from last week except for that spike down through the bottom of the wedge and has left a tail. SPX has also climbed back above 1250 which I think is an important level to hold. If it continues to hold and pulls back correctively, this bearish count is not the correct count and we go to the one below.

SPX chart, Weekly, Intermediate Bullish

With that lower trend line holding, and as long as price doesn't spike back down (an impulsive move lower after bouncing off support like this would be a bearish move), this EW count is the preferred count. It shows the need for a 3-wave choppy rally through the summer that should take us to new market highs. It would be a great setup for a long term short play into 2007, which by some longer term cycle studies shows this fall and into spring of 2007 will be an ugly time in the market.

The bad thing about the chart above is that it means traders will have a devil of a time trading this summer. We'll continue to see choppy whipsaw price action which will be aggravated by low-volume summer trading. Forget trading Fridays. The good news is that those who are long positions in equities will have one last chance to liquidate and get the heck out of Dodge. You will not want to be long the market, at all, starting this fall if this pattern plays out. It'll be a back-up-three-trucks short setup if I ever saw one.

In the meantime, keep your powder dry and wait on your long term trading decisions. A break back below this week's lows in the indices and you'll want LEAP puts to ride the market down. Or buy them at the new high after the summer. But not yet. Good luck tomorrow and I'll see you here next week.

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