Option Investor
Market Wrap

Grinding Higher II

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Grinding higher was the title of last week's Wrap and the grind continues. The market is struggling higher in a very choppy pattern with lots of overlapping highs and lows. This is a bearish pattern but for the past couple of weeks it's been hard to short. Every time the market threatens to roll over some more money is jammed into the market to hold it up and then the shorts cover and we get another little spike up to another high. That's followed by no follow through and another roll over in the making. In comes more money and the whole process repeats.

It's been a frustrating pattern to trade unless you got long at or near the July low and just ignore all the noise. I've been talking for weeks now about two potential scenarios that could play out this summer, one being a choppy summer rally. Guess what I think is playing out. I'll give an update to the SPX chart that shows that scenario in progress. It was the one I've been leaning towards if for no other reason than because I couldn't see a hard sell off in the summer. A hard sell off in the fall makes a lot more sense.

However, I had been thinking that we'd see a choppy summer rally to new market highs. I no longer believe that will happen. I think the scenario that we'll see is a choppy rally that retraces a good portion of the May-June drop that then sets up a large and fast drop to new lows into the fall. I'll show that depiction at the end of this Wrap.

I think we're getting close to topping out for the leg up from the July low which will set up a tradeable short but then we should rally again into September is my best guess. All of the moves will likely continue to be choppy and full of whipsaws. In other words the next month or so could be a good time to take that well deserved vacation away from the market.


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In the meantime, reviewing this morning's economic reports, the market was first surprised by an unexpected rise in interest rates out of the Bank of England. They raised the key interest rate by a quarter point to 4.75%. Fear of inflation was the reason. Then the European Central Bank (ECB) raised its key interest rate a quarter point to 3%, also citing inflation worries as the reason. This hike had been expected and is the 4th one in the past 8 months. There is concern that the ECB may start to accelerate rate increases as evidence of increasing inflation continues to mount. These rate increases instilled some fear into the pre-market futures players but then the cavalry (mega banks and their trading teams) arrived after the open and lifted the market high enough to get the shorts to cover.

We had our weekly unemployment numbers which at 315K for new claims was higher than the expected 308K and up 17K from the revised 298K for the previous week. The 4-week average for new claims stayed flat at just under 314K. Continuing claims rose 11K to 2.48M while the 4-week average rose by 8K to 2.47M. The numbers show some softening in the employment picture (Fed friendly?).

Factory Orders increased 1.2% which was up from the revised 0.7% for May (down from the originally reported 1.0%) but less than the 1.7% expected by the market. Along with the ISM Services number dropping to 54.8 from June's 57.0, we have more signs of some slowing in the economy. June factory shipments fell -0.3%. Last week we had a report showing a surprising drop in business investment in Q2 as reported in the GDP data and now the factory orders report shows shipments of core capital goods fell 0.5% in June after no change in May.

Other June factory numbers reported:
-- Factory inventory-sales ratio rose to 1.16 (either higher production, which increases GDP, or lower sales but in either case it's going the wrong way).
-- orders ex-transportation were up +0.1% (the transportation orders was a result of a large one-time jump in orders for ships and aircraft from the military).
-- core capital equipment orders were up + 0.9% (a sign that businesses are still somewhat hopeful about the future but demand has softened).
-- nondurable shipments fell -0.7%.
-- durable goods orders were revised up to 2.9% vs. 3.1%.

In addition to the 54.8 ISM Services number the non-manufacturing prices index was up slightly at 74.8 vs. June's 73.9. New orders index dropped slightly to 55.6 from 56.6 while the non-mfg employment index was up slightly at 54.5 from 52.0. Increased pricing from higher fuel costs is an "area of concern" for the Fed.

Some retailers reported results for their July sales and generally speaking sales were mixed. While sales were lower than expected most were pleased at the continued strength of the consumer in the face of rising fuel and housing costs. In the face of a plummeting savings rate (the lowest since the Great Depression) I can only believe this is all going to end badly. But the consumer continues to spend and that's helping our economy. I just keep wondering where critical mass is. At any rate, bad news must have been priced into the retailers because they were one of the leading sectors today, up +2.2% today, behind only the Transports.

Taking a look over the charts leaves me with the impression that we're not far from tipping back over (of course I thought that last week). The closer we get to FOMC on August 9th with the market held up like it is the more bearish I feel the reaction will be to the Fed. That tells me we should expect not just another rate increase but probably no change to their wording. The market would throw a big hissy fit if that happens and that's what appears to be setting up to me. Let's take a look at the charts.

DOW chart, Daily

The DOW has looked reasonably strong during the July rally but once again I ask why the DOW is leading the way as compared to the techs and small caps. This looks defensive to me just like it did as the market rallied into the May high. I think the outcome will be the same although not necessarily right away. The DOW looks like it will have difficulty with the 11300 area as the oscillators have cycled back up to overbought. The climb up off the July low has been with negative divergences and looks like a market being held up into the FOMC meeting next week. Sell the news is the way it looks to be shaping up.

SPX chart, Daily

The big caps have been getting a lot of money poured into them lately. The techs and small caps have been woefully ignored and that's not a good sign. I show a price depiction here that says we'll see more consolidation between the June and July highs and lows before this is ready to tip over. As I show in the SPX weekly chart at the end of the report, this scenario is a mix between the "immediately bearish" and "intermediate bullish" scenarios that I've been showing for many weeks now. This scenario says the market is holding on through the summer rather than make new highs and then there will be a hard drop in the fall.

Nasdaq chart, Daily

Tech players should realize they're on borrowed time here if they're long the market. This index is still trapped in a down trend and needs to break above 2100 to break it. Better yet they need to get this index above its 50-dma just above the downtrend line at 2118. But facing stiff resistance here as the oscillators reach into overbought is not usually conducive to long plays. Pull up those stops. MACD has risen up to the zero line but is still negative. If it rolls back over here that would be one of the strongest MACD setups you look for--a move back to the zero line without crossing it means the original trend (down in this case) will continue. That's the setup here.

QQQQ chart, Daily

The Q's look the same as the COMP now. For a while there I thought the Q's might be acting a little stronger but now they look just as week as the COMP. Hitting the downtrend line while stochastics hits overbought doesn't give me the impression there's enough fuel to break the down trend. MACD coming up to the zero line but still negative and looking ready to cross back down is a bearish setup. The Q's need to break the downtrend line at 37.20 and then the 50-dma at 37.75. That could be tough.

SMH index, Daily chart

With the semi's breaking the downtrend line from May perhaps that's a positive sign for the Q's and the COMP. But if the trend line is drawn from the April high (which was a little higher than May's high) then SMH is struggling with the same downtrend line. And stochastics and MACD paint the same bearish picture here.

As interest rates have risen over the past year we've been talking more and more about how difficult it will become for homeowners to handle higher mortgage payments on their adjustable rate mortgages. In addition to the primary mortgages many people have borrowed against their homes and these loans are almost universally adjustable rate. That means the majority of homeowners are likely facing higher payments in the past year.

The higher payments will push many over-extended families past the edge and the fear has been that many homes will then hit the market as banks try to get rid of this inventory that they don't want. Today there was a report on the number of defaults on mortgage payments which reported a rise to a three-year high in Q2 in California. According to DataQuick, a real estate data-compiling firm, lenders sent 20,752 default notices to homeowners in CA, up 10.5% from 18,778 the previous quarter and up 67.2% from 12,408 in the second quarter of 2005. Notices of default are formal documents filed with the county recorder's office which mark the first step of the foreclosure process. Marshall Prentice, DataQuick's president said, "We would have to see defaults roughly double from today's level before they would begin to impact home values much." So now we know what to watch for as the next quarter's numbers are reported.

BIX banking index, Daily chart

Banks aren't worried about foreclosures yet though as they rallied today to a new high for the month. The trouble I see for the banks is the shape of the rally--it's filled with overlapping highs and lows on the short term chart and looks very corrective. This means to me that it's a correction to the previous move--the May-June decline--and that the previous move will continue once the correction is finished. Whether or not the banks can make it up to the 390 area is doubtful but possible. I'd be looking for opportunities to find some short entries in this index.

Securities broker index, Daily chart

The bounce in the brokers from the July low looks even more corrective than the one for the banks. If this can rally back up for another test of the broken uptrend line near 220 I'd short it. It may not make it up there but instead top out near here and be part of a developing sideways triangle forming since the June low.

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

The bullish divergence at the July low has led to a nice bounce in the home builders. Now that it has made it up to the 50-dma that may be all there is. I'm not sure if we'll get a larger sideways consolidation in the builders or a turn back down to new lows but I don't expect to see this head much, if any, higher.

Oil chart, September contract, Daily

Oil got a bounce off its 50-dma but it's looking more like a correction to the July decline rather than the start of something bigger to the upside. It's a little early to determine that but I'm leaning towards seeing this drop back to a new low and break its uptrend line as it heads for its 200-dma. One reason I'm leaning this way is because I think the oil stocks are ready for a more substantial pullback.

Oil Index chart, Daily

The oil stocks have formed a nice 5-wave advance off the June low which took the index right up to the trend line along this year's highs. The trend line and the 5-wave move says this is finished and we're due for a much larger pullback. More bearishly this high could be it for the oil stocks and we'll start to see a longer term pattern to the downside develop. If you're long this sector I strongly suggest taking some profits, sell some covered calls or some buy puts. You've had a nice run and you don't want to give the bulk of it back.

Transportation Index chart, TRAN, Daily

The Trannies had a big day today but in the bigger picture it didn't amount to much. Any higher tomorrow and it will run into its downtrend line from the July high, at about 4450 tomorrow. If it manages to rally above that then we should see this head for the 50-dma but for now this is in a downtrend that hasn't been broken.

U.S. Dollar chart, Daily, courtesy stockcharts.com

For some reason QCharts is not giving me a dollar chart today so here's one courtesy of stockcharts.com. Last week I had pointed out how the dollar rallied again up to its broken uptrend line from January and March 2005 (the July high). You can see from this chart that that new high (above the June high) left a bearish divergence on MACD. A break below the July low now would be confirmation of that double-top failure and that's what I believe will happen. I'm still waiting for the dollar to drop to the $83 area to see if it finds firmer support for a much bigger bounce back up. A drop in the dollar here could give gold a boost.

Gold chart, October contract, Daily

Gold is either consolidating in preparation for a continuation of its rally or else it's going to continue lower which will probably break below 550 and head for a Fib target at 495. Play the break of this sideways triangle since it should carry in that direction for a while.

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

With the attention to the Nonfarm payroll numbers now we could see tomorrow's report move the market. We're getting close to the next Fed meeting and all eyes are on the reports the Fed is watching closely. Wage inflation and wage growth (or non growth) are important numbers. So the hourly earnings and average workweek hours are also important. The unemployment rate doesn't have much meaning anymore.

As we saw this morning, a down open doesn't necessarily mean anything. There is some big money moving the market right now and it's not that difficult in a lower volume environment. It's my opinion that the Boyz are lifting this market, selling into, rinse and repeat. They're slowly working it higher and if they continue to do this into the Fed meeting then there's little doubt what will happen after the meeting. If the Boyz are distributing their stock to unsuspecting sheep (otherwise known as the retail crowd) then they'll probably be ready for the down elevator after the Fed meeting.

The reason I have this opinion is because of the weak rally we've been in. It has been choppy and overlapping while building ascending wedges since the July low and the negative divergences makes it appear that there's some underlying distribution going on. If this interpretation is correct then we'll see a market sell off once we get past the Fed. At least that'll be as good an excuse as any. We could then drop back down to near the July lows over the next few weeks before starting the choppy rise once again into Sept/Oct before the bottom falls out.

But we can't fight the tape and the tape is currently bullish. While I have trouble buying this market I also recognize it's a difficult market to short. That's why personally I'm finding more success in selling spreads away from the noise of the market. But today looked pretty bullish, or at least was supported by a look at the internals as well as my sector list. There was nothing exceptional in the internals but at least there wasn't much to negate today's green day, except for one--the new 52-week lows vs. new highs. At 263 vs. 262 this is another sign to me that we have underlying distribution going on in this market. While price says stay long the market I see enough signs that tell me to be very careful if long. Personally I think short or flat is a better place to be although it may be a tad early to be short.

Looking over today's sectors, the leaders of the pack were the Trannies, retailers, SOX, securities brokers and cyclicals. There weren't that many in the red but they included gold and silver, energy, utilities and healthcare.

After today's close we had an earnings report from Gateway (GTW 1.59 +0.02) which reported a loss of $7.7M, or -2 cents a share. This compares to a profit of $17.2M, or +5 cents a share in the year-ago period. Revenue was up but obviously their margins were lower. That will probably be the name of the game in the tech field for a while.
Hard to believe GTW was an $84 stock once way back when. It dropped another 0.16 after their earnings and closed at $1.43.

SPX chart, Weekly, Choppy Summer-Bad Fall

This weekly chart puts the daily chart, at the beginning of the above charts, into perspective. A drop back down near the June low and then a bounce back up into September would look like a relatively small consolidation on the weekly chart. It's been a long dragged out affair on the daily chart but is just a blip on the weekly chart. After carrying two scenarios for weeks ("more immediately bearish" and "intermediate bullish") I've settled on this scenario which is a hybrid between the other two.

Instead of expecting a choppy summer rally to new market highs vs an immediate hard decline below the trend line along the lows since August 2004 this price depiction shows a consolidation just above/around that lower trend line and then a break below it in the fall. Weekly stochastics looks bullish while MACD looks bearish (staying in negative territory) and the combination means choppy price action. Sound familiar.

Based on the internal price action I feel confident about this scenario. I think the pattern needs a move back down and then another bounce before we'll see bad things happen in the market. If you're long the market you may want to take some profits, sell some covered calls or buy some puts. Assuming we get the drop and then bounce back up, it'll be in Sept/Oct that you'll want to seriously consider getting flat or short in a big way.

For the next week we could see the market chop its way slightly higher as we head into FOMC next Wednesday. It appears to me that the Boyz are pushing this market higher while they sell into it (the internals and price pattern looks like distribution to me). If true then we're being set up for a sell the news once FOMC announces their decision. It could get wild after that and we could see a hard drop but I don't believe it will be the start of anything major to the downside (other than a 500-point drop in the DOW over the following couple of weeks). It should be a great swing trade to the south side.

But I expect the moves up and down to be choppy and full of whipsaws through the rest of this month. Trade fast, take profits often and try to go with the larger trend (whatever time frame you trade) and ignore the noise as best you can. Selling credit spreads continues to work. Good luck and I'll see you tomorrow on the Monitor or here next week.

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