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Market Wrap

Once Again, Bad News Is Good News

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(Linda and I (Keene) have switched Market Wrap nights so I'll be writing tonight's and Linda will take tomorrow.) We all know the market is not logical. It's a living, breathing organism that's made up of millions of us people. It has the collective emotions of all who trade it. And like an individual human being, the market doesn't always react rationally to events or news. Take the inflation data as an example, which is the reason we're being told the market has rallied so strongly the past two days. First of all, the inflation data by the PPI yesterday showed a drop in inflation. Today's data was a little more of a mixed message but the CPI was up +0.4% from +0.2% for June and is higher by 4.2% than a year ago. Even core CPI, at +2.7% year-over-year, is the highest reading since December 2001.

So if the market rallied strong on the drop in PPI why did it rally strong on the rise in CPI? Silly me for asking such a logical question and expecting a logical answer. Trading the news is a hit or miss proposition for traders. The market does what it does regardless of the news. The commentators then try to fit the market's moves into a neat little package that they can explain. What's really amazing is that many of these people believe what they're saying.

How about this? It's opex week, there were many funds who had sold calls as part of their monthly option writing exercise and they had to cover their positions once their strike positions were threatened. Those who felt least bullish about the market were the ones forced to do the buying the past 2 days. How ironic. We know the mega banks' trading teams have been doing extremely well over the past few years (since they've been able to remove market risk from their trading). If they want to move the market in a certain direction they have enough firepower to do it. If they position for opex with a lot of deep in-the-money sold puts and cheap front-month long calls, and they know that they can probably get the market up high enough to trigger a bunch of stops, then it's easy to see how they've been able to remove risk from the market. I would venture to say they've had this plan all along for this week and the market would have done this regardless of the inflation data. Yesterday's and today's conflicting inflation data supports my contention.

Furthermore, if the Fed is being successful in slowing down the economy, which inflation data is used as one of their gauges, does it make sense to buy stocks when growth is slowing? Of course not, but that's one of those logical considerations that the market ignores. The recognition will come later and that's why the market is consistently lower 6 and 12 months out from the time the Fed stops raising rates. If the Fed has stopped as of August that means in February and August of 2007 we will be in a market that is below today's prices. Those are the statistics. So again one may ask why the market is rallying so strongly. Silly question.

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The bond market has been rallying strong as well. That of course drives yields down. What the bond market is predicting is a drop in interest rates instead of a further increase. If the Fed turns around and starts to drop rates we'll know they've recognized the signs of a too-fast slowing economy. If anything that's what the bond market is telling me. But that's all in our near future. For now (opex week at least) we've got a rally on our hands and we all know better, I hope, than to argue our point with the market. Price rules and we do our best to get on the right side of those moves.

In addition to the inflation data this morning we had some housing data. None of it was particularly good but that didn't prevent the home builders from rallying. By the way, did you catch the news yesterday that the confidence level of home builders is at the lowest it's been in 15 years. These are the people that peer over the horizon to see how the housing market is looking and they're not feeling especially rosy about the future of the housing market. We should be listening to these people.

Today's numbers showed a drop in building permits from 1862K in June to 1747K which was almost 100K less than expected. This is more evidence of the economy slowing and more bad news is good news for the equity market, for now. Housing starts fell from June's 1841K to 1795K, the lowest it's been since November 2004 and is the 5th decline in the past 6 months. With permits declining faster than housing starts, and lower than starts last month, we can see where housing starts are headed. Permits have declined 6 straight months now and is the largest drop since September 1999.

Industrial production numbers were also released this morning and showed an increase of +0.4% which was half of June's +0.8% and below expectations for +0.6%. More evidence of an economy slowing down. But hey, that means the Fed won't have to raise interest rates anymore. And that's bullish because? Capacity utilization was also reported and showed a slight tick higher to 82.4% from June's 82.3%. It was a little lower than expectations for 82.7%.

But as I said, the market (or some big players) had an agenda so the news wasn't really the reason for the rally. Unfortunately the market has been so choppy and full of whipsaws that it's been very hard to make any decent swing trades. Each time one side thinks we've started a new trend the market reverses and forces traders out at break even or at a slight loss. Now we've had a strong 2-day rally and we must wonder if it's the start of something bigger to the upside or just more of the same chop. Those bulls who got excited yesterday and today may be the ones who are stopped out tomorrow as the market takes back all their gains. Then it will happen to the bears. Rinse and repeat. This market has only rewarded those who take their profits early and quickly and play the base hits rather than the homerun plays. Let's see if we can make any sense of the charts tonight.

DOW chart, Daily

The last two times the DOW pressed up against the trend line along the highs since January 2004 (other than the big rally above it in April-May), in July and August 4th, a quick decline followed. The bulls are hoping for a different outcome this time. Stochastics and MACD support a move higher. It's always hard to tell whether or not a move during opex week is sustainable or not. If this is just opex then we can expect a quick reversal into next week. If this is the market rallying on what many perceive to be a good thing that the Fed is stopping its rate increases then it should run higher at which time it will set up a very good long term short position. But caution right now as we let this run its course.

SPX chart, Daily

We have a similar picture to the DOW except with a different trend line--one along the July and August highs and slightly higher than the March 2003 uptrend line. Each time it pressed above that trend line it dropped back down the following day. If the market is able to hold its gains tomorrow then that will be a change in behavior. But even if we're going to get a choppy summer rally the operative word there is choppy. It is unlikely to go up in a straight line (if it did I'd be soon backing up two trucks and loading up on long term put options). Opex is exaggerating moves this week so be cautious at this point about the long side. And clearly shorts are not working at the moment.

Nasdaq chart, Daily

When the COMP decided it was time to leave that down-channel it did it with gusto. Hopefully this isn't just an opex related jam to the upside to catch the bears napping. It will be important to keep this going for the bulls now. The 38% retracement of the April-July decline is at 2151 and two equal legs up from the July low is at 2154 so this makes a potentially important Fib area to watch for resistance. The move up from that July low is so far only a 3-wave bounce. If it turns back around and heads south then the EW (Elliott Wave) count on this suggests we could see a very nasty sell off. The previous dip to 2050 must hold now on any pullback otherwise the bulls could be in trouble. But until then this could develop some legs to the upside. Just remember, this is opex week. The chart of the Q's looks the same.

SMH index, Daily chart

Similar to the COMP, the 38% retracement of the decline in the semis from the January high is at 33.46 and two equal legs up in its bounce off the July low is at 33.67. At the same level is the previous bounce. Also located there is the top of a potential parallel down-channel. Therefore keep an eye on this area for a potential topping, at least for the short term.

BIX banking index, Daily chart

After breaking down from its ascending wedge pattern that it had built from the June low, the banks have now bounced back up to the lower line. Any roll back over from here will look like a perfect retest and kiss goodbye and would be an excellent short play. The bulls need to hold this up or else.

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

The housing numbers were not good today but obviously traders didn't care today. Or at least bulls didn't care to hear bad news anyway. And the shorts were forced to cover so the combination created a nice day to be long the market. The home builders stopped at the 50-dma today so we'll have to see if it breaks or not. If the bulls can keep this going then I think there's a good chance we'll see this index work its way up to its downtrend line from January. If it rolls back over from here then we might see a longer sideways consolidation form before this index heads lower again.

Crude inventory numbers were released today and showed another drop in supplies. But that didn't stop the slide in crude futures to their lowest level since late June. OPEC lowered their forecast for oil demand for the rest of 2006. They cited an unexpected decline in demand from industrialized nations and this is more evidence of a slowing economy on a global scale, not just in the U.S.

Oil chart, September contract, Daily

As expected oil has now broken its uptrend line from last December. We should see oil head for about $70 where it will test its previous low and 200-dma. I'm sure we'll soon get a bounce back up to test the uptrend line and 50-dma near $74 before rolling back over.

Oil Index chart, Daily

This index gave plenty of warning about an impending decline. The negative divergence was glaring. With the drop in the price of oil we should see this index head lower as well. The 50-dma near 611 should be an initial target.

Transportation Index chart, TRAN, Daily

With the drop in oil's price the pundits were saying the Transports benefited from that. Donkey dust. The transports have rallied and declined regardless of what oil does. After a long and hard sell off there were clearly some shorts who were chased out of their positions the past 2 days. Nothing more. The trannies stopped at the 200-dma so that's resistance for now. Not shown on the chart is a downtrend line from the July high that sits just above where it closed today. We should see a pullback begin. It may consolidate near its lows for a while. But if the rally continues above 4430 and holds it above, then the 50-dma is very likely next.

U.S. Dollar chart, Daily

The US dollar bounced back up to test its 50-dma and has dropped from there. This all looks like part of the pattern for a move to a new low and I'm still waiting to see if the $83 area gets tested and acts as support for a much larger bounce back up.

Gold chart, October contract, Daily

Gold is threatening to break below its short term uptrend from June but is finding support at its 50-dma just below the line. If it drops below 620 it's probably headed for longer uptrend support near 600 for a brief bounce. I think it would then continue lower from there. If it continues to consolidate between 620 and 650 for another month then we'll probably get an upside resolution in which case we could see gold head for new all-time highs.

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

Tomorrow's economic reports include the usual unemployment numbers to be followed by the Leading Economic Indicators at 10:00 AM and then the Philly Fed number at noon. The LEI number is one of the better numbers for an indication of how the economy will do 6 months down the road. If it comes in as expected we should not see any effect from it. Besides, the market has its own agenda this week. But use the information to help you make some longer term decisions about the market and our economy.

Today's trading volume was average and that was a bit surprising considering we usually see higher volume during opex week. For such a strong rally I would like to have seen stronger volume. At least up volume swamped down volume by nearly 5:1. That's a little excessive but certainly not of the blow-off variety. Total advancers beat decliners a little better than 2.5:1. New 52-week highs beat new lows 300 to 165 which is not great but not bad. Certainly the internals supported the price action.

My sector list was almost all green except for the utilities and energy. Leading the winners were the Transports, SOX, airliners, networkers, disk drives and other computer hardware, and biotechs.

Hewlett-Packard (HPQ 34.50 +0.44) announced earnings after the bell and reported a fiscal Q3 profit of $1.38B, or 48 cents a share, compared to $73M, or 3 cents a share a year ago. Revenue rose 5% to $21.89B from $20.8B. H-P also said its board of directors authorized a buyback of up to $6B of company stock. The stock rallied big after the cash market closed and finished at $36.40.

Many indices seem to be up against resistance of one form or another, be it trend lines, moving averages, Fibs, etc. The best thing the market can do from here is tread water or pull back in a choppy sideways/down correction (or rally of course but then that would quickly become too much too fast). That would be an indication that we're going to see these resistance levels broken. But if you're long the market you may want to tighten up some stops in case we see a reversal like so many recent times where traders give it all back.

With the strong rally this week I'm reposting the weekly SPX chart that shows one of the scenarios I was tracking for weeks with you. This is the "intermediate bullish" scenario that called for a choppy summer rally before the bears take over and maul the bulls. I had abandoned this for the past couple of weeks because it was beginning to look like we might see only a sideways consolidation through the summer before the market continued south for the winter. I'm still leaning towards this sideways scenario but I wanted to show this slightly more bullish chart again so that we can track the market's progress on it.

SPX chart, Weekly, More Immediately Bearish

This scenario calls for a new market high to finish off the EW count for the move up from August 2004. It's a long term ascending wedge that needs another 3-wave move up from the June 2006 low in order to give us a 5-wave count inside the wedge. This is a tricky pattern and difficult to count and that's why I've been considering a couple of different wave counts to see which one shows its face. The fact that the lower trend line from August 2004 held is what told me the more immediate bearish case was likely not the one playing out. Now it's between a sideways consolidation (which would mean this week's rally will get quickly reversed) or a choppy rally continuing into September. If we get the rally into September then we'll have every bull in town pounding the table why you should buy the market into the end of the year. Nothing could be further from the truth but we'll worry about that later. For now be careful about another quick reversal and deeper pullback. This is a scalper's market and not a swing trader's. That will change but not yet. Good luck and I'll see you next Thursday or on the Market Monitor tomorrow.
 

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