Option Investor
Market Wrap

Keeping the Bears at Bay

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I've been reading a lot of analysts reporting on why the market will or should drop. I'm sure many bears have been shorting every tick higher in this market and it's been a frustrating experience for them. When you think about it there's really no reason for the market to rally. Because the Fed is done raising interest rates? Hardly. That means the economy is slowing down and companies will therefore start suffering a slowing in their earnings. That doesn't make for a bullish equity market.

Geopolitical concerns are many and certainly the Iranian situation sits at the top of that pile. While N. Korea presents a threat I think most people realize their leader Kim Jong Il is just a kook who likes to threaten people. Iran's president, Mahmoud Ahmadinejad, is threatening the world with nukes and withholding oil and I think more people take him seriously. But the market continues to give a big yawn of a response to these global threats to peace and oil availability/prices. It's the wall of worry that the bulls love to climb.

The wall of worry is of course not so much the bulls climbing the walls as it is the bears. Those who are most bearish the market are constantly forced to cover their positions when the market doesn't sink. The bears really can be their own worst enemy. But the market has been moving higher in a very corrective manner (overlapping highs and lows and in 3-wave instead of impulsive 5-wave moves). This is the mark of an ending pattern (to the upside in this case) or a correction to the previous move (the May-June decline in this case).

In either case it doesn't look good for the bulls since it would appear that the bounce from the June low could be on its last legs. We could still rally into September but even if it did it would just be a better setup for short plays. As always, the trick is finding the entry without constantly being stopped out (and being forced to climb that wall of worry).

Those of you who have been following these Market Wraps for a few months know that I was tracking two different scenarios for SPX through this summer. I was using weekly charts, with each showing the bearish ascending wedge that has developed since the January 2004 high, to show two different scenarios that could play out. Both scenarios were bearish but it was a matter of figuring out when the next leg down would begin. After the June low it began to look like we might consolidate sideways through the summer and I tossed out the more immediately bearish scenario. Now it looks like we're getting another ascending wedge developing since the July low and this suggests a combination of my two earlier scenarios is playing out--a choppy summer rally where some markets could make a new high but others will fall short.

I'll show an updated weekly SPX chart at the end of this report for a projection of where and when I think prices are headed. I'll also show a daily and 120-min chart to show why I think the current rally is coming to an end soon.

But first let's review the few economic reports that came out today. The usual weekly unemployment numbers were released and showed claims decreased by 1,000 to 313K but that was from a revised number of 314K after being reported at 315K for the prior week. So essentially it stayed flat. The 4-week average rose 3,500 to 315,250. Continuing claims fell by 9K to 2.5M while the 4-week average rose to 2.47M. The unemployment rate is 4.8%.


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New home sales data was released and it doesn't bode well for the housing industry. Sales came in below expectations dropping 4.3% in July to at 1.07M rate. Sales are down 21.6% in the past year which makes for the largest drop since late 1994. Meanwhile inventories of unsold homes rose to an 11-year high. Reports are popping up all over the place about the troubles home sellers are having. We are one year past the peak in the home builders' stock prices and it's normal for sellers to recognize a softening market about a year later.

Lewis Alexander, chief economist for Citigroup Global Markets in his global update to clients, said "...the pace of the downdraft in the U.S. housing market bears watching. It may be a leading indicator of a more significant correction in that sector and the U.S. economy overall." In my opinion this is a gross understatement. Not since the early 1900's have we seen the real estate market get way over-inflated across the country. It's always been in geographic pockets and those pockets suffered the effects of a bad housing slump. Now we will have it on a nationwide scope (actually on a global scale which will make it even worse). The consequences to our economy (and stock market) will be very negative. I've been super bearish the housing market since last summer.

In addition to the slowing in July's sales the sales data for April, May and June were also revised lower. The unsold homes inventory is now at a 6.5-month supply which makes it the largest since the end of 1995. Inventories are up 22.4% in the past year (nearly the same as the drop in sales--looks like someone didn't scale back their building plans as sales slowed down). Even though the median sales price ticked up +0.3% year-over-year to $230K it doesn't account for all the incentives/giveaways to entice the buyers into closing.

This new home sales data follows yesterday's report that the inventory of unsold used homes has risen to a level not seen since 1993. What's beginning to happen is that the speculators are being driven out of the market. I've said repeatedly to those who claim the housing market won't drop like the stock market because "everyone needs a home" that it will drop just like any other over-inflated market. Once the speculators (and the flippers) decide they can't afford the homes they're carrying they'll dump them onto the market to get whatever they can. People are now turning houses back over to the banks (foreclosure) at a record pace. Other people are holding back on buying. This will all have a very negative effect on the price of housing and it will be on a national (global) scale.

Add into the slowing housing market and the unsold homes the problem with home owners who can't afford their mortgages as rates tick higher. The adjustable rate mortgages and home equity loans are knocking more and more people out of homeownership as their payments are revised higher to the point where they can't pay any longer. Hence the "sales" back to the banks. The banks will dump these houses faster than cash-strapped speculators. I hate to paint a grim picture here but let's face reality instead of sticking our heads in the sand. The housing market will have dire consequences for the stock market and to think otherwise is just pure Polyannish.

The other report out this morning was Durable Goods Orders and it was down -2.4% vs. June's +3.5% and much lower than what the market expected (-0.8%). It was only the 2nd decline in the past 6 months. So all in all it was a dismal report and normally the market should have tanked since it's a pretty solid signal of a slowing economy. But that's just more bad news is good news for the Fed. Once the light goes off in investors' heads about this slowing economy they will not be able to get out of stocks fast enough. As we say often, the market can remain irrational far longer than you can remain solvent fighting it. Go with the flow and follow the price instead of trading what you think the market should do.

And with that let's see what price is doing.

DOW chart, Daily

The initial bounce off the June low is a 3-wave move. That's a clearly corrective move and says it's not the start of something bigger to the upside. That gave us two possibilities to look for--one, a choppy move to a new market high that would be the Last high for the bull market or two, a choppy move higher that is a correction to the May-June decline (meaning the bull market ended at the May high). In either case it's a bearish signal but we've been waiting for more price information to tell us which scenario is playing out. It now appears to me that the 2nd scenario is playing out--the bounce from the June low is correcting the May-June decline and that the bull market is finished. Now we wait for the next leg down to begin and based on the current pattern I would say we're a week or two from the top in this bounce. I would be very surprised to see DOW 11500 at this point. We may have topped already but I'm hoping we see one more push to a minor new high, perhaps near 11450, before tipping back over.

SPX chart, Daily

Like the DOW, the SPX appears to be forming an ascending wedge for its final move higher. Unlike the DOW I see the possibility that the SPX will make a new annual high but if it does it will be by only a few points. There's a Gann target of 1345 and I have Fib targets closer to 1330. So for now I'm saying the market will top out between 1330 and 1345 (that's assuming the rally continues into next week). This chart shows a Fib projection to just over 1322 based on the 2nd leg up, from the July low, equaling 162% of the 1st leg up from the June low. But dialing in a little closer I get some correlation in the 1329-1330 area.

SPX chart, 120-min

When I draw in parallel up-channels for price action since the June and July lows, I see that the tops of the channels intersect next week near 1330. Fib projections for the wave count point to 1329-1330. I don't know if we'll get the rally up to this level (any break of today's low would have me thinking the opposite) but if we do then I'll be thinking seriously of loading up on short positions.

Nasdaq chart, Daily

The COMP has had a very different price pattern from the DOW and SPX for a long time. For a while it was looking stronger after the July low but I'm beginning to wonder about the techs. There is the potential for a very bearish EW (Elliott Wave) count to play out here. We could be set up for a strong 3rd of a 3rd wave down and that would be a screamer of a decline coming up. I'm not ready to jump on that bandwagon yet but mention it because you don't want to be long the techs if the COMP drops back below its 50-dma. Below 2150 and it will be lights out for this index. In the meantime if the market can rally for another week we could see this press up to its 200-dma at 2225.

The QQQQ looks very similar to the COMP and leaves me with the same impression. The recent low needs to hold in which case we should see another leg up. Otherwise a drop to a new low, below 37.60, could mean a nastier sell off is in progress.

SMH index, Daily chart

The semis found resistance at the top of a parallel down-channel but the pullback looks corrective. It's either winding up for a big spill or else it's preparing for another rally leg. If it can break to a new high we should see the 200-dma at 35.60 get tested quickly. But the March low near 34.50 could be tough resistance.

BIX banking index, Daily chart

The banks haven't rolled over yet and they're making me think the market might not be done pushing a little higher. But if they do roll over here we'll see negative divergences left on the chart and that would be a bearish sign.

Securities broker index, Daily chart

The brokers leave me with the opposite impression than the banks and this index has done a better job at predicting the next move in the market. While price is holding on after testing the broken uptrend line again, we see negative divergences at the last retest of the August high. Another test of the 50-dma looks in progress and I'm not so sure it will hold this time. Any break below 206 could be trouble.

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

The lousy housing numbers yesterday and today didn't faze the investors in these stocks. A lousy housing market means the Fed will stop their interest rate hikes (I'm not so sure about that one) and that means homes will be less expensive to mortgage. Strange logic but what else is new. I'm not sure the home builders will try to continue their bounce and reach for the downtrend line near 700 or if will consolidate sideways instead. Or it could even drop from here and continue its southbound journey. I'm leaning towards further sideways consolidation before the next leg down.

Oil chart, September contract, Daily

Oil has broken its uptrend and consolidating underneath. We might see a bounce back up in a little bit that tests both the trend line and the 50-dma near 74.80. That's just speculation on the short term. At the July high, based on the EW count, I was calling a top and expected we would see at least a deep retracement in the price of oil. I expect oil to test, and bounce off of, its 200-dma but that should eventually give way as well.

Oil Index chart, Daily

The oil stocks are holding on but they should also continue lower. The 50-dma might offer some support but I'm expecting this index to head for the bottom of its channel and 200-dma near 600. I think those support levels will eventually break but obviously the bears have their work cut out for them for quite a while.

Transportation Index chart, TRAN, Daily

The Trannies found support on their uptrend line but I think we'll see a consolidation on top of that line before it finally gives way. We could see some back and forth for another month or so.

U.S. Dollar chart, Daily

No change to the dollar chart--still looking for a move to $83 to see if it finds support there. After this move down I expect to see the dollar get a nice multi-month rally back up into the upper $80's. That would likely set up a decline in gold which is what I'm beginning to expect now.

Gold chart, October contract, Daily

Gold has had me guessing for weeks now which way it might break. It's still a guess but if it continues to consolidate in a sideways triangle then that will probably be bearish. The sharp drop from May followed by a sideways triangle would make it a continuation pattern. Two equal legs down in that kind of pattern would give us a downside target below $500 and this is the way I'm currently leaning. It takes a break above $670 to say we've got something more bullish going on.

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

Since there are no major reports tomorrow morning the market will be on its own. But even with economic reports, like this morning's terrible numbers, the market does what it intended to do anyway. It only becomes a game for the Cheerleading Network of Buffoons and Clowns and their "guests" to then tell us why the market reacted the way it did for the news. Pretty silly if you ask me.

For a short term perspective, use the uptrend line from August 11th. Yesterday and today we saw the DOW and SPX bounce off those lines (with some slight undercuts) so we know traders are using them. As long as those uptrend lines hold, which means we can't see price break below today's lows, then I'm recommending long positions. If the SPX is going to rally up to 1330 then we have a 34-point trade ahead of us (340-point DOW trade). Whether it will rally, or rally that far, one can never know but that's the potential I see. If price breaks below today's low then I'll be looking to short the bounces. Until then I'd buy the dips.

If we do get a rally into next week, as I showed on the SPX charts above, we should watch for potential topping by the middle to end of next week. Trading continues to be choppy and is driving traders to drink. It probably won't be any different for the next week. If the SPX manages to get near or exceed the May high you can bet the pundits will be pounding the table that now is the time to get long the market. Do so at your own risk and understand you'll probably be buying the top of the market. I believe we will have one of the best short play setups that we've seen in a long time--one that should last for a couple of months before we get an end-of-year recovery (to a lower high).

This is my latest thinking on how the weekly SPX will play out:

SPX chart, Weekly, More Immediately Bearish

After moving a little higher the correction to the May-June decline should be finished. That should then set up a very strong decline (in a c-wave which is like a 3rd wave, the strongest waves of the bunch). Testing the October 2005 low (1168) should be in the cards. Then a bounce into the end of the year to be followed by a vicious sell off into the new year. Bulls will be very unhappy but if you can play the short side you should have one of your best years.

I will of course keep this picture updated as we move along. Good luck in your trading tomorrow and next week. Remember that tomorrow is a throw-away day--don't feed the zoo animals (no reference to our market of course) and don't feed your broker. A quiet summer Friday is best left alone. If you trade it, play it long unless today's low gets broken. Good luck and I'll see you next Thursday or on the Market Monitor tomorrow.

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