Option Investor
Market Wrap

Holiday Weekend Starting Early

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The total volume today (3.9B) was light and the trading range (DOW swung a total of 45 points) was puny. I'd say traders decided today was a good day to take off and start their weekend early. Also, with tropical storm Ernesto headed for the east coast, and likely to spoil the weather for the weekend, there are probably many who want to start their holiday weekend early before it gets washed out. Whatever the reason today was a very slow and listless day and provided next to nothing to trade. Even day traders had little to scalp. Options traders have only seen time bleed away from their positions. If you're trading credit spreads this is of course good news. If you're trying a directional trade then you're likely disappointed with this market.

The past two weeks has seen a very flat market. The S&P 500 has moved a grand total of 17 points in that time and each day has been full of choppy price moves. It could be consolidating for a big move higher after Labor Day or it could be finishing its choppy move higher through the summer. For a while I was thinking we could see the S&P 500 challenge its May high just below 1327 (closed today just under 1304). That's not far away and entirely possible but I'm beginning to think the rally won't be able to push up quite that high before it rolls back over. A post-Labor Day push higher to try to run the bears out of the park is a possibility but it's starting to look to me like it will be the bulls who will be run out of the fields.

If you look at the summer rally in 2002 you will see a similar pattern--a 3-wave bounce that was followed by a strong sell off in Sept/October to new lows (below July's). The August 2001 rally completed on September 1st which was the Friday before the holiday weekend. This year's pattern is very similar but a little larger time frame (so it's a fractal). This leaves us with a setup that is very similar and the short term charts suggest we could see a high tomorrow that sets up a down September. As I'll show in the charts we have some bearish ascending wedges with negative divergences. While these can always be overcome with new buying pressure after the holiday, the higher-odds play should be to the short side soon.

A trader friend (thanks John) sent this to me: "I read an article the other day by a guy who had done extensive research on the Crash of 87. He was pointing out how the chart pattern on the DOW was almost identical to the chart pattern today. It formed a big W (much like we have since May 10th). Coincidence? Maybe, and maybe not.

I've shown charts in the past that show the close correlation between consumer confidence and the stock market. This of course makes sense (to me) since the buying and selling in the market is driven by human emotion (and not such funnymentals as P/E ratios, interest rates, GDP or other such measures). When people get into a sour or fearful mood, they sell; when they feel good, they buy. And these mood swings run in cycles. Unfortunately for us we have a Fed who keeps chasing this and changing interest rates up and down when in fact all they're doing is chasing the economy up and down while thinking they're controlling things. But I digress. My point is that with consumer sentiment dropping there's a very good chance the stock market will follow.

As most of you know, I've been very bearish the housing market, and stocks, since last summer. I think the move down is only beginning to accelerate. I came across a chart showing the tight correlation between housing and the S&P 500. This chart is from 1996 to the present:

NAHB Housing Market Index and the S&P 500, 1996-2006

This chart is downright scary (for bulls, whereas bears are likely licking their chops at this chart). Since last summer we've seen the housing index crash lower and if that orange line (S&P 500) follows then we're sitting on the edge right here. The stock market is normally about 12 months behind the moves in the housing market (as indicated on the chart--S&P 500 "lagged 12 months") and the housing index peaked last July. I look at this chart and combined with many other signs that I'm seeing in the market right now I'm strongly suggesting that people protect their long positions--get out (flat), buy protection (put options) or get short. I think selling covered calls right now is foolish since the loss on your long positions will far outweigh any puny gains you make on your short call position. Bears on the other hand may want to get out the good china and silverware, fine linens and a good bottle of wine. Steak tartar is about to be served.

Before getting to the charts let's review today's economic reports since it was a fairly busy morning. The unemployment claims continued to stay flat--they fell by 2,000 to 316K but in actuality they were up 3,000 from last week's 313K before that number was revised higher to 318K. The 4-week average of continuing claims rose to its highest level, up 13,500 to 2.48M, since the end of February. The Help-Wanted index continues to inch lower. It dropped to 32 in July vs. 34 in June.
The deterioration in the job environment is felt by many to be good for the Fed since they'll feel less inclined to increase rates (I'm not so sure about that).

Personal income and spending numbers were released and showed income was up +0.5% which was expected and is a drop of 0.1% from June. Spending was up +0.8% which also was expected and was double June's 0.4%. It was the highest level since January. The higher spending vs. income led yet again to a negative savings rate which has been negative for 16 consecutive months. As Sherry Cooper, chief economist for BMO Nesbitt Burns said, the increase in spending "should prove to be short-lived, as the recent rapid deterioration in consumer confidence, sluggish job growth and the steadily weakening housing sector crimp spending going forward." A slowing in consumer spending would obviously have a negative impact on our economy which is so dependent on consumer spending.


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Consumer prices increased at a slower rate. The combination of the increase in consumer spending and the core inflation rate rising only +0.1% in July (smallest gain since December) sparked more discussion about a Fed on hold with interest rates (and sparked a rally in bonds, drop in yields). But core prices are up +2.4% for the past year which is the largest gain in 11 years. It's also higher than what the Fed wants to see (1-2%). So the moderating inflation data got people thinking the Fed could be done raising rates. The report "will convince some that core inflation is coming under control," said Stephen Stanley, chief economist for RBS Greenwich Capital. "Don't count on it." Stanley also mentioned that Dallas Fed President Jeffrey Lacker
had mentioned "until core prices are consistently rising 0.1% or less each month, the Fed is, not out of the woods yet."

The Chicago purchasing managers' index (PMI) stayed relatively flat at 57.1 vs. July's 57.9. The measure of production was 61.7% which was a slight drop from July's 64.1%. New orders were down to 59.6% from July's 60%. Prices paid also pulled back while inventories increased.

Factory orders declined -0.6% which is a drop from +1.5% in June. The drop was attributed to a 10.1% decline in transportation orders (orders for civilian aircraft dropped 10.6% and orders for ships and boats dropped 57%). Excluding those transportation orders, factory orders rose 1.1%. Shipments of factory goods were unchanged in July while inventories rose, the 9th increase in the past 10 months and is not what producers want to see. For the latest example of this, see the housing market.

None of these reports was market moving, except for brief buying or selling spurts. As mentioned at the beginning of this report the market was pretty much on hold today. Let's see how it fits in the larger picture.

DOW chart, Daily

The new highs over the past month are weaker in breadth and volume and it's not what the bulls want to see here. This lack of strength at new highs is creating an ascending wedge and these patterns are typically bearish. We've seen countless times in the past where price came roaring out of these to the upside but those times tended to be consolidations after a strong rally. In this case we have a bounce that appears more as a correction to the May-June decline than a consolidation of any rally. An ascending wedge in the larger pattern is more bearish than bullish here. If the bounce is a correction of the May-June decline then the 78.6% retracement should be the limit for the bounce. That's at 11462 and would be a slight over-throw above the top of the wedge. I'm not sure it will make it up to that level but I'd look it over carefully for a short play setup.

SPX chart, Daily

The SPX is also near to completion of an ascending wedge and the top of it is near the downtrend line from March 2000 (remember way back then?) through this past May's high at about 1314. The internal wave count inside the wedge is about complete and just a small move higher should complete it. The fact that it's so close to this downtrend line while completing the wave pattern is a strong indication to me that it's about done rallying. There are not many times when I'll pound the table for a play but this is one of them. It doesn't mean I'm right but I really like this setup for a long term short play. Back up that truck and get shorty for what I think will be a good ride on the southbound train. Just be smart and use good money management and risk management. The usual warnings go here, you know, such as don't play in traffic, don't eat yellow snow, use appropriate stop losses and position sizes, etc.

Nasdaq chart, Daily

The COMP is also nearing a wall of resistance. It could be the wall of worry for the bulls to climb but that's not how I'd bet it here. Fib and trend line resistance between 2194 and 2237 (QQQQ 39-40) is an area I'd watch carefully for short plays.

SMH index, Daily chart

The semis have been rallying strongly and this index is the one holding me back from going crazy on short plays. While this looks very close to finishing the rally up from the July low, its rally looks impulsive (5-wave rally). That would mean it's only due a pullback to correct that rally which would then be followed by another strong rally. I'll have to see what kind of decline we get and then assess whether or not it's corrective (in which case expect another rally leg) or impulsive (in which case expect lower). For now SMH has stiff resistance from here (34) up to 36. Between the 50% and 62% retracements, the 200-dma and the downtrend line from January, that's quite a wall for the bulls to overcome and it's highly unlikely this rally leg has much more life left in it.

BIX banking index, Daily chart

The banks look like they're about to roll over. But the bears have strong support they'll have to break--the 50-dma, uptrend line from last October and then the 200-dma in the 373-378 area will be difficult to break through. Needless to say, if price breaks below 373 then the bears will rule. But until then we'll have to see who the stronger side is.

Securities broker index, Daily chart

The brokers have been leaving lots of negative divergences after failing retests of the uptrend line. It's now fighting to hold onto the 50 and 200-dma's. A break down through this support zone would obviously be bearish and is what I think will happen.

Most of us are now seeing lots of reports on the housing market. As sellers wake up to the fact that their house is not selling for 20% more than last year's price they're lowering their prices. Now many are beginning to recognize that the values are actually starting to drop. We're seeing some very creative sales efforts. The new home market is cratering. Toll Brothers, the builders of McMansions, stated that they're experiencing "the biggest slump in US housing in the last 40 years." Mr. Toll says he has never seen a slump unfold like the current one. I've been saying for well over a year that it will be different this time. The fact that we've had such a huge run-up in prices on a national level (actually global) we would see a massive correction the likes that no one alive today has ever seen. It's happened before but not since the 1800's. The loss of wealth due to the dot.com bust will be a mere blip compared to what will be felt from the loss of wealth due to a housing market crash (yes, I said crash).

The lack of home appreciation, rising interest rates on adjustable rate mortgages and home equity loans and rising energy prices will all have a negative impact on consumer psyche and cause many to close their wallets. Savings rates might actually turn positive again. The lack of home sales will ripple through our economy that is only now beginning to register. The home industry has been responsible for some 30% of new jobs created. The lack of sales in consumer durables (appliances, furniture, etc.) will only add to the woes felt by those who are tied to a growing housing market. We're first seeing the speculators leaving the market and their panic will lead to further depression of prices. Foreclosures are on the rise; more houses on the market. I could go on but you get the point. A real estate correction on a national (global) scale will be very negative for our economy. Those who have been saying we'll have a soft landing have not reviewed history.

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

While the housing index could bounce a little higher it's also equally likely that the sideways consolidation has completed with this week's little rally. This should continue to stair-step lower.

Oil chart, September contract, Daily

Oil has hit a level (near $69) that should provide some support. I'm not sure we'll see a strong bounce or something that goes more sideways. I'm expecting more of a sideways consolidation if we've seen a major high for oil. That sideways move followed by another push lower would give us an impulsive 5-wave move down and would be a strong signal that we've seen the high in oil for a very long time. A slowing economy supports this interpretation.

Oil Index chart, Daily

With the drop in oil it's now looking like the stocks are following. As expected the 50-dma did not offer support. This index should drop relatively quickly to the 600 area before finding support. That, and the 200-dma just below it, should eventually break but they will certainly provide at least some temporary support.

Transportation Index chart, TRAN, Daily

If the transports can get another leg up in its bounce then it should be able to test its 50 and 200-dma's. That would be tough resistance especially since the 50 will soon be crossing the 200 if price stays down. It's equally possible that we'll see a sideways consolidation rather than a higher bounce.

U.S. Dollar chart, Daily

The current consolidation in the US dollar should lead to another leg down. I expect the 50-dma to continue to hold it down. Still looking for the $83 level to get tested.

Gold chart, October contract, Daily

Gold remains trapped in its sideways triangle and a break of either side should be the direction that you'll want to play it for the next several months. I show a depiction for a downside resolution since that's the way I'm leaning here. But until we get the break it's best to watch and wait.

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

Tomorrow is a busy day for economic reports, several of which could be market moving. I'm looking for an upside resolution to the sideways consolidation that the market has been in so watch for that possibility tomorrow once these reports are out of the way. Bad news will be good news and good news will be good news. The pundits will spin their reports to make it look like they know what they're talking about.

SPX chart, Weekly

With a daily chart that looks near complete for the rally leg up from July, and completing a 3-wave corrective bounce from the June low, this weekly chart also supports the view that we should be getting ready for another leg down. A drop to the October 2005 lows (DOW 10200 and SPX 1170) should be the next move and it should happen relatively quickly. If you find that hard to believe go back and look at that chart I showed in the beginning of this report that compare the SPX to the housing index. The decline is coming.

For tomorrow, other than a very quiet summer Friday, a day before a long weekend, I'm looking for a bullish day. Depending on how high it gets I'll be looking for a high to be put in place tomorrow or early next week. DOW 11455 and SPX 1314 are two numbers to keep an eye on. The techs might be a little stronger relatively speaking. If we do get the rally you might want to think about selling some credit spreads and let the long weekend work its magic on those.

This market has been cruel to day traders and that may not change tomorrow. Wait for the rest of the traders to return next week and hopefully you'll get some good bearish plays in. In the meantime continue to keep your powder dry and wait for better evidence that we've made some kind of high. I'm hoping by this time next week that we might have some early signals in that respect. If I'm right about the next decline you'll have plenty of time to grab a short play off the first big bounce. We don't need to be heroes and catch the tippy top. It's fun when you do but usually costly trying to find it. Let the market pull back then bounce and then we'll identify some good short entries that should be good for a multi-week short play. Good luck in the next week and I'll see you back here next Thursday, or on the Market Monitor tomorrow.

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