Option Investor
Market Wrap

The Year of Opposites

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This year has demonstrated rather remarkably how the "norms" can't always be traded reliably. Throughout the year what typically happens during certain periods of the year has not happened this year. When past years have shown the market declined we've rallied and vice versa. This September and October are turning out to be no different. Many market participants were setting up for a big correction in the August/September time frame and when it didn't happen we saw a relatively strong rally instead.

Coming into October, especially after an end of month/quarter rally in September, many expected to see a down week. Instead we had a strong rally. So if October is known as the "Bear Killer", meaning significant lows are typically found and we see strong rallies into the end of the year, will it be the same this year? Or is the positioning of the participants for the expected rally going to cause the opposite result? At this point it wouldn't surprise me in the least.

The bullish sentiment in the media is thick enough to cut with a knife. It seems everyone is expecting a rate cut soon and that the economy will rebound. New DOW highs and highs for SPX not seen since 2001 have gotten so many excited that they can't stand it anymore and they're investing their hard-earned (borrowed?) money. Will they be buying the top as often happens? It seems the bullish excitement of the late 1990's and 2000 has returned with a vengeance. One look at the near record low VIX is enough to show you that complacency reigns supreme.

For those wondering whether or not I've been shamed out of my bearish stance on the market I will simply and emphatically say no. The past week's rally was a masterful job by Big Money to get the DOW to a new all-time high and the accompanying media frenzy around the new high. This has resulted in every Mom and Pop with money to call their broker, or log in to their brokerage account, and put it to work in this great bull market of ours.

The market's relentless push higher for the past 3 months has stretched the rubber band further than normal. The fundamentals haven't changed and all the reasons we're hearing for a rallying market are not holding up, namely lower oil and the expectation of lower interest rates. A stretched rubber band will snap back harder if it's stretched further and someone finally lets go of it.

I turned bearish this market too early that's for sure. And I've missed a couple hundred-point run in the DOW because of it. I should have had greater confidence that Big Money would be able to drive the DOW to new highs so as to create the bullish excitement they need in order to hand off their inventory. I underestimated them and it cost me in lost opportunity and in short positions that got stopped out. To those who may have followed me I apologize for that error in judgment. But the underlying reasons for my bearishness still exist.

Before going further, let me show just two charts to emphasize my point. First is the pharmaceutical index:

Pharmaceutical index, PPH, Daily chart

The pattern on this one is pretty clear and shows a nice 5-wave advance from June with the 5th wave clearly negatively divergent against the 3rd wave (the high in late July). Price broke its uptrend line this week, jumped up for a retest and sold off today. Big bearish divergence and a big sell signal today.

The NYSE is harder to manipulate because it has far more stocks than the DOW's 30 or even the 500 in the S&P. Here's its chart:

NYSE chart, Daily

While the DOW and SPX have broken above their ascending wedges (shown below), the NYSE is now just hitting the top of its parallel channel which is the top of its ascending wedge. The bearish divergences support the bearish picture here, and again this one is less manipulated. Driving the DOW and SPX up was done relatively easily in order to get the media attention.

Could this market continue to ignore lots of sell signals and march another 1000 points higher on the DOW. Absolutely. Is that the way you'd like to bet your money when you look at the NYSE chart? Me neither.

The big unknown in front of us, especially this month, is what the Fed is up to. And they could be one of the primary driving factors behind this rally. There's all kinds of conspiracy theories about holding the market up until the elections and while there may be money behind that effort I think it pales by comparison to the efforts by the Fed to hold the economy up, and by association the stock and bond markets.

The Fed loves to jawbone the market. They'll say one thing but do another. The stock and bond markets have been rallying under the assumption that with a slowing economy the Fed will not only stop raising interest rates but they could be close to lowering them. The Fed has sent out a few of its emissaries this week to disabuse the market of that idea. Philly's Fed president, Charles Plosser, said today that we'll probably see another rate increase before a decrease. In his words, "Recent developments in the real economy may be suggesting that lower interest rates are called for, but I do not believe that is the case." He said he is much more concerned that inflation could spiral out of control than he is about a sharp slowdown. The stock market didn't care and rallied a little more. The European Central Bank (ECB) raised rates .25% to 3.25%, the 5th increase in 11 months. The stock market didn't care and rallied a little more.

Did you notice what the bond market did though? It sold off and nearly gave up all its gains from its strong rally yesterday. That's where the smart money trades and we should be listening. The stock market tends to be a little slower on the uptake and then when general recognition hits it's usually a knee-jerk response (often news related but was obviously primed and ready for the move). Today's decline in the bonds leaves just a 3-wave bounce from the low put in on September 29th. That corrective bounce means lower bond prices (higher yields) just ahead. That's when a lot of new buyers of the stock market will give a collective uh-oh.

There's a lot of money coming into the market and we know the money supply is up (but we don't know about M-3, which specifically measures the Fed's activities with money supply). This money makes it into the banking system through its primary dealers which are the same big banks I've discussed often--those with trading teams that are involved in "risk-free" trading. If they see a lot of Fed money coming in, they simply tack on their considerable trading capital and make huge bets that pay off. If the Fed withdraws money the mega-banks' trading teams sell short, buy puts, etc. to enjoy the ride down.

The question of course is why the Fed would be pumping up the money supply. The Fed uses money supply to tweak the economy far more than they use interest rate changes. They'll jawbone the market about concerns they have and what that might do to the economy but that's usually an effort to sway the opinion of the bond market. In the meantime the man behind the curtain is pulling the currency levers. If they're concerned about a slowing economy (and housing) they can and will pump huge sums of money into the economy to keep the pump primed. The longer term problem with this is that they'll worsen inflationary pressures. Hence their jawboning about the need to stay vigilant against the inflation monster (that they're helping to create, or inflate).

There were early headlines this morning about oil back over $60. The stock market rallied a little more. There's clearly a disconnect between reality and expectations, but isn't that always the case. They say the stock market is able to forecast what's coming six months down the road. I say the stock market has trouble figuring out what happened yesterday.

There was only one economic report this morning, other than the ECB interest rate change, and that was the unemployment numbers. Initial claims fell by 17K to 302K, the lowest level since July. The 4-week average fell 2,750 to 313,500 which is the lowest it's been since August. With that, let's take a look at the charts to see what the past week has done to them.

DOW chart, Daily

With the ascending wedge drawn in here, this move above it looks downright bullish. That's a breakout if I ever saw one. And if I were getting some confirming signals from other areas I'd be very bullish here. But I view this as a manipulated market that can't be trusted for the signals it gives us. If you're long the market stick with it as long as it lasts. Just realize the DOW is now going parabolic and we all know what happens to parabolic rises. If you forget, see what happened to gold after it topped in May.

SPX chart, Daily

The SPX is a little larger than the DOW but it seems to be just as easily manipulated. With the number of futures and options players in this index it's relatively easy to force it higher. I took off the ascending wedge on this chart and put in a parallel up-channel for price action since August. With price hitting the top of its channel it should be due at least a rest. The "rest" may turn into a full-fledged decline as I've depicted but obviously one step at a time on that one.

Nasdaq chart, Daily

The ascending wedge for the techs still holds although much more of a rally here and it took will break out. Obviously the more these ascending wedges begin to break to the upside, the more bullish the market becomes and the more wrong I become. Beware of that possibility. In the meantime, and especially with the bearish divergences at this latest high, I'm guessing resistance will hold and we'll soon see a reversal. The retail crowd (which includes many fund managers) tends to buy the techs and small caps for the better returns in a bull market. This is all normal in the state of the market we find ourselves where excessive risk is sought in order to improve the returns (with the mistaken perception that the market is more stable and therefore less risky). Speaking of the small caps, there chart also shows price at an interesting point.

RUT index, Daily chart

There's been a lot of buying interest in the small caps the past two days and that has taken the index right to the top of its ascending wedge. It too could break out to the north here and negate the bearish divergences on the chart. That's not the way I'd bet my money on this one.

SMH index, Daily chart

Look at the congestion around $35 with the trend lines and 200-dma. That's a tough wall to break through. I've drawn in a rounded top pattern which is a bearish pattern and that's how this looks to me. The big bad bearish divergences over the past month support the bearish view here. One has to wonder why the semis are not rallying hard with the techs. We've observed many times that when the semis don't participate, up or down, then the move in the techs and broader market is suspect. Just another piece to the bearish puzzle.

BIX banking index, Daily chart
Banking index, Daily chart

It seems there are several indices/sectors reaching the top of their parallel up-channels. Unless we have a bonafide breakout in progress these channels do a good job at identifying support and resistance. By that measure we should see the banks hit resistance at 400. With the longer term bearish divergence, even at new market highs for this index one has to wonder if this isn't going to be a bull trap for those who bought the move to new highs.

Securities broker index, Daily chart

Another index and another parallel channel whose top is getting tagged. The EW count on this is a bit tricky but after the impulsive decline from April I've been expecting a corrective bounce against it that will eventually turn back down and head for new lows. Where it has bounced too is a logical place for it to finish. Now we'll just have to see if logic has anything to do with it.

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

While the major indices enjoy a robust rally the poor housing market is still on hold waiting to report "Help, I've fallen and can't get up". Its 4th wave consolidation continues but it should start heading south fairly soon.

Oil chart, November contract, Daily

Oil should have completed its 3rd wave down from the high in July. If the EW count is correct we should see a larger 4th wave consolidation before heading lower again. If price follows the path I've depicted then after the next low we should see a much larger bounce into the new year.

Oil Index chart, Daily

This index is still mirroring the oil index pretty well. It too looks to be in a 4th wave correction and should proceed lower once it's done. But the new low, assuming we get it, will set up a bigger bounce into the new year, along with oil. But even with a relatively larger bounce I'd be surprised if this index makes it back above 600. In other words I think this one is down for the count and the bounce may provide only a chance to lighten up on long positions and get short for a bigger ride down next year.

Transportation Index chart, TRAN, Daily

A retest of the May high for DOW and SPX is not being accompanied by a test of the high for the TRAN. That's bearish non-confirmation. Lest you think the 2-day rally we've seen is bullish you can see that it too has reached the top of a small parallel up-channel. This might make it up to its 62% retracement (4670) but I'd be surprised to see more than that. It should then turn back down and head for new lows.

U.S. Dollar chart, Daily

The sideways consolidation since May continues. The longer it goes sideways the more bearish it becomes. I have little doubt at this point that it will crash through the $83 level that I thought might provide some support. A declining US dollar should be bullish for gold but so far that's not what I'm seeing.

Gold chart, December contract, Daily

Gold has hit potential support at the bottom of its channel again and if the US dollar is ready to drop maybe we'll get a bigger rally in gold. It should get at least a small bounce/sideways consolidation and that's what I want to see before picking the next direction. If it consolidates then I'll stick to my bearish view on gold and expect it to head for at least its first downside target near $509. The lower bearish target near $400 is quite possible although I admit I have no idea what could drive gold down that far. If anything the funnymentals argue for a rally in gold.

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

Tomorrow will certainly be a little busier with economic reports than today was. As usual, the payrolls number has the power to move the market. If the number is considerably higher (not expected or even whispered) then that would spark an immediate "uh-oh" response from those who've been bullish this market with the expectations that we'll see a Fed rate decrease. A dismal number could actually rally the market (although I think that's already priced in) since it would spark more discussion about how the Fed just Has to lower rates now (to which they've been communicating loud and clear that that's not going to happen). Logic will not prevail here.

Today we saw relatively high volume (almost 5.1B shares) and yet the major indices had a hard time making some gains today. That could be considered bearish as the market could be churning at the top (as inventory is handed off to the retail crowd). In fact the recent spike in the techs and small caps could be considered bullish except if it's the retail crowd doing the buying there also.

From a very short term perspective, in looking at the pattern of the rally this week, it looks to me like a small pop up in the morning will be followed by selling for the rest of the day. Whether we get a sharp decline or a flattish sideways/down move I can't tell yet. A sharp decline that drops below last week's highs will be a big heads up that the rally is in trouble. If we see this week's lows violated then the rally is likely toast. But a sideways/down consolidation will point to higher highs ahead.


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Of course if uptrend lines from July/August start getting broken then we'll have some good confirmation that a more serious decline has started. In the meantime it's better to be careful and keep your powder dry. This has already gone on longer than I thought it would and you know the ol' expression about the market's ability to remain irrational (overbought in this case) far longer than your ability to fight it. I thought we were at a top each of the past few highs and yet the market presses on after a corrective pullback. That's why we need to see how it pulls back the next time.

I again think tomorrow's high will be the last one but obviously price is the final arbiter and I try not to get in its way. I may lose on an opportunity to make money but that's far less of a problem than losing trading capital. There are lots of reasons why the market should sell off, and many of the charts fully support that view. Now we need price to cooperate before laying on some big short positions.

SPX chart, Weekly, More Immediately Bearish

The weekly update to my SPX chart shows some changes. The new high in SPX is now getting it very close to the top of its long term ascending wedge that's been in play since the January 2004 high. The line at 1357 could very well get tagged tomorrow. Or we could get a throw-over and head into the 1360's, 70's or 80's. Or it might fail short of the line (happens often if it doesn't do a throw-over). I've relabeled the EW pattern to show that we'll be due a decline that will break below the wedge but will very likely not break to new yearly lows as I had earlier expected. Instead we should see those lows hold and then get a rally into early 2007. That rally would then be followed by the strongest move down (3rd wave) and convince many that the bear market is indeed not dead.

Good luck tomorrow and continue to exercise caution on both sides as we could very well be at a tipping point. Longs should keep trailing up their stops and shorts should carefully test the waters before jumping in with both feet. We'll be given plenty of notice to be able to catch the bulk of the initial move down. Preserve that trading capital of yours. See you next Thursday or on the Market Monitor tomorrow.

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