Option Investor
Market Wrap

Go To Your Cave

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Like a little child I've been scolded by the market and told to go to my cave and think about the bad things I've done (not listened to the market). My bearish bias has clearly been too early as the market continued to thumb its nose at the bears. Most of them have been shooed back into their caves. They're watching action carefully but most are now too shy to show their snoots. As for me, I'm still trying to peak outside my cave for an opportunity to make a slashing attack on a bull.

To say that I was early on my bearish opinion for October would be an understatement. Not that it makes me feel any better but some very good market analysts I've come to respect over the years have been equally chagrined by this market's ability to rally in the face of multiple bearish signs. Call it manipulation or PPT or just plain bullishness by the masses, it doesn't matter. What matters is price and it has become painfully clear that I wasn't listening. That's what I get for trying to pick a top.

My style of trading is picking tops and bottoms, or more accurately I try to identify potential market turns. It doesn't matter the time frame--I try to identify when a run is finishing and use that to trade the other direction. I'm not a momentum trader but instead I like to identify levels where I believe the market will turn. Once it looks like the market is turning I jump on it and place my stop just above the most recent high (for a short) or the most recent low (for a long). To say I've been stopped out a few times this month on my short plays would also be an understatement.

But I think it's important for you to know what kind of trader I am so that you can assess your own risk and determine whether or not you'd like to follow my thinking/recommendations. If I were a momo player I would have been long and stayed that way through this month since we didn't get any sell signals to tell us the momentum is ending. Congrats to those who have hung in there through this rally. It was probably a nail biter for you as well at times but you made money.

The short term pattern looks like some more upside for the market. That might only be a result of opex showing up in the charts but as of tonight it looks like the bears are going to have to wait in their caves a little longer. We might get an immediate pullback from tonight's high but I'm not so sure it'll last any longer than the recent pullbacks. Two examples of listening to price instead of indicators are the two charts I've shown the past two weeks--the PPH and NYSE.

The market's rally this month, in the face of bearish divergences goes to show how technical analysis doesn't always work. Some times you just need to go with the flow. Last week I had shown an update to the Pharmaceutical index and how I thought we got a great sell signal. Well this week's update shows why you can have a great setup but you still need to use discipline in your trading and stick to your stops.

Pharmaceutical index, Daily chart

The break of the uptrend line after a very clear bearish divergence at the high was a great setup. A retest of the uptrend line after it broke was another great short entry. Both entries should have been stopped out this week had you taken either short. So a great setup was busted. Happens all the time. If you're interested though, it looks set up again for a short play--the same broken uptrend line is acting as resistance still and the bearish divergences persist. The one caveat is that price may find support on that trend line across the recent highs, currently near 79.25. Today's low was 79.27.

The other chart I was using, to show a broader market view, was the NYSE. My thinking was that this index is less prone to manipulation. But the fact that it too continued to advance past the top of its parallel up-channel is a good indication of just how bullish the market has been. Whether we're in a blow-off top or just the start of a bullish up leg is the great debate at the moment. I stand in the blow-off top camp.

NYSE chart, Daily

The NYSE chart is a good example of how technical analysis is helpful but certainly not always correct. Price is king and I have to keep reminding myself of that every day the market pushes to new highs. This index has also now gone parabolic. Is it the beginning (or the end) of the end or is just getting started to the upside? Once again I'm in the bearish camp on this one but I can't argue with price. One warning to the bulls is that this index is forming a triple top this week as part of a small ascending wedge. This would be a classic finish to the rally so be careful. If this one suddenly breaks down it could get quite a bit of selling behind it.

We had two economic reports this morning and then the Philly Fed Survey at noon. The unemployment numbers for last week were released and showed a nice improvement in the employment picture. That is of course if you can believe the numbers as we head into elections but I won't go there (wink). Initial claims were down 10K to 299K which was a much larger drop than had been anticipated since most economists had actually expected a slight increase to 310K. The previous week's number was revised up 5K vs. 4K originally reported for a total of 309K from the original 308K. The 4-week average dropped, down 5,750 to 307,750, making it the lowest since the June 24th number. This 4-week average has remained steady in the 310-320K area for the past 4 months so the new number has dropped below that range.

The Leading Economic Indicators (LEI) result for September was 0.1% so a slight improvement to last month's -0.3% but not as good as the +0.3% that had been expected. It was a bad number that was a good number, judging by the reaction of the stock market. We got the same response to the Philly Fed survey number--it came out at -0.7 which was down from last month's -0.4. The market had expected a big improvement from last month's "outlier" to 7.8. So once again, a bad number must be a good number since the market only dipped on the news and then rallied back up again into positive territory. A slowing economy must be good because it means the Fed will sit tight, or might even lower interest rates, right? Yea, that's it. (Just don't tell the sheeple that a slowing economy will mean slowing earnings growth which will mean lack of support for today's lofty P/E ratios). Ah, the games Big Money is playing with peoples' heads right now. Don't get suckered in here.

Back to the LEI, the Conference Board said the number indicated "the U.S. economy should continue to expand at a slow pace." That's one way of looking at it. The index is down 5 out of the past 8 months and down 0.9% is the past 6 months. Half of the 10 indicators rose in September -- Consumer expectations, money supply (again? Why am I not surprised, judging by the stock market rally), stock prices, jobless claims and core capital equipment orders.

I can't stress enough the importance I believe money supply has on our markets. The money created by the Fed makes it into the banking system through their primary dealers who are the mega banks I often refer to. These banks' trading teams are the ones raking in obscene amounts of money now and it's because they're trading with the Fed's money (and adding their own). It's absolutely no wonder they consider their trading to be risk free. Ugh, where did our free market go?


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Sorry, I digress. The 5 indicators that fell were building permits, factory working hours, delivery times, interest-rate spread and new orders for consumer goods. For the past 6 months most of the indicators have been negative so it does indeed say we're slowing down. The big question of course is whether it's pointing to a soft landing or a hard landing. That of course will determine the outcome of the current stock market rally. I continue to strongly believe the collapse of the housing market will lead to a wicked correction in our economy. And the dead cat bounce this past month in the housing market does not mean all is better is housing land.

The coincident index was unchanged in September. A drop in industrial production offset an increase in income, sales and employment. The lagging index rose 0.2% in September.

The Philly Fed index number came out at noon and surprised the market with another negative number. There were many people saying we'd see a big improvement to the -0.4 in September but it didn't happen. At -0.7 it indicates a continuation of the deterioration in the factory sector in and around Philadelphia. Readings above zero indicate overall growth whereas negative readings indicate a slowing factory sector. A survey of factories shows conditions have worsened--22% report better conditions while 23% report worsening conditions.

Economists were quick to jump on the number and report that the "details were better than the headline number". They pointed out that some of the parts of the index showed some improvement. I could be mistaken but that's like saying everything's fine as you fall from the top of a building. Everything is of course fine until you hit the pavement. Gotta love those economists. I'm an eternal optimist but I have to give them credit for being hyper-optimistic.

The inflation numbers were good so that's what the market seems to be paying attention to. The prices-paid index fell to 32.0 in October vs. 38.1 in September. The prices-received index fell to 17.8 vs. 21.6 in September.

With opex winding down and DOW closing above 12K it should be interesting to see what happens next. Many who were betting on a down October lost their shirts this month as the market has been pushed higher into opex week. With the achievement of DOW 12K will there be anything more to hold the market up? One thing that could hold it up will be the bears themselves. Forced to continuously cover their short positions, those who are most bearish this market are the ones helping it rally. Kind of ironic don't you think? We have a lot of money coming into the market from the Fed and it's going into stocks--this helps maintain a good public attitude and helps those in elected office stay there. OK, that's opinion and not fact. Let's see what the charts tell us.

DOW chart, Daily

Whenever you see a steep tight channel like the current rise in the DOW you know it's not "normal" buying. You often see this kind of move off a deep decline as the shorts continually cover their positions as they take their profits off the table. It's actually why have short players in the market is helpful. Without them it's hard to get prolonged buying going sometimes. But when you see this kind of move after a prolonged rally it's usually indicative of a blow-off top. I make reference to an article later that was in yesterday's MarketWatch. It discussed the amount of money coming from the retail crowd and it's so typical at the end of a rally. Smart money needs it to happen so that they have willing buyers for their selling so that they don't drive prices down while they sell.

So here we are at the top of price channels, clearly overbought, and in an unsustainably steep rise. Obviously picking a top has been difficult, to say the least, but I continue to urge caution to those who are long and a strong recommendation to at least not chase this higher. I'm continuing to look for opportunities to get short for what should be a very good position trade.

SPX chart, Daily

SPX looks very similar to the DOW except not as steep. That's because the rally has been primarily focused on getting the DOW to 12K. That was needed to suck the sheeple into the market and it's succeeding. But again, with price up against the top of its multi-year channel, with overbought conditions, I'll continue to recommend testing the short side. When it sticks it will be a nice ride.

Nasdaq chart, Daily

The techs have been in serious catch-up mode. While the DOW has been driven higher by Big Money intent on getting it above 12K for publicity, retail and institutions are chasing the high-beta stocks in hopes of capitalizing on this bullish market. The rise in the COMP is also in an unsustainably tight and steep up-channel. There is strong resistance in the 2350-2375 area and that's where it is stalled. It could press a little higher but at this point I'd be looking for bounces to short rather than dips to buy. Look at a new high as a gift to short, especially if you see lots of bearish divergences on the 30 and 60-min charts. I'd feel more comfortable with a bearish divergence on the daily chart as well so that's a bit of caution flag for bears right now.

SMH index, Daily chart

After a quick stab above its 200-dma and another test of its broken uptrend line, the semis left a very bearish spinning top doji on Monday. The red candle on Tuesday confirmed the bearish reversal signal. Wednesday's red candle was icing on the cake. Today there's another small doji as support was found on the 50-dma but it will likely be only a speed bump. The decline should continue.

Last week I showed a chart of the 30-year yield because it suggests to me something different than what I'm hearing from many market pundits, namely that yields will probably drop as the Fed realizes the economy is slowing down too much. I will admit that argument strongly resonates with me. But the pattern is worth watching here because I get the impression from it that we might see a surprise upside move.

30-year Yield, Daily chart

An upside move in yields could only mean the Fed will surprise the market with either a more hawkish statement, perhaps out of next week's meeting, or worse, another rate increase (highly doubtful right in front of elections). So far the consolidation since tagging the downtrend line (the inverse H&S neckline) supports the idea presented on the chart. I'll continue to post this chart until we get either a downside or upside resolution here. I don't need to tell you how negative it would be for the stock market if the Fed even hints they'll have to raise rates further (to fight the inflation monster that they're creating with their easy money policy).

BIX banking index, Daily chart

The pullback in the banks over the past week looks like it could lead to another push higher and that's when the Fib projection at 401.39 and the top of its up-channel near 402 may come into play. The other possibility of course is that the rally is already finished and the move down is starting slowly. Any fast break lower that gets below 394, Tuesday's low, would look more immediately bearish.

Securities broker index, Daily chart

The brokers continue to trade well technically and are a good proxy for the market--they rallied higher out of the consolidation in July and August and so did the broader market. Now the short term pattern is looking particularly bearish to me. One interpretation of the price action since the October 10th high is that it's consolidating for another run higher and I have to say that has a lot of merit. The more bearish interpretation, primarily an EW viewpoint, is that we're seeing some 1st and 2nd waves play out and it calls for an "unwinding" of the count in some 3rd waves down. These being the strongest waves it says be ready for a hard sell off right around the corner, possibly as early as Friday or Monday. We'll know which by this time next week.

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

The home builders Bullishly climbed above the downtrend line from January and have now come back down for a retest. It would be bullish if the retest holds and the index then turns around and heads for new highs. A break back below the downtrend line would obviously be bearish. If it bounces a little higher, keep an eye on the top of the bear flag it's in since I continue to expect another leg down once this consolidation is complete. The fact that it bounced up to Fib resistance near 690 (38% retracement of the previous down leg and two equal legs up in its bounce) tells me to lean towards more downside from here.

The price of oil got a helping hand from Saudi Arabia today as they threw their support behind an effort by OPEC to cut back on oil production. The plan is to reduce production by 1M barrels a day (current production is 28Mbpd). I think that's a token gesture, especially considering the amount of cheating going on but it's all in the name of publicity in an effort to support the price of oil. It was good for an 85 cent bounce in crude to $58.50. Later news confirmed that OPEC agreed to cut production by 1.2Mbpd. In after-market hours oil was getting a bounce to 59.40.

Oil chart, November contract, 120-min

After the low in early October I had mentioned that the EW pattern suggested we'd see a consolidation for a couple of weeks before heading lower again. The wave count is looking good as I had labeled it back then which says another low should then lead to a much bigger bounce. A downside target is just under $55, maybe $54. If true it tells us that OPEC will not be successful yet in propping up price, not yet anyway. Maybe when they cut back by 2M bpd.

Oil Index chart, Daily

While oil has consolidated sideways the oil stocks have been recipients of the bullish investors' enthusiasm. But is there a disconnect here? One or the other will give soon--either oil will start rallying or oil stocks will sink back down. As I've depicted here I think the oil stocks are in a corrective bounce, correcting the decline from the August high, and once it's done we'll see the index turn back down and head for new lows.

This analysis is based strictly on what the EW pattern is telling me so far and has nothing to do with fundamentals, which I don't follow closely enough. Jim does an outstanding job in that regard and my analysis here is 180 out from his so understand that there is disagreement between Jim and me on this one. But that's what makes a market. I see the possibility for a little higher in the index to the 620 area (62% retracement and 2nd leg up achieving 162% of the 1st leg up off the September low). By my analysis you should be lightening up on your exposure to oil stocks. Sorry for the confusion with Jim's analysis but that's what I see so far. If we get a sideways consolidation near the highs for this bounce then the EW pattern turns bullish so that's what I'm waiting for before changing my bearish opinion on this index.

Transportation Index chart, TRAN, Daily

The Trannies haven't even come close to confirming the new highs for the DOW so that continues to raise a caution flag for the bulls. Like the broader market we could see the Transports chug higher but it's looking tired here. Each new high from here will another opportunity to see if more bearish divergences show up and another opportunity to test the short side. If it breaks down from here and drops below 4574 then the fat lady could be singing.

U.S. Dollar chart, Daily

This one could take a while. I'm anticipating that the US dollar will consolidate into the new year between 85 and 87 before it's set up for the next big leg down that should drop the dollar below 80. The pattern for the dollar, and perhaps gold, should be a choppy mess for the next couple of months.

Gold chart, December contract, Daily

The down-channel for gold is still in play so watch for resistance at the top of it near 615. This is also the location of the potential H&S neckline across the lows from December 2005. First resistance will be the 50-dma at 607 (although that has been somewhat ignored in the past). Based on the larger sideways consolidation pattern that I think is going to play out in the US dollar I'm entertaining the thought that we'll see the same thing (in reverse) for gold. For now it's too early to tell. I think a short in the 615 area is about the best play I see here.

Results of today's economic reports include the following (there are no major reports tomorrow):

There are no major economic reports tomorrow so it will be a quiet open as far as that goes but the market is primed for a goose higher on Google's (GOOG 426.06 +6.75) earnings announced after the bell on Thursday. They announced 3rd quarter sales up +70% and profits up +92% on increases in online ad revenue. Sales were $2.69B and their profit on that was $733M, or $2.36 a share.

GOOG's price jumped to as high as $460.71 in after hours, settling at $459.85 by the close, for a 33.79 jump up from its normal hours closing price. That's an 8% jump so we'll have to see if that excitement survives the opening bell and translates to broader market excitement. DOW, SPX and NDX futures (ES, YM and NQ, resp.) are basically flat in after hours.

An article that appeared in MarketWatch yesterday, written by Alistair Barr, says it all I think. The title was "Retail Investors missed most of recent rally, but as indexes hit records, individuals have begun piling back in." Need I say more? This is exactly what happens at tops -- smart money needs the masses to get excited so that they come rushing in to buy and take the inventory off the hands of the pros.

There's been a strong buying surge by the retail crowd, as measured by inflows to mutual funds during the period October 4th through the 16th. About $2.5B had been sent in and of that, $900M flowed in on Monday alone. This compares to just $2B in all of September. Thomas McManus, a strategist from Banc of America Securities, commented "At big turning points you typically find retail, and even big institutional investors, leaning the wrong way." Got your hand on the ejection handle?

Looking at the weekly SPX chart we don't see any evidence yet that it's about to turn down. Or do we?

SPX chart, Weekly

We got the throw-over above the top of its long term channel/wedge. The weekly candle, if price closes near today's closing price, will be a doji star. A doji star at resistance, as I think it is here, is a potential reversal signal. Quoting from "Candlestick Charting Explained", by Gregory Morris, (I recommend this book), "A Doji Star is a warning that a trend is about to change." A red candle for next week would be confirmation of the turn so keep an eye on the weekly chart.

Lest you think I'm a permabear who's out of touch with reality, I'll show one more chart to say "Hello, are the bulls listening to this?" I've talked a lot about the complacency in the market and how participants have become less afraid of higher risk. The higher risk taking is needed to get higher returns. This sets the market up for an even sharper reaction with the introduction of a jolt that frightens people out of their complacency. With that in mind, the VIX chart is a warning that things are getting out of whack here.

VIX daily chart

The VIX can be charted and analyzed just like any other symbol. It's in a descending wedge that has been developing since the June high (June low in the equities). The EW count inside this wedge has been suggesting a new low is needed ever since its high in September (coinciding with the September 11th low for equities). In hindsight I should have trusted this indicator more than what I thought equities would do. I have stated several times over the past 6 months that I felt a VIX reading below 10 will be needed before the market tops out.

Well, we're getting close. If we can get a little more rally out of the market then we could see the VIX below 10. It may not get there since I see a very good possibility that the market is hammering out a high here (as shown in the SPX chart above) but if it does I would strongly recommend buying up some of those super cheap long term puts on your favorite short candidate. The inflation in premium alone from a market scare could do wonders for your account.

Tomorrow being opex Friday we might see the market get locked into its present tight range. For the last couple of opex Fridays we've seen some good volatility but that was following a volatile week. This opex week has been relatively quiet and therefore tomorrow might follow suit. Don't force trades. Maybe next week we'll get into a little more normal ebb and flow of buying and selling. Be careful of a reversal in any initial selling since I don't think the bears will at first be successful in driving the market back down. Good luck and I'll see you in a week (or tomorrow on the Market Monitor).

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