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Market Wrap

A Quiet Veteran's Day

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I (Keene Little) will be filling in for Jim for this weekend's report. Today seemed more like an opex Friday rather than the day before opex week starts. Lately we've seen the Thursday and Friday before opex get a little volatile as traders square up a lot of their positions (exiting or rolling out) before options expiration. Other than a bit of selling Thursday afternoon we haven't seen much volatility. Friday was a downright snoozer. Of course Veteran's Day had many traders taking the day off in order to give themselves a nice 3-day weekend. Thursday's selling might have been a result of the holiday weekend--take some profits off the table before leaving for a long weekend rather than leave it at risk. After all, the bulls have some pretty good profits sitting on the table right now and I would imagine some are getting a little nervous and moving more into profit protection mode now.

There was no major economic news on Friday and the day started out with a slight dip but then consolidated for most of the day. A further dip in the afternoon was followed by a lift into the close which gave the major indices a marginally positive close. The techs and small caps were the strongest of the bunch which could be considered bullish. The VIX dropped sharply into the end of the day which is also potentially bullish. Finishing at 10.79 the VIX is showing no worries about the lofty levels in the market.

VIX chart, Daily

The VIX has been chopping its way lower since its spike up in June, which of course was a low for stocks. There are a couple of ways to draw the top trend line of its wedge but it appears to have broken out of it as of last week and has since been spending its time consolidating and pulling back to retest the broken downtrend line. If the stock market rallies further in the coming week we'll probably see VIX slide down this trend line and could find support at its previous 2005 lows near 10.

One of the explanations for the lack of fear this week is the expectation that the market will rally next week out of relief that the elections are over and the uncertainty has been removed. If that were a good reason I wonder why it didn't rally at the end of this week. At the end of this report I show which economic reports we'll get next week and again it seems there's an expectation that we'll see good numbers for the economy. As earnings wind down there's also less fear that we'll get a nasty surprise in that department.


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Dell and Hewlett-Packard will report next week and there's hope they'll continue the string of strong earnings reports from technology companies. The tech earnings helped drive the Nasdaq up this week, giving it its best week in two months. Certainly if there was a lot of concern about the market we would not see the techs and small caps leading the way. These stocks are a measure of the market's appetite for risk and clearly the market's appetite has not been satiated yet. But why are the semis so notably MIA? That sector continues to be a warning flag but as has been the case for two months now that warning flag has been trampled by the bulls.

There is also an expectation that the stock market will rally into the end of the year since that's what it typically does after mid-term elections. The challenge for this scenario is that 2006 has been the year of moves counter to normal expectations. It has rallied during times when we should have expected declines and vice versa. In keeping with the counter moves we should see a decline into year end. That remains to be seen obviously.

And of course we're heading into opex week and anything can happen by that influence alone. Other than this past May we have usually seen a bullish opex week. Many times it starts down, usually the Thursday before, and then gets a strong reversal the following week. This Thursday was down so that could be setting up our bullish week. I've reported on the trading activity of the mega-banks' trading teams and the way I think they make a lot of their money (with the help of hedge funds jumping on the band wagon). It's relatively easy for them to manipulate the market during opex. If they can drive the market down, buy some cheap front-month call options and sell deep ITM put options, and then drive the market higher into opex they can make a boatload of money. They've consistently shown each quarter the results of their "risk-free" trading.

The only fly in the ointment for this scenario is what I see in the charts which indicate to me that we might have topped. That's a tough call right now since the up trends are still well intact. The opexantics can also result in moves that are counter to what the charts are telling us. But there are enough signals that indicate to me that we could be very close to a trend change, which I'll review with the charts below.

Next Tuesday we'll get retail sales data. It was down -0.4% in September and expectations are for a slight improvement to -0.2% in October. If that number comes in much worse, signaling a stronger slowdown in consumer spending then the market is not going to be happy. Spending is expected to be strong during the upcoming holiday season and if that doesn't happen then the market's anticipation for a strong end-of-year run will evaporate instantly. Wal-Mart has already been warning of lower expectations and I think that's the warning shot across the bow. If the other retailers follow suit then batten down the hatches.

Naturally there's lots of speculation going on now that we know we have a Congress and Senate dominated by the Democratic party. We could get the gridlock that the market favors but with both the Congress and Senate under the Democrats there may be more influence by the Democrats than the market had been expecting. That has started up the worries about higher inflation due to higher taxes and wages (raising the minimum wage would be inflationary). That puts us back on Fed watch since they've made it very clear that higher wage growth (which we've seen lately) will put them back on the rate-increase path.

Bonds have been all over the map recently which says they don't have a clue either (they're supposed to be the brighter bunch). Yields have been spiking strongly up and down since September and my first impression is that it might be in a consolidation pattern before continuing lower.

30-year Yield chart, Daily

The other interpretation is that bond yields are hammering out a bottom and will start to rally after possibly chopping a little lower. It's too early to tell. As can be seen by the RSI we're beginning to get some bullish divergences at the test of September's low. If we see the yield continue to consolidate in a descending triangle pattern then it will look like a continuation pattern (for lower yields). Lower yields would likely mean we're heading into (or already in) a recession.

China was back in the news this week. Our trade deficit with them continues to worsen, hitting a record high of -$23.0B in October. We, and many other countries, have handed off much of our manufacturing to them and now buy our products from them vs. producing it ourselves. It of course means lots of US dollars leaving the country which has been coming back to us in the form of treasury purchases. They continue to indicate their desire to diversify into other securities rather than the US dollar and that helped depress the value of the dollar to nearly a 3-month low. China reiterated its desire to invest more in gold and that helped boost the price of gold to near September's high.

But China's news is nothing new and the price patterns of the dollar and gold look ready to reverse again as they continue to consolidate.

Gold chart, December contract, Daily

Gold has rallied up to its broken uptrend line from August 2005. With the daily chart in overbought it seems unlikely that the rally will continue. From a short term perspective I see the possibility for gold to rally to the 643 area but that's just an upside potential that I see for gold. Short term bearish divergence at the last high (you can see it on the RSI on this chart) raises the possibility that we'll see a pullback start from here.

U.S. Dollar chart, Daily

The US dollar is dropping to its uptrend line from January 2005 and with the daily chart looking oversold we should see the dollar start to bounce back up. The longer term pattern suggests we should see the dollar bounce back up to the top of its consolidation pattern, near 85.30, and at the same time would hit its downtrend line from November 2005. That should set up a decline to new lows as we head into 2007.

A declining dollar fits the scenario when two things are considered: One, like China, many other countries have also stated they wish to diversify and invest in other securities as they feel they are too heavily invested in the US dollar. Lack of demand for, if not outright selling of, the greenback will of course depress its value. Two, the Fed has been producing money at hyper-inflated rates which will of course devalue the dollar itself. Think of those countries that were experiencing strong devaluations in their currency. They were at the same time experiencing rampant inflation. I'm not saying that's where we're headed but that's the risk.

That brings up the subject of money supply.

Calculated M3 Money Supply, Daily chart, courtesy nowandfutures.com

The first thing you should notice when looking at this chart is the parabolic rate at which the money supply is growing. Bernanke stated this week that they're not concerned about money growth anymore since they don't see the correlation between it and economic growth. He said this was due to the innovative financial products that have been introduced in the past few years. I guess that remains to be seen. I have trouble with that opinion when I see the value of the US dollar dropping over the past few years while the rate of growth in the dollar continues to grow at an expanding rate.

If the Fed is intent on monetizing the debt (to be able to buy it back with cheaper dollars) then that would be a reason they wanted to stop reporting M3 money supplies and try to convince us that they are not concerned about money growth. And if the stock market is the beneficiary of all that money, well then, all the better. As I had commented previously, the spike in money growth, as indicated in the big jump in the rate of growth (light blue line) since August seems suspiciously connected to the huge run up in the stock market. When (if) the rate of growth in the money supply slows down, as has started in the past two weeks, then the stock market may lose its prop.

Thanks to Monday and Tuesday the stock market had a good week. As can be seen in the table at the beginning of this report, most indices and sectors were up nicely for the week. As can be seen, this week reversed the losses we saw last week. Let's review the charts.

DOW chart, Daily

The DOW continues to hold inside its bullish up-channel for price action since July. I added small horizontal lines that indicate the stair-stepping higher that this market has seen. It all looks very programmed. Each step is roughly 130 points and the step above the current high is near 12250 so that's our upside potential if we get an early rally next week.

But I see some bearish things developing here. One, RSI has broken its string of higher lows since June. Two, RSI came up for a bearish kiss goodbye against its uptrend line this week. Three, price stalled at the mid line of its up-channel, often an indication the rally is losing steam. Four, we have a large bearish divergence against the high on October 26th. These are all warning flags so the question for the upcoming week is whether the bulls, especially with opexantics, simply trample those flags again.

Bullishly I see the following on the above chart: one, it's still within its up-channel; two, the DOW held its 10-dma on Friday (12095) after bouncing off its 20-dma (12071); three, RSI has held above the 50 line (thin red horizontal line) on its pullback; four, see #1. By the way, if the DOW breaks below RSI 50 it will probably be breaking its uptrend line at the same time and will be confirmation it's likely real selling (not a head fake) taking hold.

DOW chart, Weekly

The DOW's weekly chart shows that it is overbought on this time frame and threatening to turn back down. It's also overbought when you look at its bullish percent--it's now reaching the level it was at in early 2004, which marked the high for the DOW at the time. I also show the measured move from October 2005--we have two equal legs up from that low to the projection at 12197. The high this past week was 12196. These measured moves are very common reversal levels so this is another warning flag. If I've got the long term wave count correct, this leg up is the one that will finish the 2002-2006 rally.

SPX chart, Daily

SPX also looks bullish here when I look at that strong jump off its uptrend line from July. As long as this stays inside its steep up-channel then long is the place to be. Just be ready for a quick exit when that uptrend line breaks because everyone and their brother is watching it. Also be careful about a head fake break down. It's been very easy for the market manipulators to move the market in one direction, let's say a break down in this case, suck in the bears and stop out the longs, and then hit it hard with some buy programs to get both sides scrambling to buy it again. It's been almost too easy for them to do this so expect it again. But a real break will likely open up the flood gates of selling.

Like the DOW I see a couple of bearish developments here: one, the same mid line of the up-channel is acting as resistance now; two, the uptrend line for MACD (and RSI) has been broken; three, a retest of the October 26th high is leaving a bearish divergence; four, price has stalled at the 78.6% retracement of the 2000-2002 decline (the line in the sand for bears) and the Fib projection based on the move up from August 2004, both in the 1386-1389 area and the high for SPX is 1389.

Bullishly, also like the DOW, I see: one, it's still within its up-channel; two, price bounced off it's 10-dma (1377) and 20-dma (1375); three, RSI bounced off its 50 line and holds above it; four, see #1.

Nasdaq chart, Daily

Same exact comments for the DOW and SPX hold for the COMP. The only extra bearish thing I see here is that the bearish divergences since early October are more pronounced. Even though the techs have exhibited more relative strength this week, from a price standpoint, they could be considered weaker when looking at the lack of breadth exhibited by this chart. The bullish thing I see is the fact that price held the retest of the April high at 2375. As long as that continues to hold then stay on the long side (not to mention its uptrend line now near 2367.

The good thing here is that the market is in synch--all indices are in agreement and that's refreshing. When one is breaking they will probably all be breaking (or rallying).

Where In the World Is the SOX semiconductor index, Daily chart

Someone stopped me in the street wondering if I'd sign petition and wear a bracelet with the name "SOX" on it. For those who grew up in the Vietnam era you'll get the joke. The SOX continues to be MIA in the broader market rally. The bearish divergence on MACD can be interpreted two different ways here. The bullish interpretation is that MACD is "resetting" itself back to the zero line as price consolidates. This could be a very bullish interpretation. The bearish interpretation is that the new highs, or retests of highs, is being accompanied by lower highs in MACD. At this point I would say a failure to get back above its 200-dma, which continues to act as resistance, is bearish. It takes a break below the October low, so below 444, to confirm we're probably in a break down.

BIX banking index, Daily chart

While the banks didn't quite rally up to the top of its parallel up-channel it did come within a half point of its Fib projection at 403.68 (Wednesday's high was 403.20). The rally continues to leave bearish divergences, including at its most recent high. The EW (Elliott Wave) counts looks complete for its rally from June. If it manages to rally a little higher in the coming week then the top of the channel is near 405. A break below 392 would indicate a top is very likely in, and it should be a long term top.

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

The home builders got a bounce on Friday and it was just in time. That's a bounce off support at the bottom of its bear flag pattern and its broken downtrend line. I have very mixed feelings about this chart. On the one hand it looks potentially bullish for another run higher to the top of its flag pattern where it would also meet resistance at its 200-dma. But in order for that to happen I would think the broader market will have to be rallying strongly as well and I'm having trouble seeing that possibility at the moment. So for the time being let's see if the 50-dma holds price back. A small bounce here followed by a break below 600 would indicate that the high for the bear flag was the October high.

Oil chart, December contract, Daily

Oil looks bullish in that it broke above its downtrend line from August. But it's floundering. I was expecting a firmer break to the upside. So far it's looking a bit corrective with overlapping highs and lows. This signals to me that my interpretation of the wave pattern could be correct--it says we've seen the long term highs for oil and price will continue lower after this bounce is finished. I still believe we'll see a multi-month rally in oil but it could end up being very choppy and difficult to trade.

Oil Index chart, Daily

The rally in the oil stocks was a predictor that oil itself was finding a bottom. I can't help but feel that has now been priced in and we're going to see price stall for this index. As depicted on the chart I 'm expecting to see a pullback. Whether that leads to another bounce higher or to new lows is too hard to tell right now. If long the oil stocks continue to follow Jim's analysis in his LEAPs updates. From a strictly technical analysis I would say you want to protect positions here and perhaps selling some covered calls is the right play.

Transportation Index chart, TRAN, Daily

If the Transports manage to rally to a new high I suspect it will be associated with more bearish divergences. But it's close to breaking its uptrend line and that's the way I'm currently leaning. A break below 4600 would be bearish.

Next week's economic reports include the following:

As you can see, it will be a busy week next week for economic reports. There are some big reports in there that the Fed watches carefully and depending on how the market interprets how the Fed will interpret the data (confused?) will determine the knee-jerk response. On top of that we've got the potential amplification of opex. Need I say be careful this coming week?

The plethora of warning signals I see in the charts now, on the daily and weekly charts, tells me we could finally be putting in a high. Whether or not we get the opex push to new highs I can't tell but if we start breaking the uptrend lines from July/August then there will be little question in my mind that we've put in a major high, at least one that should last for quite a while. More bearishly, the highs, once put in, will not be seen for many years to come as we start bear market leg #2.

I could easily justify a move either way for the upcoming week. My feeling is which ever direction it starts on Monday could easily be a strong move for the week. I continue to believe the mega-banks' trading teams and hedge funds get the momentum started during opex week and won't let up until Friday's close. At least that's been the pattern. Therefore I'm almost inclined to suggest joining an initial move and stick with it rather than try to day trade it.

But countering the argument to stick with a swing trade for the week I've got concerns that if we're in a topping pattern then we could see lots of volatility with big spikes up and down. The number of important economic reports this week could help amplify those spikes. The easy recommendation is to stay long above the uptrend lines shown on the charts and get short below. Those uptrend lines are close so it won't take much of a move to show us whether or not they're going to hold.

Good luck this coming week since it could be a tough one. Trade light and don't let a move go much against you since the potential is that we will not see much in the way of corrections to the move (as has been typical pattern). I'll see some of you on the Market Monitor for the intraday calls on Monday and everyone else back here for a review of market action in Tuesday's Wrap.

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