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Market Wrap

Rarified Air

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Rarified air is the air at high altitudes, such as above 18,000 feet, where the partial pressure of oxygen becomes too low to sustain the body's need for proper oxygen exchange in the lungs. For example, at 18,000 feet the partial pressure of oxygen in the air is half what it is at sea level. It's why climbers above these levels, if they haven't been conditioned for it, will often use oxygen tanks to help them maintain a sufficient oxygen level in their blood. Breathing in rarified air without proper conditioning can subject you to loss of mental acuity if not physical brain damage (swelling). It can cause you to make some very dumb, if not deadly, decisions.

How can this be relevant to today's market you ask? Well because I think too many unconditioned market participants are now breathing rarified air. One look at the record low VIX tells us we're into rarified air now. Other than the DOW, which is too easily manipulated and not representative of the broader market anymore, many of the other markets are below their 2000 peak levels and yet complacency is even lower than it was after the super go-go years of the late 1990's into 2000. From an EW (Elliott Wave) perspective this completely supports my contention that we're due the next bear market leg down which will be more painful than the first.

The big question of course is how high this over-stretched market can go. I was reading a report over the weekend that mentioned the fact that the S&P 500 was 7.8% above its 200-dma and that this was a rarity and signaled danger ahead. That sounded ominous and while I agree with that assessment I decided to do a little research and found some interesting data. I went back to 1998 and took each price high that looked like a sprint higher that stretched above the 200-dma which was then followed by a more significant decline than more recent previous pullbacks. Including the current sprint higher over the past few months I found 16 occurrences to give me some data points.

The average "stretch" above the 200-dma was 10.5%. The maximum was 14.6% in July 1998 and 14.0% in July 1999. In March 2000 it was 11.4%. In June 2003 it was 13.8%. In price peaks for the rest of 2003 and in early 2004 it averaged a little over 12%. All of a sudden the 7.8% stretch today doesn't sound so stretched and in fact is at the low end of the range (the lowest being 5.7% in May 2006). Does that mean we should look for much higher prices based on this metric? I don't think so and in fact believe the final price high that we get will be closer to the bottom of the range (again having to do with this being the 5th wave in the EW pattern which is typically weaker than previous waves in all kinds of measures).


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But in case you're reading the same reports I am I just wanted to point out that the S&P 500 being 7.8% above its 200-dma is not a rarity. As part of researching this though I calculated the pullback from these peaks and how quickly they pulled back. The average pullback was -6.3% and the average period was 4 weeks. Using those averages would mean a pullback in the SPX (from a round number of 1400) of 88 points to 1312. The DOW would pull back to about 10600. If the pullback starts December 1st we could see those levels by the end of the year. That is of course all hypothetical.

The high for the "pullback" range was -19.3% following the record stretch of +14.6% away from the 200-dma in 1998. This was of course following the LTCM debacle and it took 6 weeks for that decline. The decline from July 1999 was nearly -10% and it took 3 weeks. After March 2000 the decline was -11.1% in 3 weeks. I don't discount the possibility that we'll see something similar after the current rally peaks out since it should be the start of bear market leg #2 and it could be one heck of a kickoff.

But if I'm wrong and the coming pullback will be just a correction to a longer term rally yet to come, as we saw in 2005 and 2006, then the average stretch above the 200-dma of 7.0% during this period was then followed by -4.8% pullback in 3 weeks. That would be a 67-point pullback in SPX to 1333. That's actually not a bad target in December if a decline gets started. In my longer term bearish scenario the bounce into the new year will get all the bulls excited about finally relieving the overbought conditions and what a wonderful buying opportunity it was. Then the bottom will fall out as we head into February. OK, I'm getting ahead of myself on that. If you're interested in seeing the data that I collected on this, in an unpolished Excel format, you can see it here: http://www.OptionInvestor.com/premium/mm/chartlink.aspx?mm=&Path=/oin/mm/chartlink/603_11212006125929

I thought it would be fun to review the above information today since quite frankly the market is boring me to tears right now. There were no exciting economic reports today, price went nowhere and volume is drying up. Even the VIX is declaring total boredom with this market. Or is that total complacency?

VIX chart, Daily

Ever since the VIX broke above the top of its descending wedge it has been sliding backwards right on top of that broken downtrend line. It hasn't broken inside and therefore there's nothing particularly "bearish" about the VIX here since it's hanging above the top of its wedge but it's close to crunch time. The top and bottom of the pattern intersect near 9.74 and I can see the possibility for a brief spike below (throw-under) before starting to "rally". This would of course be bearish for stocks.

So with VIX nearing potential support at the bottom of its wedge while at the same time nearing oversold while at the same time making record lows, the danger to equity bulls couldn't be clearer. VXO, the old VIX before the change in September 2003, is even lower and much lower than its historical lows. This is one of the measurements used in EW analysis--the rally back up following the first bear market leg typically finishes with a higher level of bullishness and complacency than the previous price peak. Even with the SPX a little more than 20% below its 2000 peak we have a public that is more bullish and more complacent than they were in 2000. This is classic and it's what sets up the next leg down which is typically much worse than the first leg down (the 2000-2002 decline).

Today saw very little price action and the table above shows the same results--low volume with up volume and advancing issues marginally ahead of down volume and declining issues. New 52-week highs though are still strongly beating new lows. There's just not a lot of selling pressure out there.

Note that all charts show November 23rd as a trading day which of course it's not. That will be corrected after that day passes. You'd think they could figure this out and remove the date before it happens but for some reason QCharts has never figured this one out. So when I look at price projections I have to add a day to see where it really should fall next week. Let's take a look at the charts.

DOW chart, Daily

The day before and after Thanksgiving is typically bullish so perhaps tomorrow we'll see an end to the current small consolidation and get the next move higher. If we instead get a little bit more of a pullback first, it should set up the next rally leg for next week. I don't see anything yet that tells me the bulls need to take all their marbles off the table but I do see a lot that tells me the bulls are now at a much higher level of risk than they've been since the summer. If the bulls can press this higher, the next stair-step up is near 12400. The top of its steep ascending wedge is closer to 12500 and that's the zone I'm going to be looking for a top. It should become clearer once the leg up is underway (assuming of course we get another leg up).

SPX chart, Daily

The SPX has been consolidating at the top of its longer term parallel up-channel and that makes it look bullish here. Right now it's struggling at the mid line of its narrow up-channel and the daily oscillators are flashing some warning signs here. This could give us a brief pullback before heading higher but it looks ready to resume its rally tomorrow and that's what I depict.

SPX chart, 60-min

Looking a little closer at the leg up from November 3rd I'm showing some internal Fib projections for the wave count I'm using. Only time will tell me whether this is the correct wave count but if it is then I get 1420 for an upside target. That intersects the top of its ascending wedge at the end of the day on Tuesday. That's where I'll be looking for a potential high to this rally and it's where I'll add to my long term short position. I'll certainly be watching this very closely on the Market Monitor next week to call it as I see it.

Nasdaq chart, Daily

Like the SPX the COMP has been pressing the top of its longer term parallel channel for the past few days. If this is bullish, and so far it appears so, then we should get another leg up to finish off the rally leg. Upside target is 2500. If it instead pulls back a little further first then I would expect a rally leg next week and in that case it might not give us much better than a retest of the high. There's nothing bearish whatsoever about this chart but at the same time I would strongly recommend Not buying it here and instead pulling stops up tighter. The 10-dma at 2426 (and rising) is as far away as I'd let it go. Any lower and I'd be hanging in my chute after a successful ejection.

NDX-100 (QQQQ) chart, Daily

The Q's look similar to the COMP with an important difference. Jeff showed this last night in his chart as well. The broken uptrend line from April 2005 is very likely to be strong resistance. Even if it will ultimately get above this line the odds are it won't happen until after a pullback to relieve the overbought conditions. I do see the possibility for a brief spike up so if we see that happen and then a drop back down below the line and below the last pullback to $44 that would be a good sell signal. In the meantime I see upside potential for the Q's to get above $45.

SOX semiconductor index, Daily chart

The SOX made it up through its downtrend line from January 2006 and back above its broken uptrend line from October 2002. This makes the SOX look very bullish here. But then Mr. Fibonacci stepped in and slapped the SOX down. The 62% retracement of the January-July decline at 492 has held back the bounce and the short term pattern makes me think the bounce could be over. If a continuation higher in the broader market is not accompanied by the SOX then we'll have one more clue that the broader market rally could be very close to finishing.

BIX banking index, Daily chart

I had mentioned last week that we should see a quick test of the 50-dma if the banks didn't immediately continue rallying from Thursday. Today we got the test and the disconcerting thing here for the bulls is that the relative weakness in the banks is not a good sign for the broader market.

From a technical perspective I'd feel comfortable calling a top in the banks. After the high on November 8th, which came 0.48 points of achieving its Fib target (where the 5th wave of the move up August equaled the 1st wave, a very common relationship) I had said that may be all we get, that we got "close enough". Now the pullback to the 50-dma is off a higher price high that was clearly met with negative divergences. RSI has pulled below its 50 line after not being able to get back above its 70 line.

These are all bearish indications and based on these I'm thinking the November 8th high of 403.20 will hold. But, if the 50-dma holds and we continue to chop in a larger sideways consolidation into December then it's going to look bullish for another run to new highs. It takes a break below 390 to negate that possibility in my mind.

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

The brief stall over the past few days looks bullish so I'm still expecting to see the top of its bear flag pattern get tagged. Its 200-dma is currently hitting the top of its flag pattern at 720. The top of a larger parallel down-channel from 2005 intersects the top of its flag pattern near 732. A Fib projection for the current leg up is just under 734 and a 38% retracement of the January-July decline is at 734. Therefore you can see the 720-734 zone as a wall of resistance facing any further rally. This one should be very close to topping and then starting a new leg down.

Oil chart, December contract, Daily

Oil found support at the trend line along the lows of the past two months. The bullish divergences at the new low held and I'm counting the latest pullback as just part of a larger bounce that should develop. I think that larger bounce will now begin.

Oil Index chart, Daily

The oil index has benefited from the general bullishness in the stock market and with that about to come to an end (imho), we should see this index top out soon as well. I'm expecting a rally in oil so a rally in the commodity without a rally in the oil stocks would not make sense. But maybe it doesn't matter--the decline in the commodity didn't stop the rally in the stocks.

A small push higher here, perhaps even with a retest of the August high, would give us a price pattern for the rally from September that could count as corrective. That would tell me that a minor new high could finish the bounce which would then setup the possibility for a new leg down to start which heads for new lows below the September low. It's obviously a little early to make that call but that's the risk I see for holders of the oil stocks. It's actually the risk I see for holders of Any stock.

Transportation Index chart, TRAN, Daily

The Transports couldn't make it above its downtrend line from May and that might be it for its rally. But ideally it looks like it should get another minor push higher and a Fib projection at 4925 makes for a good upside target to finish the move.

U.S. Dollar chart, Daily

The US dollar's bounce off support hasn't been very strong yet. But unless and until it drops below $84 I'm still expecting another bounce back up to the top of its consolidation pattern.

Gold chart, December contract, Daily

Just the opposite to the US dollar the pullback from resistance at its broken uptrend line hasn't led to much selling yet. This may bounce back up to retest its broken uptrend line one more time (which should leave lots of bearish divergences) but regardless I still expect to see gold pull back within its larger consolidation pattern before setting up for the next bull market rally in gold.

There were no major economic reports today. Tomorrow's reports include the following:

There's nothing here that I see as market moving so the market will be left to react to whatever causes a stir in this lethargic holiday week.

Not much has changed on the weekly view of the SPX. Price is still pressed up against the top of its long term up-channel. With an up side target near 1420 I can see the possibility for a brief throw-over above its channel and then a drop back inside, thus creating a good sell signal.

SPX chart, Weekly, More Immediately Bearish

I've been showing a quick decline into the end of year and then a bounce into January that would form the right shoulder of a big H&S pattern. With the rally lasting nearly into the end of November now it changes my expectation for how much of a pullback we can expect this year (maybe SPX 1330 area) before a bounce into January and then a stronger decline into February. The right shoulder may not form until next summer. That would be the less bearish scenario that I foresee. More bearishly, as we head into the spring of 2007 we could see some very nasty selling take hold.

The week before Thanksgiving is generally bullish, as is the week after. I wouldn't classify this week as bullish but nor would I consider it bearish. Just flat. Tomorrow though stands a reasonably good chance of being bullish. I see a short term consolidation pattern from last Thursday as being nearly complete. We could see a quick drop some time tomorrow morning to finish it but it should not break Monday's lows and there's a reasonably good chance we won't even see today's lows tested.

We look about ready to start the next, and final, leg up in the rally from the November low. This leg up should also finish the rally leg from July, and that rally leg should be the one that finishes the rally from October 2002. I think we're that close. When I run some internal Fib projections for the November rally I get SPX 1420 for the upside target. That would be close to DOW 12500 and it could happen as early as next Tuesday.

The trading risks for tomorrow will be the low volume environment. It can be exceedingly boring or it can spike you out on buy or sell program spikes. But I'd lean to the long side and if you want to trade and catch a ride to a new high next week then tomorrow could be the day. But here's the greater risk--I'm looking for the last leg up in this rally and these moves are the riskiest. More people get burned trying to capture the last bit of upside in a bull market (or the last bit of downside in a bear market) and find they get run over by a stampede for the exit door that they weren't ready for.

Unless you can play intraday I'd sit it out now. Literally a panic sell could hit at any time and for any reason. There are too many people either completely complacent and who will panic at the first hiccup, or they're ready for a pullback and they're already holding the exit door open. Both groups could suddenly produce a no-bid situation. If we break some support lines in the next week or so then you'll have plenty of opportunities to join the bear party on a bounce.

If you like playing intraday, don't hang around long on either side until we get a break down. I think upside is very risky now, even with an expectation for SPX 1420/DOW 12500 but we know how well the bears have been faring during the past few months. Bears look like this poor possum right about now:

Picture of a bear in the current market:

Don't become road kill no matter which side you're playing. The bears now feel like this possum--no sympathy even after they've been hit, run over and squished flat. Good luck trading tomorrow and Friday. I hope everyone has a great Thanksgiving Day (and for our non-American friends please enjoy a day away from the U.S. markets). Be thankful for your family and friends and for being able to share another year with them. And be thankful for the kind of opportunity we have every day in the stock market. I wish it were a little freer like it used to be but the alternative of not having a market to trade is even worse. I'll see you on the Market Monitor tomorrow and I'll be back here for the weekend Wrap.

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