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Market Wrap

The January Effect

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It's a well-known axiom that as January goes, so goes the year. The first 5 days of January often tell us which way the month will go and the first month tells us how the year will end up. There's no telling what will happen between those periods of time but a lot of traders hang their hat on this. Therefore it's very important for big money to ensure we see an up January. As of Monday's close the DOW was only 17 points in the black. It obviously wouldn't take much selling to drive it into the red for the month. If we're to keep the public bullish on the stock market then surely we can't have the DOW closing in the red.

The rally from Monday's low has been impressive--another one of those relentless rallies with nary a pullback. The kind that has bears pulling their hair out and bulls buying in a panic, afraid they've missed the train. The resulting buying spree, from both sides, has resulted in yet again another record high for the DOW. It also fits the Elliott Wave (EW) pattern that I've been looking for (a 3-wave move up from the January low) in order to finish up the rally from July. This puppy is close to being finished now.

With only a week to finish out January it will be interesting to see how well it's either held up or jammed up into the end of the month. There are many investors literally banking on the theory that the stock market will have another bullish year based on the 3rd year of the 2nd term of a presidential cycle. So a bullish January is important to keep people in here. I happen to believe 2007 will be a bearish year and the shock from disbelief that we're not going to have an up year will be one of the reasons for a swift decline (probably not until late summer into fall). We should be very close to topping out and then a decline into the spring, a rally into the summer (relief that we survived another sell-off attempt) and then the big hit. That's what I see happening from an EW perspective so we'll just ride the waves to see how it sets up.

For now, and something I'll review more thoroughly in the charts tonight, the rally is progressing as I had hoped it would. We're getting the 2nd leg up from January's low and this is doing a good job for the EW pattern. Based on Fib projections within the rally from last July and the rally this month, we're nearing some important levels to start watching for topping in the market. The DOW could rally another 100 points to reach its upper Fib projection but the risk is increasing for bulls from here.

After last week's pullback, especially in the techs and small caps, it was looking downright bearish for the market. The techs and small caps still look bearish but I'll get to those charts later. I was surprised at the end of the week to see that the Fed had been very busy making more money. Helicopter Ben is living up to his word that he will use the technology called the "printing press" (his words) to stave off an economic slowdown. I showed this chart at the end of the day on Friday on the Market Monitor and suggested we might see this money come into the market this week.

Calculated M3 money supply, Weekly, courtesy nowandfutures.com

Take a look at the large increase in calculated M3 over the past two weeks (the light blue line is the annual rate of change). After dipping sharply in the shortened first week of January, this chart shows money creation going through the roof. To say this has gone parabolic would be a gross understatement. There are those who say money supply is not increasing and maybe by M2 measures it's not. But M3 includes money being created by the Fed and this chart is clear as day what they're doing.

This is updated by each Friday evening so when I saw it last Friday I wondered why the market had pulled back instead of rallied. That's a lot of money they created. There were two possible scenarios--one, the new money coming into the market was being overwhelmed by sellers; two, the money hadn't been used yet by the mega banks' trading teams to insert into the system (by buying securities). And if the money hadn't been used yet then it was likely we'd see a rally this week. Tada! Nice rally off Monday's low.

It's unfortunate that we can only get an update on this M3 number at the end of each week but at least it's better than what the Fed is doing for us--they're not reporting it at all (and seeing the past 7 months is it any wonder they wanted to stop reporting it?). We're operating with hindsight when trying to see what the money supply is doing but I think it at least provides some clues.

The Fed is clearly worried about an economic slowdown. For all their jawboning about the economy being in great shape, one has to wonder why then all this money coming into the monetary system. This is usually done to keep the economic pump primed. The excess liquidity that's sloshing around the global market right now (whether it's because of cheap Yen, excess dollars or highly leveraged trading) has created all kinds of bubbles. Tech stocks, gold, commodities, housing, you name it and we've seen huge run-ups.

As I've mentioned before, with all this money being created the Fed will paint itself into a corner as far as fighting inflation. It will have to raise rates if inflation doesn't come down and I'm not sure how inflation can come down if the Fed keeps printing money at hyperinflationary rates.


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If they stop printing money and credit dries up (which will eventually happen anyway as demand for credit slackens) then the economy will slow down, especially the housing market (tighter credit will reduce the buyer pool).

If they are forced to raise rates to fight inflation then that too will cause credit to dry up and the economy to slow down, especially the housing market (higher interest rates will increase the foreclosure rate and reduce the buyer pool). Notice the common component? Yep, no matter what, the housing market is facing some very tough times ahead. I'll discuss that a little more with the home builders chart.

I'm trying to lay out some fundamental reasons why I'm bearish the market this coming year (and into 2008). The EW pattern is very clear and we're oh-so-close to a top now by the pattern. A bullish January to keep the sheeple buying should lead to painful times for the new bulls. The pieces are falling into place nicely for the bears.

Are there any more bears left? They've been pretty much annihilated. There are several bullish vs. bearish sentiment measurements and all show a heavy skewing towards bullish sentiment. That's been true for quite a while now, just like the bearish divergences on the chars since last October, so it clearly doesn't help us trade today. But when it gets too much to an extreme then the danger mounts daily.

As I mentioned last week, Elliott Wave International showed a chart of bullish vs. bearish sentiment, using a 60-day moving average of the investment advisors' sentiment. In the past, including prior to the 1987 crash and the tech boom into 2000, a reading of 20% bearish always triggered a large market correction. When most everyone is bullish, most everyone is already in. We are currently at 16% which has never been seen before.

We've got record low VIX (dropped back below 10 today), most everyone is expecting a bullish 2007, hot money is chasing emerging markets and junk bonds and we see a total disregard for the risks involved in investing. This is the perfect storm setting up and the "dislocation" in the first sand pile will likely cause some cataclysmic collapses in surrounding sand piles that no one expects. That's what causes panic selling--not a care in the world suddenly turns into panic and catches most everyone by surprise. Watch for it, be ready and trade it. It could end up being a highly profitable year if you properly prepare yourself.

I mentioned interest rates are on the rise so I thought I'd update the chart of the 10-year yield:

10-year Yield (TNX.X) chart, Daily

If you're used to looking at bond prices instead of yields, just use the inverse of this chart. After stalling at its downtrend line from July, that line was broken and then retested in early January. Since then TNX has made it through several layers of resistance and is now a stone's throw from its 200-dma where I suspect we'll see a pullback (so a long play will set up in bonds). Yields had fallen (bonds rising) since July but the downtrend was broken in late December. They had fallen under the presumption that the Fed would soon lower interest rates. The bond market is recognizing that the Fed is nowhere close to lowering rates.

This is of course begs the question what the heck is wrong with the stock market. Some believe the stock market is all-knowing but I beg to differ. If it was all knowing, it would be dropping with bonds. The stock market is stuck in lala land, convinced in the Goldilocks soft-landing scenario. Recognition is not far away.

Competing for dollars will be the bonds. As interest rates rise closer to 5% we will see fund managers start to remove some risk from their portfolios and move into the safety of a guaranteed 5%. Once we get through January, possibly before, we'll probably start to see more of a rotation out of equities and into bonds. That's another reason I think the 200-dma for yields will hold (bonds rally). Then we'll have to see what kind of pullback we'll get in yields and whether or not it will likely lead to even higher rates.

Yawn, the DOW made another all-time intraday high today. For those investors who do not follow the market closely it must seem like the market is just rocketing higher. After all, after a gazillion new all-time highs surely we must be approaching DOW 20,000 by now, right? Many would be disappointed to know the DOW is only 454 points higher than the high in October, for a 3.7% gain over the past 3 months. As a return on assets that's nothing to sneeze at but all these new all-time highs has made it sound like a lot more than that. And that of course has kept people bullish, even after the bonds have given us a pretty good sell signal. Interestingly, of that +3.7% increase in the past 3 months, 1.4% of it happened since Monday's low and is the new year's rally so far.

So let's move to the charts and see why I'm thinking we're really close now and I'm on "top watch".

DOW chart, Daily

After a strong and impulsive rally (no overlap between highs and lows during the rally) from July to October, the DOW has been a corrective mess--lots of overlap between the highs and lows. When a market does this but continues to move higher it's an ending pattern. It's always a challenge to figure out where the end will be but the whole mess since October is what's called an ending diagonal or an ascending wedge. You want to see bearish divergences during these patterns as confirmation that it's an ending pattern. As shown on the RSI we've clearly had major bearish divergences at each new high.

I show a Fib projection at 12626.20 which is based on the 1st wave up in the rally from July. Very often in a 5-wave move up the 5th wave will equal the 1st wave. The 5th wave is the "rally" from the beginning of November. It's also very common to see an ascending wedge, with bearish divergences, for a 5th wave. The 5th wave will itself be made up of 5 waves and we're into the 5th of the 5th wave since the January low. With the end of the wave count here and today's high at 12623.45 we're very close to a potential top and is the reason I'm watching this move carefully to see if we're putting in a high, as in THE high.

DOW chart, 120-min

Moving in closer with this 120-min chart, I'm showing the tail end of the move inside the ascending wedge. The January low would have been the end of the 4th wave of wave-5 on the daily chart and the 5th of the 5th wave started from January 8th. Because we're in an ascending wedge this final 5th wave will be a 3-wave move (all triangles are made up of 3-wave moves inside the triangle). So I've been looking for an A-B-C move up from January 8th, hence last week's comment on the chart that I was waiting for a pullback to be followed by one more leg up. Today's new high for the DOW confirms it. Now we watch for the end of it.

In an A-B-C move the most common relationships between a-waves and c-waves are 62%, 100% and 162%. A 62% projection off wave-A gives us an upside target of 12621.70 which was hit today. Notice this is also only a few points from the larger pattern's projection to 12626. This kind of Fib correlation always gets my attention. Did we make a final high today? We'll know if we start to get an impulsive decline starting on Thursday.

If the market proceeds higher then the next Fib projection (for wave-C = wave-A) is at 12726.80 so another 100 points. In between these two Fib projections is the top of the ascending wedge near 12660. A brief "throw-over" above the wedge (a common ending, if not falling short of the top of the wedge) could see 12700 tagged, a nice century mark for resistance.

We've seen several setups in the recent past where I was comfortable calling a top. It was not to be each time and it may not be again. But I have to say this one looks very good, almost too good. Sometimes the obvious is an obvious error and I always worry about that but to me this is an obvious top in the making. I would once again be thinking about plans to protect long positions and position for the short side.

SPX chart, Daily

Everything I said for the DOW pertains to the SPX as well. The two Fib projections for the move up from January are at 1439.74 (tagged today) and then 1451.70. After breaking its uptrend line from July SPX has been bumping underneath it and working its way higher. Today it closed slightly above the trend line again so I'm watching for potential failure here.

The weekly chart (see at the end of the report) shows a Fib projection at 1455 (for two equal legs up from October 2002) and now we have the last move up from the January low pointing to an upper Fib target of 1452. I believe the SPX is within spitting distance now of putting in a major high, either here at its lower Fib projection or at the upper Fib projection near 1452 which is close to its weekly projection. The risk is to the bulls now since we could see a nasty bit of selling hit at any time.

When looking at SPX's cousin, the OEX, 670.13 could be an important level for that index. That's where it retraces 62% of the 2000-2002 decline. Today's high was 669.95. Makes one want to go hmm...

Nasdaq chart, Daily

After breaking back inside its consolidation range of the past 2 months the COMP has now bounced back up near what was resistance (but not support) at 2470. If the January high was THE high, which I could easily argue that it was (because of the impulsive decline since then, especially true for the small caps), then we should get just a corrective bounce to correct that decline. An A-B-C bounce with C = 162% of A is at 2468. A 50% retracement of last week's decline is at 2466. Today's high was at 2465.81. Makes one want to go hmm...

SMH semiconductor holder (ETF), Daily chart

SMH looks like it's permanently stuck between 33 and 36. It looks like an impulsive decline from the January high so any bounce followed by another decline below this week's low would be bearish. Another decline in the semis would also be a leading indicator for the broader market.

Before getting to the banks I wanted to show an update for the broker index since they've been very bullish since the pullback in December.

Brokers (XBD.X) index, Daily chart

After a brief pullback from the January high, which was another test of the top of its parallel up-channel, the brokers appear headed to the top of the channel once again. There's a Fib projection at 260.56, which is based on the 1st and 5th waves being equal in the rally from June. This is also very close to the top of the channel and where I think the brokers will top out and will be a very good shorting opportunity.

Banking (BIX.X) index, Daily chart

The banks appear to me as though they've already topped out. The decline from the December high looks like a clean impulsive 5-wave move down. That suggests we have a trend change to the downside and therefore a top in December. With the completion of the 5-wave move down on Tuesday we should now see a correction of that decline. A 38%-62% retracement gives us a potential resistance zone between 403.49 and 406.84. Today's high at 402.97 tells us to be cautious about a possible turn back down from here.

The banks have been hurt by inverse yield curve that won't go away. As they have to pay higher interest on short-term deposits and receive less or the same return on longer term loans, it eats away at their bottom line. An increase in the longer term rates recently is going to put a further damper on the home market although you wouldn't know it by recent price action in the home builders.

But as a further sign of contraction in the home building industry, Centex Corp. (CTX) said today that it is planning additional layoffs and will continue to reduce its land positions (they're selling land and taking a loss on their options to purchase additional land. CTX says it is adjusting to slower sales while positioning themselves for a "hoped-for housing rebound during the spring selling season." Ah, there's that word traders live by. But you know what they say about the slippery slope of hope in a bear market.

"It's a tough market and it's going to remain tough for a while," said Tim Eller, Dallas-based Centex's chief executive. He warned "the housing market could still be in the early innings of the current slowdown. "This housing correction is still unfolding and although we're seeing some encouraging signs in some markets, it's still too early to call the bottom." The home builders are expected to announce more land and inventory write-offs as housing continues to unwind.

With the bounce in the home builders that we've seen over the past three weeks, and the bounce since the July low, we have a lot of hope out there. This price action is very typical in a post-bubble move. Take a look at the decline in the techs following the dot com bust in 2000-2002. For those who traded through that time, how many times did we here about a recovery in tech spending and how we were putting in a bottom?

That's what makes bear market rallies--hope that we're putting in a bottom and a desire to get in at the bottom for a good ride back up. The exact same thing is happening in the home market right now. It's why I feel strongly that the spring housing market is going to be a bust and recognition time for home sellers. But in the meantime it looks as though the home builder index could get another lift higher. If the index manages to rally up to the 840 area (I have my doubts but it could happen) then I think it would be one of the best shorting opportunities out there.

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

The current rally has taken the index to the top of a parallel up-channel for price action since the July low. Price had jumped above this channel in early December before dropping back inside. Now price is back to the top of the channel and the daily oscillators may be topping out. If price rolls back over from here it will leave a bearish divergence at a double-top against the December high. That would be a good shorting opportunity. But if it manages to rally up to its downtrend line from July 2005 then the best shorting opportunity may be yet to come.

For you Elliotticians, I've relabeled the bounce from July as a double zig-zag which is made up of two a-b-c's with an x-wave in the middle. The 2nd a-b-c, the move up from November, would achieve equality between wave-a and wave-c at 837 which is right on top of the 50% retracement of the decline from July 2005. Whether it will get there or not I have no idea but it would be one heck of a short play setup. I consider the home builder index very risky for bulls from here as upside potential doesn't warrant the risk for new bullish plays (imho).

Oil chart, January contract, Daily

Oil almost made it down to the bottom of a parallel down-channel for price action since the July high. Internally it looks like oil needs another leg down to finish its wave pattern. The bottom of the channel and a Fib projection (for two equal legs down from July) at 47.42 intersect by mid-February and I'm currently thinking that's what we'll see.

Oil Index chart, Daily

Oil stocks started bouncing just before oil bottomed and they've bounced up to a level just above a 50% retracement of the decline from December's high and up to the 50-dma. This could do it for the bounce, especially if the broader market tops out. If this index turns back down and breaks back below its 200-0dma at 612 then there's a good chance we'll see the sell off accelerate to new lows.

Transportation Index chart, TRAN, Daily

The Trannies are working hard to break its downtrend line from May. I'm not sure it will make it but if it does then we should see a run to 5000 and a test of its May high. I don't think it would be able to rally much higher than that. A drop back below 4700 would suggest a new leg down has started.

U.S. Dollar chart, Daily

The pullback in the US dollar from its January high looks like it could resolve higher again. If that happens I think it will stop near 85.50 at its downtrend line from November 2005. Whether it drops from here or after a small move higher, it looks like it's set up for another drop down towards 82.

Gold chart, February contract, Daily

Gold's ability to break its downtrend line from July, as long as it can hold above 640 now, should mean a rally to 656 and potentially higher. Any pullback following that will probably retest the broken downtrend line which will need to hold in order to support the idea that gold is headed much higher from here.

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

The rest of the week will continue to be relatively quiet as far as economic reports go. We'll get the usual unemployment and help-wanted data tomorrow and then the existing home sales. Investors are hungry for any morsel of good news in the housing market so don't be surprised if a negative report here is spun in a positive light which gets that market rallying. Same with the new home sales numbers on Friday. A positive number there may mean more apartments are being built instead of condominiums. It is new construction but it wouldn't mean a recovery in home ownership.

The updated weekly chart shows price marching a little closer to potential resistance at 1455.

SPX chart, Weekly, More Immediately Bearish

The short term charts suggest potential resistance at today's close (1440) and then 1452-1455. A this point we're "close enough" and I would not want to chase any move higher unless you're sitting in front of your monitor with your finger on the sell button. It's always dangerous trying to call a top and therefore if you're not able to watch the market tick by tick (to nibble on a short and be able to cover quickly) it's much better to wait until we see support breaking.

After today's close eBay (EBAY 30.00 +1.38) announced its earnings which were very good numbers and even better, good guidance. Profit rose 24% and earnings were 25 cents a share, up from 20 cents a year ago. I'm unable to pull up after-hours pricing and I'm late submitting this report. But ES and YM futures haven't moved much while NQ is up slightly. What effect they'll have on tomorrow's open is unknown. Watch for a potential gap n crap in the techs.

The best sell signal will be a break below the January low. Until that happens we could see a very choppy move higher with deep pullbacks along the way. Once the January low breaks there will be plenty of opportunities to get short on bounces, especially bounces up to resistance-turned-support. Therefore be patient and wait. With the low VIX and relatively small price move to get there you will not miss much.

For you Type-A's and gunslingers who have to at least try to catch the top (I've been known to try it a time or two) we have our first opportunity as of today's close. If we get a gap n crap tomorrow morning then I'd short it and use the morning higher for your stop. If you try to short the market you need to stay aware of those upside targets. It might not even stop there. But I like the setup here for a first attempt at a short play. If it doesn't work here then the next attempt will be near SPX 1452-1455 and DOW 12727.

If you're long the market now is the time I'd pull my stops up tight, certainly no lower than just under the January low. More aggressively I'd place my stop just below this past Monday's low. A break of that low would be a heads up that the January low is danger of being broken.

Good luck in your trading. I'll see you back here next Wednesday and on the Market Monitor tomorrow.

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