Option Investor
Market Wrap

The Sky Is Falling!

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Having the last name Little, and having somewhat of a long neck, there have been times in my past when I've been teased about being Chicken Little. Maybe that's why I went into the Navy to get myself qualified as a carrier pilot. Needed to prove my manhood and all that (smile). It was actually a lot of fun and I strongly recommend you encourage your kids to go for it if they enjoy the idea of flying the greatest toys on earth, and getting paid to do it! But I digress.

For the past many months I've been stressing the vulnerability of the stock market to a sell off. But ever since the drop into the January 8th low I've been saying we needed a 3-wave move back up to a new high in order to complete the wave count from July 2006 (for those following Elliott Wave (EW) counts, it needed to be a 3-wave move because we started forming an ascending wedge since November and each of the 5 waves inside the wedge is a 3-wave move). After the rally to the January 17th high and then a funky correction back down to the low on January 26th, I was looking for one more push to a new high to complete the whole EW count.

The significance of this wave count is that the rally from July finishes the wave count for the rally from October 2002 and therefore to say that the rally leg up from January 26th was a significant one would be an understatement. So when the rally started from that January 26th low I've been watching it like a hawk in order to determine where I thought it would end. If you are able to follow me on the Market Monitor you'll know how important this leg up has been--I've tracked it every step of the way looking for where it should end. As of tonight I'm saying that leg could very well be finished. Again, the significance here is that the rally leg from January 26th finishes the rally from July 2006 and that rally leg finishes the rally from October 2002. That means the 2000-2007 bull market may very well have ended at today's high for the DOW and SPX.

For those of you who just gave a big sigh and are ready to click the "close" button on your browser, hear me out. Humor me. Find holes in my argument and argue with me. But don't ignore me. You owe it to yourself to see what I have to say and then, and only then, will you have a little more knowledge to help you make a decision for your own trading/investments. Besides, if I'm wrong we'll know it right away tomorrow with a continuation of the rally. I'm calling a top today which means today's highs have to hold.

Market tops are typically "rolling" affairs. Not all indices and sectors top out together. Look at what happened in 2000 and it's more than obvious. The DOW topped out in January 2000, SPX in March 2000, the NYSE in September 2000. I fully expect we will see something similar this time around. For example, it's quite possible the techs, especially the NDX topped out on January 16th. I'll show that in some charts tonight. I'm pretty excited by the setup after today's price action. Could it fool me and continue to zoom higher tomorrow? Without a doubt. And that's why we use stops. We make our best guess based on the evidence in front of us, place our bets and then more importantly, place our stops.

I'm going to change the format of tonight's report and lay out my argument for a market top. Several major indices look similar enough and I'll show some ideas of what could be happening if we're Not topping. As I started in the Market Monitor in the past week, I'm attempting to lay out road maps to show where the market could turn bullish or bearish. Then "all we have to do" is let price lead the way. I may feel bearish as of tonight but it wouldn't take much to push me out of a bearish play if price proves me wrong. That's trading.

I'm primarily referring to the DOW and SPX since the small caps and techs seem to have a little wind behind their sails currently. They could spurt a little higher tomorrow but I also see them as either topping out today (actually January 16th for NDX) or possibly after a minor push higher in the next day or so. I'll lay out my argument with more charts than usual but I'm going to focus on the major indices and only cover the other sectors that I usually cover as time permits (before I'm required to hit the 'send' button).


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I'm also going to use EW analysis more heavily than I've used it before with you. I like EW analysis because it uses price and as I've said repeatedly, price is the final arbiter. Sentiment, overbought, oversold, contrarian signals, you name it and they're helpful but not accurate for making timely calls. But EW analysis gives me the opportunity to identify specific price levels, using wave counts, Fibs, time projections and trend lines, and that's what I'll go over today. If you're new to a lot of this then bear with me as I do my best to explain why certain wave counts could be very significant here. Before we get to the charts though I'll cover the brief economic reports we received today. This is a very light week for these reports and today was no exception.

Productivity of the U.S. non-farm business sector rose substantially in the 4th quarter--up an annualized rate of +3% after a barely positive number of +0.1% for the 3rd quarter. Unit labor costs rose at an annualized rate of +1.7% which is a number used by the Fed in their calculations for inflationary pressures from wage inflation. Today's number is Fed-friendly. For all of 2006 productivity rose +2.1% which is unfortunately the slowest improvement in 10 years. Compounding that problem, the unit labor costs rose +3.2%, the most since 2000. So the year's numbers were not Fed-friendly and while one quarter does not a trend make, I'm sure the Fed will be watching closely for a developing trend.

Consumer Credit
Consumers were a little less willing to pull the credit cared out in December--the number was $6.0B which was less then half of November's, and 25% less than the expected $8.0B. Again, hard to define a trend with such short term data but a consumer who's keeping his wallet parked on his hip is not going to be helping our economy. This is fully expected though. The slowdown in housing and the overspending consumer just can't continue as it has been. And with a slowdown in spending we will see some rough patches ahead in our economic road. Hopefully the pot holes won't be so deep that we fall into them.

Crude Inventories
The only other reports out today were oil inventories and they showed distillates fell for a 2nd week in a row, down 3.7M barrels to 136.3M. Crude supplies also fell, down 400K barrels to 324.5M. Gasoline supplies were up for the 8th week in a row so either motorists have scaled back in their driving or the refineries have been catching up. Sure glad that's being reflected in the price of gas at the local gas stations (cough).

OK, let's get to some charts.

DOW chart, Daily

Using the same daily chart of the DOW that we've been following you can see how price rallied up to the trend line along highs since December. Along with the trend line along the lows since November you can see the ascending wedge (and all the choppy price action inside which helps confirm that it's an ending pattern). The bearish divergences associated with this ascending wedge also helps confirm the fact that we should be looking for a top instead of a breakout (except sometimes we'll get a brief breakout and then collapse back inside the pattern). With price up against the top of its wedge, and oscillators overbought and looking vulnerable to rolling over, the daily chart warns of a potential reversal.

DOW chart, 60-min

Dialing down a bit, the 60-min chart shows the move I was talking about above when I said I wanted to see a 3-wave move up from January 8th, labeled wave-4 on the chart. I show a Fib projection for two equal legs up from January 8th (for the a-b-c move) at 12707.70. Once we got the pullback into the low on January 26th I started watching very carefully for a 5-wave move up (c-waves are 5-wave moves), labeled waves (i) through (v) on the chart.

DOW chart, 30-min

The 30-min chart zooms in a little closer to this wave-c of 5. Today's rally to a new high was either the completion of the 5th wave of the leg up from January 26th (as a truncated 5th wave which nearly reached the Fib level where the 5th wave = 62% of the 1st wave, at 12702.60, a very common Fib relationship between these waves). The DOW dropped below yesterday's low at 12634 and that was a complete retracement of the bounce off yesterday's low. That tells me the move up today finished the count. The SPX leaves the door open in that regard. After this afternoon's bounce any drop to a new low now, and I've highlighted the need to drop below 12625 just for good measure, is a sell signal--get short and hang on.

SPX chart, Weekly

I usually show this chart at the end of my report but I'll start with it here and then dial in closer to show how the move has developed to the point where I'm calling a top. I've shown this chart for what seems like an eternity now and have been referencing the 1455 level which is where the rally from October 2002 has two equal legs up. Today's high was 1453. This is important because it's very common to get an A-B-C bounce with equality between A and C. Why is this significant here? Because it's an A-B-C correction to the 2000-2002 decline. In other words this long 2002-2007 bull market has been nothing more than a bear market rally. A really long bear market rally but a bear market rally nonetheless. That's the significance of identifying where we are in the larger pattern. The monthly chart (not shown) would point to a new bear market about to start, with a leg down that drops below the October 2002 low. Typically that move should take about 18-24 months. Pretty scary if I'm right about this.

SPX chart, Daily

This is the same daily chart we've been following for a long time. SPX rallied up near its broken uptrend line from July, oscillators are getting overbought, bearish divergences continue and the wave count for the move up from July can be considered complete on the daily chart. It says prepare for a reversal at any time.

SPX chart, 30-min

This is the 30-min chart I've been showing on the Market Monitor for the past week or so as I made an effort to show how I'm using the EW count to identify where the count should end (by both the count and Fib projections). As the move developed, and especially after the sharp pullback on Tuesday I showed the Fib projection for wave-5 at 1453.38, based on equality with wave-1. The common Fib relationship between 5th and 1st waves is 62%, 100% and 162% with equality the most common. Again, today's high at 1452.99 was pennies away before it rolled back over and broke the uptrend line from the end of January.

The trend lines for these EW patterns are important tools and that break is potentially very important. This afternoon's bounce stopped right back up against that trend line near 1450 and is set up for a kiss goodbye tomorrow morning. This count requires a decline out of the gates tomorrow morning. A break below this afternoon's low would confirm the sell signal. If price instead rallies to a new high then the next upside target near 1460 would be in play. Risk is small and the potential for downside profit is large. My kind of play.

SPX chart, Daily (with bullish and bearish price projections)

I'm experimenting with some daily charts on the major indices and a few key stocks in an attempt to show a "road map". By identifying key levels for the market, call them make or break, do or die, or whatever, these levels will help confirm we're in a bearish or bullish price pattern. It gets a little busy trying to show all this on a small chart so please bear with me on this. I show a green target at 1455 which means the price pattern stays bullish for at least a little longer (follow the green lines in that case). The red target, at 1417, shows the price level where the bearish price pattern is confirmed. This is on a daily chart and I'm doing the same thing on the intraday charts to better manage intraday trading. For example on the intraday SPX chart above I show the red target at 1440--a drop below that puts us on a confirmed bearish track. With these road maps I'm hoping to provide help in managing longer term trades such as spread positions where you try to identify major levels for confirmation you're on the right side of things or not. I will be working on this to then develop a matrix sheet that shows key levels for the market to help manage trades without even needing a chart in front of you. Imagine that!

Nasdaq chart, Daily

The techs got a nice little boost today from the CSCO news but I'm not sure it will amount to much more. I think the January 16th high will hold and that opinion is based primarily on the fact that price has been too choppy since the low on January 22nd. It looks like a corrective bounce that will soon lead to another, and faster, leg down. Obviously a rally above 2509 on January 16th would say that the techs haven't finished putting in their high.

Nasdaq-100 (NDX) chart, Daily

This chart is the same format as the SPX daily chart just above--showing the road map for the bullish vs. bearish wave counts. We simply let price lead the way from here. So the daily chart we've got two important numbers to watch--to the upside is 1830 and a rally above that would tell me there's a good chance the bullish count is in play, with upside potential ultimately close to 1900 (perhaps 2550 on the COMP). To the downside is 1763 and a drop below that would confirm we're in the bearish wave count. But yesterday's low at 1776 would be the first heads up that 1763 will likely be taken out.

Nasdaq-100 (NDX) chart, 120-min

I'll use a 120-min chart to zoom in a little closer to whichever count I think we're currently in and until 1830 is taken out to the upside I believe we're in the bearish count. That's what's shown here and a possible price path to the downside. Once again, 1763 is the important confirmation level although a break below yesterday's 1776 low would tell me we're likely going to continue lower.

Russell 2000 (RUT) chart, Daily

Again, same idea for the daily chart on the RUT. This one looks a little busy with all the trend lines, notes and counts so it takes a little bit to look through this. Key levels for the RUT are 825 to the upside and a break of the uptrend line from August, currently near 790 (higher as time progresses), to the downside. Until that uptrend line breaks we could get a pullback and then a continuation higher as depicted by the green lines. The green wave count fully supports this possibility. Upside targets in that case would be near 823 and then 845. So a break above 825 would have me thinking at least a little more bullishly. That 845 target could be important for those of you in bear call spreads and another reason to try to help you with these road maps. Right now the fact that the RUT is up against the parallel trend line which stopped the advance in early December, and the bearish divergences at the new high, and overbought oscillators, and...well you get my drift. I don't like the upside here.

Russell 2000 (RUT) chart, 120-min

Zeroing in on the RUT with this 120-min chart, and assuming for the moment that the bearish count will be confirmed, this shows how it might look. I want to see today's high at 816 hold and but recognize we could see a move up to near 823. I have a green solid circle at 816 to signify a potential switch to the bullish count so pay attention tomorrow. If the RUT reaches 825 I would again be very careful about bearish positions in this index.

The reason for identifying the 816 level is because that's where the 5th wave in the move up from January 26th (same as the move for SPX and DOW) is equal to 62% of the 1st wave. I show an ascending wedge shape and when you see this it's more common to see the 5th wave = 62% of the 1st wave. Today's high was 816.20. But if it gets up to equality between the 1st and 5th waves then that's where the 2nd green circle is located--just under 824. With the 5th wave in the move up from July equaling the 1st wave (you can see this projection on the daily chart above) just under 823 you can see the Fib significance in the 816-824 area. It's also why I identified 825 as the important level for negating the bearish count on the daily chart. In this way we can trade unemotionally and without bias--we simply follow price and let it tell us what's playing out.

I've run out of time and will not be able to show my normal charts so I hope that doesn't inconvenience anyone. If you'd like a quick update on any of my regular charts just drop me an email and I'll be happy to send you something. But I will show one more--the housing chart only because I had some comments I wanted to pass along about this industry.

There were some stories out today relative to the home market that are worth reviewing. Since the housing market has started slowing down there's been much hand wringing and gnashing of teeth as to what it all means. Let's face it, home ownership is one of the most common things, across just about economic classes. We all are deeply interested in what affects the values of our homes, and the economy is deeply dependent on the health of the home market. So it's not surprising that Congress is now getting interested. I'm sure they're getting an earful from their constituents so it's suddenly the "right" thing to do.

The Senate Banking Committee Chairman Christopher Dodd (D-Conn.) made a statement that "U.S. homeowners are facing a 'crisis' thanks to predatory and irresponsible lending practices." As usual, by the time Congress gets involved, as in this case, they're attempting to close the barn door after the horses have already escaped. But considering the deceitful lending practices used by many lenders, especially sub-prime lenders, and the resultant loss of homes by those caught up in mortgages they can no longer afford, we certainly need to do something and the faster the better.

While it's true we all need to take responsibility for our own actions, including financial ones, it's a well known fact that many people are simply not financially astute enough to understand some of the "bait and switch" kinds of mortgages being pawned off on unsuspecting home owners. And it's usually the ones who can least afford the loss of their homes/down payments--minorities, immigrants, retired, etc. We're seeing a very large spike in the failure rate in mortgages and most especially in the sub-prime loans (these are the ones given out to a person who only needed to fog a mirror and sometimes even that requirement was waived). So the fact that Congress is now getting involved means people are starting to feel the pain in the housing sector and are clearly worried. Worried constituents make for active Congressmen.

About one in five sub-prime mortgages made in the last two years are likely to go into foreclosure, according to a report written by the Center for Responsible Lending, a research group in Durham, N.C., which was based on data supplied by Moodys Economy.com (found at responsiblelending.org). The report pointed out that at that rate, about 1.1 million homeowners who took out sub-prime loans in the last two years will lose their houses in the next few years. The foreclosures will cost those homeowners an estimated $74.6B, primarily in equity. Here's a chart they used to highlight the explosive growth in sub-prime mortgages:

Sub-prime mortgages, 1998-2006, courtesy Center for Responsible Lending

You can see the quick spike in the sub-prime loans since 2002. These are the aggressive loans, many of which are adjustable rate loans and the increase in rates is beginning to knock many people out of the homeowner box. Prepayment penalties are locking people in since they can't get a replacement mortgage now. The list of problems is heartbreaking. It's not going to help the home sellers who are hoping for a better spring season.

The report cited several factors for the increase in sub-prime mortgage foreclosures, including adjustable rate mortgages with steep built-in rate and payment increases, prepayment penalties, limited income documentation and no escrow for taxes and insurance. The report said these features caused a higher risk of default regardless of the borrowers credit score. In other words, the higher default rate is not necessarily due to peoples' low incomes but instead it's because of the loan features that place borrowers at higher risk.

In addition to the personal losses by these people it will also add to the inventory of unsold homes and further depress the value of the homes on the market. A continuing decline in the value of housing will only further exacerbate the problem for those who have mortgages nearly equal to the value of their homes. If they find they're having difficulty making their mortgage payments and know that their house is valued below what they owe, they'll simply walk away from the house. You can see where all this could lead.

It's part of the reason I'm bearish on the housing market, including the home builders. We have an incredible amount of waste and a bubble from the past several years and it will need time to be washed out of the system. It will be painful--either over many years or more drastic reductions over a few years--but it will be necessary for the longer term health of our housing industry and economy.

Potential fallout from these sub-prime loans, which end up in default, is that the investors who purchased these loan packages from the lending institutions may be in for a rude awakening. These higher risk loans were often packaged with better credit-risk loans so as to keep the overall rating higher for the package. The investors received a higher risk package for a lower rate of return and it's all part of the systemic problem over the past few years where investors have been chasing higher risk portfolios in order to capture better returns. On top of that we've got credit default swaps trading multiple times over on the same piece of paper. It's a mess and no one really knows who owns what. Ah the web we weave...

Investors in home builders though have continued focus on the positive (that slippery slope of hope) and have bid up the builders over the past several months on the premise that things will get better this spring. Not only do I not believe that rosy scenario will play out but the pattern of the bounce since the low in July of last year looks like a bear flag. The internal price pattern suggests the whole rally has been nothing more than a bear market rally.

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

I'm showing a weekly chart this week to keep this in perspective. The downtrend line from the high in July 2005, the top of the current bear flag and some Fibs point to the possibility that this index could make it up to the 840 area although I think it's now on borrow time. I've got potential Fib resistance between 780 and 800 so with a high near 790 last Friday we might have seen the end of the run up. However, with continued bullish prognostications by economists we could see investors drive the home builders a little higher towards that 840 level. I'd be more than happy to short it up there and would be uncomfortable being long here.

I don't have time to post charts I wanted to post on the Trannies but I'll just add quickly that I see a fractal pattern playing out from the weekly to the daily to the 60-min charts and these are powerful patterns to play. It strongly suggests that the test of the May 2006 high last Friday, February 2nd was either THE high or we've got a minor new high to finish the whole thing off. That index is confirming the sell signals I'm seeing in the broader indices.

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

We have nothing that should move the market tomorrow so it will be on its own to sink or swim. I think it will sink but it doesn't matter what I think--if it swims then we will swim with the current.

Normally this is where I update the weekly SPX chart but I showed it earlier as part of zeroing in on where we are in the rally and why I see very close to, if not at, a significant high for the market.

As I've stated many times, we'll let price lead the way but sometimes you just place your bets based on where you think the market is headed. I've discussed multiple reasons why I believe the market is overbought, overbullish and overvalued. At the same time we've had glaring bearish divergences on all charts staring at us for months. A low VIX has been laughing at bears trying to use it to place their short bets. We've clearly been in a market that can remain irrational far longer than you can remain solvent trying to fight it.

One of the things to be cautious about, and why you don't want to fight price (the final arbiter), is the fact that there are so many bullish people out there. They will continue to buy the market, including the dips, and the buying could get serious at times as both the shorts cover and new longs jump in, afraid they're missing the train. I like to read many other analysts, especially ones I don't agree with, because they get me to challenge my assumptions and opinions. One recent piece was by Bernie Schaeffer. Most know of him and have probably read much of his work, particularly in the area of options and how he derives sentiment indicators from them.

In a recent article (mostly an advertisement I think) he discussed how the market sentiment is not that bullish and that mutual funds have plenty of cash, more than at many times in the recent past. I've shown enough charts tonight and it's getting late for me to send this but frankly I don't know where Bernie gets his data (he didn't show any). The data I've seen shows a record (as in never seen before) extreme number of bulls vs. bears among investors and advisors. At less than 16% bears that's well below the previous record low near 20% in 2000. Mutual fund cash levels are Well below historical averages and well below where they were in 2000. It seems the bears have thrown in the towel and mutual funds have spent their cash.

Bernie expects to see DOW 14400 this year and he thinks that's conservative. As I read his piece, the biggest reason for his opinion seems to be based on the fact that the 3rd year of a presidential cycle typically results in a double-digit growth rate for the stock market. The bottom line here though is not whether he's right or wrong but it matters what other people believe and therefore what they'll try to do. With all the bullishness running rampant the bears can not, and should not, expect an easy time of it. Bear market rallies are bear killers. It's harder to make money in a down market than in an up market. So understanding what others believe, regardless of whether or not you agree, will hopefully get you one step closer to better managing your own trades.

And like the low VIX I read all these reasons why the market should roll over and say so what! It hasn't mattered a hill of beans since all the divergences started last October. But it will mean a hill of beans and likely sooner rather than later. It's why I follow EW patterns--if I've got the right wave count then there's no arguing with price. And as of tonight the price pattern strongly suggests the DOW and SPX topped out today (and NDX on January 16th).

If I'm right in my assessment you want to get short the market now (at least pull your stops up tighter and protect profits). If I'm wrong it means the final 5th wave of the advance off the January 26th low is likely "extending". A new high for the DOW and SPX tomorrow would confirm for me that that's likely happening, in which case I merely step out of my short position and wait to reposition. I'll watch it closely again for the completion of another 5-wave move which could take SPX up near 1460, maybe even 1475-1480.

I'll continue to urge utmost caution about the upside from here. If you're unable to watch the market intraday then simply decide where you'd like to take profits off the table, or buy some protective puts. Uptrend lines and/or major moving averages work well for this. If you'd like to nibble on a few short positions, buy yourself lots of time and buy a few index puts. If they start working for you, cash some in at support (or create a bull put spread with shorter time frame short puts), wait for a bounce and then use the profits to buy a few more than you had. Keep doing that a few times and you'll build yourself a nice short position that you won't have to aggressively manage.

I do have one more chart to share with you and it uses time cycle studies. It's amazing how the market sticks very closely to cycles so this one could be important:

SPX weekly chart, times between price turns

Starting from the low in August 2004, which is the c-wave in the A-B-C move up from October 2002, I show the time (in trading days) between turns. Notice the same 141 trading days for the rallies, except for the one up to from April to July 2005 and that one was a Fib 50%. The pullbacks were 49 and 50 days except the one from February to April 2005 and that one was a Fib 62% of the others. And now we're up to the current rally--141 days falls on February 8th and are usually good for +/- 1 day. That gives us a turn window of today through Friday. Makes one want to go hmmm...

As always I'll try to keep you on the right side of things on the Market Monitor and I'll see you there tomorrow and be back here next Wednesday. Good luck--this could be a fun and profitable time straight ahead.

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