Option Investor
Market Wrap

Mixed Signals

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One look at the few indices and sectors highlighted in the table above and you get the picture. The DOW was down 48 points but the Trannies rallied 32. Techs were up but semis were down. Inflation was higher than expected, meaning interest rates will remain high if not go higher, but techs and small caps rallied (counter to normal behavior). Trading volume was normal/high but up volume and advancing issues were even with down volume and declining issues. That sounds like churning to me and quite possibly evidence of distribution. All in all it was a mixed market and leaves us guessing as to what's next.

I've got a lot I want to try to cover tonight so let's dive right in. I posted some charts in yesterday's Market Wrap for both the OEX and NYSE to show why the current levels for both could mark a significant high for each of them. By significant I mean the end of the 2002-2007 bull market. That's significant because the 4-1/2 year rally, I believe, is just a bear market rally and the next leg down will very likely take out the October 2002 lows.

I had mentioned that the OEX looks ready to outperform the SPX but ran out of time to show some charts to back up that belief. Before showing the comparative charts, understand that the OEX could outperform the SPX in two different ways: one, it could rally stronger; two, it could hold up better while SPX drops faster.

OEX/SPX comparative chart, Weekly

The weekly chart shows the OEX underperforming the SPX since January. If you look at the price charts of each you can see that SPX has rallied stronger than OEX and that's what this comparative chart is showing.

OEX/SPX comparative chart chart, Daily

The daily chart shows the leg down since January. Interestingly, just as OEX has been struggling with the 670 level (as I had pointed out in yesterday's Wrap), there is a 5-wave count for the move down on the daily chart. After a 5-wave move comes a correction and that means the OEX will soon start to outperform the SPX, or SPX will start to under perform the OEX. The two scenarios then are: one, OEX is getting ready to bust through its 670 Fib resistance and accelerate higher, or OEX will roll over from here but SPX will decline faster.

For several reasons I believe in the latter scenario--I think the SPX is getting ready for a swift decline as many of the players who have been hoping for a strong rally into the spring (3rd year of the Presidential cycle and all that) suddenly bail from their positions. In contrast I believe smart money players, the owners of the bigger caps in the OEX, have been quietly distributing their stock to the masses who buy a lot of the smaller stocks seen in the SPX. Therefore there should be less selling pressure in the OEX than SPX.

There are several reasons why I believe in the market-down scenario and why I've been searching for the top. One has to do with put/call ratios. This ratio is typically used as a contrarian signal--when too many are betting on the downside and buying puts, it causes the put/call ratio to increase and very often the market does the opposite since too many were prepared for a move down and then scramble to cover their positions.

But it's been shown that smart money uses OEX puts for hedging and speculation and they're often correct. I came across two charts that were done by Elliott Wave International (EWI) that I wanted to share.

OEX Put/Call ratio, 1999-2001, courtesy Elliott Wave International

The first chart here shows the spikes in the P/C ratio in the period of 1999-2001 and shows quite well how peaks in the 15-day moving average coincided with peaks in the market. That's hardly a good contrarian signal and instead shows smart money was betting on the downside. Now look at the current chart:

OEX Put/Call ratio, 2005-2006, courtesy Elliott Wave International

The recent spike to 1.826 is higher than anything seen since 2000. Somebody is betting big that we're going to see a down period coming up soon. This is not an infallible signal as witnessed last September--the bet that we would have a down October did not pan out and in fact probably helped the rally. The huge spike up in the Fed's money creation in the last half of 2006, as I've shown for the past couple of months, probably had a lot to do with that. I don't think Bernanke will be as successful if he tries to continue that pace in money creation. He already has to deal with some of the problems created with all that excess liquidity.

So here we are with OEX pounding its head against the very important Fib area around 671 and somebody's loading up on OEX puts like we haven't seen since 2000. Which way would you like to bet your money? Go with smart money every time and you'll be right more than you're wrong.

Economic Reports
There were only two reports that had an impact on this morning's market and those were the CPI and leading indicators reports. Both numbers are on the high end and that spooked the markets, including the bond market which sold off on the news (yields shot higher) but then both bounced off their early morning lows. Equities continue to chop around and whipsaw traders out of both sides and it makes the CPI and LEI numbers look like a non-event by the end of the day. In fact, the numbers are not market friendly.

CPI and Core CPI
Core inflation rose +0.3% (+3.6% annualized) in January which was the biggest increase since last June. This removes food and energy from the equation so including those showed CPI up +0.2% thanks primarily to the reduction is energy prices. Food prices were higher (as most of us know). Medical care also had a huge jump--up +0.8% (+9.6% annualized) which is the fastest increase in 16 years. Some feel that January's numbers may be skewed to the high side, and not indicative of a trend, because of the typical price increases at the first of the year.

Estimates for these two were slightly lower at +0.1% for CPI and +0.2% for Core CPI so the higher numbers took the market a bit by surprise, hence the negative reaction initially. That's because the higher inflation numbers (higher than the Fed's annual 1%-2% target rate) puts off any rate decrease from the Fed to no sooner than the fall. The market has not had this priced in. Bernanke said last week, when talking to Congress, that the Fed expects core inflation to drift lower, but he cautioned that if inflation doesn't drift lower then they are prepared to raise rates further (their credibility lies on the line here). Considering the huge increase in the money supply I don't doubt for one minute that that's what's going to happen.

Core CPI chart, courtesy MarketWatch

The chart shows the increases in CPI over the past 2 years. Unless and until that line gets below the bottom of the chart (2%) the Fed will have to back up its words, perhaps sooner rather than later, and raise rates to fight inflation. One can only imagine the hissy fit the market will have if that happens. If a rate increase causes a further slowing in the economy then you can see why we run the risk of stagflation. In that case no amount of money creation will fix the problem. In fact it would only make it worse. Dropping the interest rate over time would be a very slow fix. The Fed could be rapidly running out of bullets.

An obvious negative impact from the higher inflation data is to the consumer. With the CPI up and average working hours down, real (inflation-adjusted) weekly earnings fell 0.3% in January. While the real weekly earnings are up +2.1% over the past year, last month's data shows it may become even more difficult for the consumer to keep up the spending performance we've seen over the past few years. Take away the housing ATM and you can understand why a slowing consumer will cause a slowing economy. With a savings rate worse than any time since the 1932-1933 period it's not hard to imagine the consumer closing is wallet and starting a savings program in earnest.

Leading Indicators
The leading economic indicator (LEI) rose slightly in January, up +0.1% which follows a +0.6% increase in December. So it was a significant slowing but still growing. LEI was down -0.1% in November so other than the little spurt in December (end of year activity?), we seem to be hovering around the zero level. Expectations were for +0.3% so the economy continues to soften a bit more than economists have been expecting. This also had a negative impact on the market this morning (slowing economy and rising inflation--bad combo) but then the market shrugged off this piece of bad news too and particularly in the techs and small caps the bulls pressed on. You know Elmo's song? Yep, lala land.

Economists viewed the report with rose-colored glasses, as they usually do, and said the number points to continued growth in the 2nd quarter. I'm a "glass is half full" kind of guy too but one has to ask the question why is it that economists consistently miss the signals for an approaching (or currently in) recession?

Of the 10 indicators in the LEI, 4 were up, led by money supply (again, I'm shocked--cough) and consumer expectations. There were 6 indicators that were down--factory workweek, building permits, capital-goods orders, the interest-rate spread, vendor performance and consumer-goods orders. I'm not an economist but I would think the 6 that are down are pretty good leading indicators and they're not exactly bullish.

Mortgage Applications
This was not on the list of economic reports due out today but it was another report that is indicative of the housing slump we're facing. Even though mortgage rates have dropped in the past couple of weeks, applications for mortgages fell -4.8% last week, to the lowest level since October. It is the 5th week out of the past 6 weeks to see declining applications. The total number of mortgage applications, which includes refinancing, dropped -5.2% compared to last week but were up +4.1% compared to the same week a year ago.

FOMC Minutes
The minutes that were released this afternoon for the January meeting showed the Fed officials were generally satisfied with both economic growth and the inflation rate but not if the inflation rate continues to hold higher than what they want to see. Their "more favorable outlook" for growth was an improvement over their concern about the "subdued tone" of the economy when they had met previously in December. The bottom line for them though is inflation and if it doesn't continue to tick lower (which it did not by this morning's CPI data) then they will not hesitate to raise interest rates further. They expressed concern that the data showing a drop in energy and rent prices could be temporary.

The market initially reacted negatively to the release of the minutes but then they got happy again and started to buy the dip, especially in the techs and small caps. There's going to be some hurtin' people over there when the music stops.

Now let's get the normally scheduled charts and see what's happened in the past week (or past day for those charts I showed yesterday).

DOW chart, Daily

The little Hanging Man Doji yesterday was followed by a red candle today. Sell signal #1. Price had popped above the top of the ascending wedge and close below it today. Sell signal #2. The big signal, sell signal #3 won't happen until the DOW breaks below 12536. Until that happens there is still the chance that we'll get just a pullback and then another push higher into March. But right now I like the setup for the short side and then we'll let price tell us what's next.

SPX chart, Daily

Yesterday's candlestick was not a good Hanging Man Doji since the body is a little too large but it still fits "close enough". Today's candle is a nice looking Hanging Man Doji except it would have been better for the body to be just a little higher. Again, it could be "close enough". Like the DOW, price popped above the top of the ascending wedge and today closed below it. Oscillators look ready to roll back over. It's possible to count the wave count as complete (although not ideally) and that makes the setup here a good one for the short side. If it turns out not to be THE top then just cover and we'll try it again at the next high, probably in the mid-March turn window.

Speaking of turn windows, I came across some very interesting data that shows time relationships between moves in the market. I haven't had time to draw it out on a chart but basically we have symmetry between the rally from October 2002 to the Feb 2004 high and the rally from October 2005. The first period was 490 days and the same period puts us at February 24th, +/- 4 days. That gives us a turn window (prior to the mid March window) of February 21-28.

Another interesting time relationship exists between the 2000-2002 decline and the 2002-2007 rally--the first period is 5/8 of the second time period. The numbers 5 and 8 are Fib numbers and 5 is 62% of 8. The turn window works out to a slightly wider time frame--from the same February 24th, +/- 4 days, to mid March.

So we're in the turn window now. We've got Fibs, EW count, ascending wedge sell signals, the OEX/SPX comparative charts, candlesticks and this turn window all pointing to a high probability for a market top. It's certainly worth paying attention to, especially if you're long the market.

Nasdaq-100 (NDX) chart, Daily

With the COMP pressing to a new high it seems it's just a matter of time before the NDX follows. But what if it doesn't? That would be bearish non-confirmation and yet another example of the generals (NDX) sending their troops (COMP) out ahead of them to get shot. Follow the generals. The top of the long term parallel channel, just above today's closing price, could act as resistance again. But if the tech buyers keep it up then it's possible we'll see this index press to the top of its ascending wedge, currently near 1875. That would then suggest we could see a pullback followed by more highs into late March/early April. I don't particularly like that scenario but I'll let price lead the way. Because of all the choppy price action over the past few weeks it takes a break below 1763 to indicate the rally is over. A break below 1774 would be the heads up for that to happen.

Nasdaq chart, Daily

The chart of the COMP shows the new high that it has achieved but it has done it with continuing bearish divergences. As we've seen for the other indices that doesn't mean an immediate failure but it does require caution if you're chasing this higher. The last time it pressed up against its Bollinger Band in January, as it's now doing, there was a sharp pullback.

NYSE chart, Daily

Since I showed the NYSE chart last night I thought I'd give it a quick update. It's got another Hanging Man Doji at Fib resistance, this time with a red body. It still needs a down day tomorrow to confirm (I consider today just another Doji day and not confirmation of yesterday's Hanging Man Doji. Oscillators rolling over and all the pieces are in place to call this one THE top.

OEX chart, Daily

Updating OEX's chart from yesterday shows another indecisive candlestick, bordering on another Hanging Man. With all these hangings going on you'd think someone's about to die. The market is certainly refusing to. As with the other indices, this looks like a good potential to call THE top--there are a lot of pieces in place. But if the pullback is a choppy sideways/down affair and finds support at the bottom of its ascending wedge (where its 50-dma is also located), then that will increase the chance for another push marginally higher into March. A break below 660 will set off the sell alarms.

Normally I'd show the semi chart next but it's not even worth posting until something happens. They've been lost in a trading range between $33 and $35.50 since last September. When they break out of this range I'll start showing them again. There is absolutely nothing to trade there so don't waste your time or money. It's dead money.

BIX banking index, Daily chart

The banks are looking bullish--nice rally, back above the mid line of its parallel channel, no bearish divergences and room to grow. What's not to like? Nothing, and this is reason for some caution about the broader market. If the banks are strong then the market may hold up with only a slight pullback and then press higher into March as the banks press to the top of their channel. Then everyone would be in synch for the downside. This chart says do Not get aggressive on the short side with the rest of the market yet.

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

Price continues to chop up and down within its larger bear flag. Word is getting out that the spring time may not be as rosy as many were hoping. As that becomes clearer we'll see it reflected in price. Whether it drops from here or makes a stab higher again is too hard to tell. The wave pattern counts well as a complete double zigzag correction (a-b-c-x-a-b-c) and looks ready for a fall. A drop below 670 is needed to confirm the next leg down is in progress.

Oil chart, March contract, Daily

With oil consolidating near its downtrend line it looks bullish. It's also bullish when you see MACD dropping back toward the zero line while price consolidates. Therefore if I were forced to bet on oil I'd bet the long side. But the longer term pattern has me thinking lower prices for oil (below $50) and therefore I don't like the long side. A break above its last high should be a good buy signal otherwise watch for the head fake move up.

Oil Index chart, Daily

The rollover from the last high in the oil stocks looks corrective enough to suggest it's going to push higher again. Similar to the oil chart, it could literally go either way here and I don't have a high enough confidence in the short term patterns for either one of them to make that call tonight. The wave count for the oil stocks suggests this will continue to drop and based on its pattern the drop should pick up speed if it does.

Transportation Index chart, TRAN, Daily

The Trannies have had a nice run once they broke resistance at the May 2006 high. It's now approaching the top of a parallel up-channel for price action since last August, near 5200. That's an area I'd watch for failure and potential topping in its own rally.

U.S. Dollar chart, Weekly

I show a weekly chart of the US dollar to give some perspective for what it's been doing the past 2 years. The longer term wave pattern suggests the dollar is due another bounce up to match (or probably exceed) the leg up from the low at the end of 2004 to the 2005 high. That leg up I have labeled as wave-(a). The pullback since 2005 looks to be forming a descending wedge, which is typically bullish. In EW patterns these wedges (form of a triangle) are found in 4th wave and b-wave positions so it fits well for wave-(b).

It's possible, assuming we do see the dollar pull back as I've depicted, that the dollar will drop to near the December 2004 low at $80.39. Then we'd be due a strong rally into 2008 and based on (a)-(b)-(c) pattern, that rally will likely head up towards $100. That would be where the 2nd leg up, wave(c), would equal 162% of the 1st leg up, wave-(a), and it would be near the 50% retracement of the 2001-2004 decline. Then the dollar would be ready to roll over to new lows again. Why do we care about the dollar? There are lots of reasons and one is what it will do to gold.

Gold chart, April contract, Daily

Gold had a big rally today and hit a 7-month high Wednesday after this morning's CPI data showed a faster-than-expected rise in inflation in January. Gold is typically used as an inflation hedge. The other shiny metals were up as well--silver rose 44.3 cents to $14.273 an ounce, platinum rose $14.10 to $1,233.20 an ounce and palladium was up $4.40 at $344.15 an ounce. Even copper was up 6.85 cents at $2.6545 a pound.

But gold is nearing what could be tough resistance. The Fib projection for two equal legs up near 692 is right on top of the 62% retracement of last year's May-October decline. It's possible the bounce from October is just a bear flag pattern in which case we'll get another leg down in gold to equal last year's. That would give us a downside target near $500.

Whether gold will press higher if the dollar continues to drop is the big unknown. If inflation fears start to subside but the dollar continues to drop then I could see the two dropping in synch. If the dollar turns around and breaks its downtrend line and gets above $86 then the dollar rally will have already begun and that would support the idea that gold will start its next leg down. It will pay to keep these two in your weekly reviews if you trade either one.

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

There is nothing in tomorrow's economic reports that should be market moving so the market will be left to its own concerns. There are no major reports on Friday either so the rest of the week will be quiet in that respect.

The takeaway from tonight's charts is that we are once again (still) at a point where it's a great setup for the top to be in. While we could get a pullback that leads to another push higher in March, which will become more obvious if the pullback is choppy. Each pullback within the ascending wedges have been corrective which were then followed by minor new highs. THE top will be followed by an impulsive move down (no overlapping highs and lows in each leg down) so we'll need the evidence in the drop to tell us whether or not there's a good chance we're starting something more serious to the downside.

I've identified key levels on the charts to show where we'll have better proof that the bulls are done. But I'm trying to call a top so that you can try to establish some better paying bear call spreads (or sell them even further out of the money), buy some puts (cheaper), protect your long positions (pull up your stops), or whatever else you like to do with a top.

I think tonight is as good a setup as we'll see for a top. Proof now will be in the decline. If the decline in the blue chips continues then the techs and small caps could be trying to swim upstream. If the techs and small caps drag the blue chips higher then I suspect it will continue in a very choppy manner (another indication of topping action) and I would continue to watch it carefully for failure. Once again, hopefully this time next week we'll have confirmation for where this will head next--we'll either be well into a decline or chopping around still. Choppy price action would indicate the turn window in mid March is the more probable time for a top. Good luck in your trading and I'll be back next Wednesday (and on the Market Monitor for those who follow it).

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