Option Investor
Market Wrap

A Little Rest for the Weary

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The dip was bought and what was amazing today were the +/- 100 point swings in the DOW that looked like puny little moves on my 5-min chart. After such a huge sell off on Tuesday today's correction was pretty normal. Bears taking profits on the bounce to take money off the table, bulls selling on the "thank you God" bounces to get out of losing positions with at least a better price. By lunch time the squaring of positions were completed and everyone leaned back and asked themselves "what's next?" Consequently the market moved sideways in an ever-decreasing range. Both sides are now waiting for the other to blink.

Interestingly, after such a rude awakening to the bulls, most of what I heard and read were bullish statements about the market. Between those recommending buying this dip now and the ones saying it's just a needed correction and it will be time to buy again soon makes me wonder what it will take to dissuade bulls of the idea of buying the dip. That of course will come with time. If we've started the next bear market leg down, which I believe we have, then it will take many dip-buying sessions that turn bad before the bullish analysts start to wonder if we have a trend change. By that time the new down trend will have been firmly in place for some time.

I've updated the "roadmaps" for the major indices to show how I think the first half of this year will play out. If you like to play the short side of the market you should have some fun. If you're a long-only (or flat) player then there will be opportunities for some good plays this year but they'll be tougher to catch and play.

Economic reports
Before getting to the charts we'll review today's economic reports. There was some reaction to the reports out this morning but mostly the market was simply adjusting to yesterday's bashing.

The 4th quarter got a significant downward revision from +3.5% reported last month, to +2.2% reported today. That makes 3 months in a row with growth less than 3%. Consumer spending was yet again the savior, up +4.2%. It accounted for 2.9% toward the growth number. But slower investments in homes, businesses and inventories pulled GDP lower than previously reported. Positive spinmeisters said the lower number is good for our future since lower inventory builds means better numbers ahead.

Also, economic growth below a healthy 3% means less pressure on capacity constraints and therefore less inflationary pressures. It seems the interest in getting data that supports a Fed lowering interest rates is more important than a slowing economy. A slowing economy, and therefore slowing profit growth, is not market friendly. This point seems to be overlooked by most market analysts.

Chicago PMI
At 47.9 the Chicago PMI number came in under 50 and indicates contraction in the manufacturing sector. Normally this is another indication of a slowing economy and should have the markets reacting negatively to it. But after yesterday's strong sell off most of the short term selling has abated for now and many feel that our service-oriented economy now means we don't have to worry about the impact from the manufacturing sector. This PMI number is the 2nd month below 50 (it was 48.8 in January) so now we've got the start of a trend.

New orders index was up slightly to 48.7 from 46.3 in January. The production index fell slightly to 51.2 from 53.2 and prices paid index had a big jump from 54.9 to 63.2. A slowing sector with rising prices is not a good combination and will be worrisome to the Fed if it starts to reinforce the idea that we could be struggling with the beginning of stagflation.

This number is usually a good predictor of what the national ISM index will be and that will be reported Thursday morning. If that number comes in under 50 then it could depress the market in the early going.


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New Home Sales
This was another number that should have depressed the market but was essentially glossed over. Sales of new homes dropped -16.6% in January to an annual rate of 937K and was a much sharper drop than had been expected, with most expecting sales to be only down -3.6%. This is a very common theme now--economists are consistently missing how quickly things are slowing down. This was the lowest sales number in 4 years and the biggest percentage decline in 13 years. These are significant drops and yet no one is talking about it much. I stress some issues below when I show the homebuilders index. We're entering some scary times.

Sales were down -20.6% in a year-over-year comparison to January 2006. The West did even worse--down -50% year-over-year, the worst since 1981 (the end of the bear market in the stock market and here we are at the peak of the stock market). The median sales price was down -2.1% year-over-year at $239,800. Inventories increased and now stand at a 6.8-month supply, the highest since 7.2 months in October. Completed but unsold homes are up 47% year-over-year.

Because sales are reported when a contract is signed and not at the closing, the sales numbers are consistently too high. Therefore, as bad as today's number was, it's actually worse. The home builders have consistently been telling us that cancellation rates have been increasing, even as high as 40% or more. The government's numbers do not include any of this. Further hiding the problem are the sales prices being reported--home builders are throwing in huge incentives such as vacations and cars in order to close deals and these are not being subtracted from sales prices. Where we find out about it of course are in the earnings of the home builders which have dropped drastically.

Crude Inventories
Distillate inventories fell for the 5th week, down 3.8M barrels to 124.5M. Gasoline stocks were down for the 3rd week, down 1.9M barrels to 220.2M. But crude supplies rose by 1.4M barrels to 329M.

Last week I showed a chart that was done by Elliott Wave International that pointed out peaks on the OEX Put/Call ratio and how they coincided strongly with market tops. The thinking here is that the smart money gets ready for a market drop by buying up a large number of puts and then let the market drop. You can see the two charts I included in last week's report if you need to refresh your memory. Since my report on this last Wednesday there was another, higher, peak in the OEX P/C ratio at the end of the week--the ratio hit an all-time record at 1.910, higher than the previous record of 1.899 in May 1999. And then on Tuesday we had the big crash. I think the Boyz knew what was coming, and you can bet they profited handsomely on those puts.

Reports by CNBC of a huge number of puts sold yesterday have me responding "well, duh, I would've sold them too!" It's not easy to determine if buying or selling options is an opening or closing trade but a quick perusal of the option chain on QCharts shows volume spiked up last Thursday and Friday on the OEX March 645 puts, trading around $1. Those same puts had huge volume on Tuesday and were trading as high as $16, closing at $13.20. Ka-ching. I'm sure there were more than a few selling them as naked puts or part of a bull put spread as well--play the bounce and cover. Those March 645 puts traded near $6 today. Sell them for $14 and cover at $7, double your money and call it a day. That's how the big boyz play.

Today's consolidation is very difficult to see on the daily charts, especially after yesterday's big red one. Additional price action will be needed to help determine whether the bounce will get bigger from here or after a new low first. Let's see what the charts are telling us.

DOW chart, Daily

After watching the ascending wedge take forever and a day, with the bearish divergences becoming laughingly long, the break was dramatic. This is what happens when people think the market is going to rally forever. Picking a top was an exercise in frustration but it was clearly coming. All that effort to push the market up over a 3-month period, wiped out in a day. That was faster than even I thought possible and I've been expecting a fast drop.

Now we've got the top of the old parallel up-channel from January 2004 supporting the DOW. The "small" consolidation that we got today will either break shortly, in which case we should see better support around 12K, or the bounce will get bigger and could even make it back up to the 12500 area by mid March (there's a turn window on March 9th).

It will be the bigger bounce that will make an outstanding shorting opportunity since the next leg down should dwarf yesterday's (just not in one day, or at least I don't think anyway).

DOW chart, Daily, Elliott Wave projection

Last week's roadmap for the DOW showed a bullish and bearish EW count and I was waiting for price to tell me which would jump into preferred status. A break below the January 26 low confirmed that we're now into the bearish wave count. The green dot at 12600 signifies the key make or break level--any rally back above that would negate the bearish pattern but until and unless that happens I'll keep just the bearish wave count on here until this moves further along at which time I'll add the bullish potential (it might be in the form of a different kind of bounce).

As I mentioned above, today's consolidation is either a small 4th wave in the move down from last week's high, meaning we've got another minor low right in front of us, or the 1st wave down completed yesterday and we've just started the 2nd wave bounce. Any rally above today's high would suggest we've already started wave-2. Otherwise I'm looking for another poke lower to the 12K area. Then we should get a bigger bounce into March.

Those who are looking at this decline as a buying opportunity will be rewarded with the rally into March. What they don't realize is that it will be a bear trap (as 2nd wave bounces are). They get people excited thinking the correction is over and start buying big, margin and all. The wave-3 kicks into gear and the scrambling for the exit doors is a sight to behold. Just don't be one of them trapped like that. As wave-2 develops I'll offer some price levels and time frames to be looking to get short.

SPX chart, Daily

SPX looks like the DOW except perhaps a little weaker in that it broke back below the top of its parallel channel from January 2004. The same discussion for the DOW holds true here--today's bounce is either going to lead to a minor new low (and scalpers can try to buy it) or the bounce will get larger and we would very likely see the 50-dma at 1431 tested (a good shorting opportunity there). A rally back above 1450 would say the bulls are back in control.

SPX chart, Daily, Elliott Wave projection

Again, similar to the DOW I've moved to the bearish wave count until I see a reason not to use it. I'll add bullish alternatives when the time is right. This depicts the need for another minor new low (1380 target area) before a larger bounce into March. That wave-2 bounce will be the one to get short. If you're more comfortable watching a decline unfold and perhaps paper trade it (since bear markets are actually more difficult to trade because of the in-your-face short covering rallies), let this larger degree wave-(1) play out and then, as noted on the chart, the end of the wave-(2) bounce will be the MoAP opportunity.

For long time readers of this newsletter you'll remember that "MoAP" phrase used by Buzz when he and Austin were writing. He liked to refer to the "mother of all puts" when looking for a nice setup. That wave-(2) bounce in a few months would be one of those rare instances where you'll want to mortgage your house and get short. Just kidding of course, because your house won't be worth anything (wink).

One might ask "how could we have known this drop was coming?" While the severity of the drop was somewhat surprising, we had plenty of warning of its arrival. And actually, considering how complacent the market had become, the severity of the 1-day decline is not at all surprising. There will be more "surprises" like that this year.

Another heads up for what happened was from our mother. No, not your mother but from Mother Merrill. I've mentioned numerous times that you should keep an eye on MER (and the brokerage index, XBD) because that stock does a good job at pointing to the market's direction, even on an intraday basis. Here's an update to the chart I showed recently.

Merrill Lynch (MER) chart, Daily

The same pattern from last April/May is playing out again (although this drop is a little more severe than what we saw last May). Right after MER's earnings report in April it started dropping, a couple weeks ahead of the peak in the DOW and SPX. MER dropped 20% into June while SPX gave up 8%. After MER's earnings report in January it has been selling off ever since, this time more than a few weeks ahead of the broader market. It was again our canary and when it fell off its perch at $91 last Friday (just when someone was doing some heavy buying of OEX put options), that was fair warning for the market. It didn't need China, durable goods reports or anything else. The sell off was coming and we were clearly warned.

MER was down 20% at yesterday's low. Does that mean the pullback is over for MER? Nope, it's just begun. Currently it's finding some support at its 200-dma so a bounce would certainly be expected. It should consolidate at/above this moving average and then break below it. When it does that, think about another warning and use it to your advantage this time.

There was another chart I showed you last week that was our heads up that something untoward could happen to the bulls. It was a great setup for the short side. This chart of the NYSE is so pretty I'm keeping it for posterity--if ever the EW pattern and Fibs were screaming "TOP!" at us, this one was it. This was a pound-the-table short setup and it followed through perfectly. China and durable goods orders were just the excuse du jour (since we need excuses to explain everything). We're at the cusp of a major social mood shift and it's showing on this chart:

NYSE chart, Daily

I had pointed out last week the significance of the 9455 area for the NYSE. Long term and shorter term Fib projections were pointing to this level and when I see that I take notice. At the same time, like the rest of the market, the bearish divergences were telling us the rally was clearly running out of steam. The move up from January was a 5-wave move and therefore the rally could be called complete at that point. Everything came together and it's why I was pounding the table last week that we're at a market high.

Now we've got a break of both the 50-dma and uptrend line from July. From a bearish perspective what's not to like about this chart? Now if we get a restest of the uptrend line or 50-dma you'll want to try the short side there. The next leg down from that test should be a doozy. A rally above 9400 would have me saying "never mind" but until then I'd be thinking short the rallies.

I also wanted to update the chart of the OEX from last week since it too was singing at the top of the mountain.

OEX chart, Daily

I had pointed out the very strong Fib cluster around 671 and said this is a wall that I highly doubted the OEX will be able to get through, at least not without a pullback first in order to gain some strength (weed out the weak holders and flush out some shorts). The bearish divergences as the OEX struggled at this level was another pound-the-table short setup.

Nasdaq (COMP) chart, Daily

The very sloppy rally over the past 3 months was also wiped out in a day for the techs. The break below 2450 was a significant break and any retest of that area should be a good setup for a short play. A rally above 2500 would say this was one of the best head fakes by the bulls that I've ever seen.

Nasdaq-100 (NDX) chart, Daily

Using a similar projection as I did for the DOW and SPX, this chart shows how a decline the first half of this year could unfold. While the decline could always take longer, say into October instead of May, it would be typical for the decline to occur faster than the previous rally. In this case that means we should come down faster to break below July's low than it took for the rally from July. And that time period includes the big bounce I show for wave-2 into late May/early June.

These depictions of a decline are obviously conjecture on my part but they're based on Fib time and price ratios, prior price levels and trend lines. For this reason they should be reasonable and hopefully they'll help you in your own money management and trade planning.

Through all the excitement in the market over the past week the semis are still stuck in the same range they've been in since September. Next!

I'll start regularly posting the RUT chart since I know many of you are using this index for your spread positions.

Russell-2000 (RUT), Daily chart

The RUT has also broken its 50-dma and uptrend line from August. Its short term pattern supports the idea we'll see a minor new low before it sets up a bigger bounce, in which case I'd look for the 770-780 area for support. From either here, or from slightly lower, the next larger bounce (wave-(ii) on the chart) should give us a retest of its broken uptrend line or 50-dma. That should be a great place to buy some puts and/or sell some bear call spreads on this index. Notice too that the wave-(ii) bounce will create a right should for a H&S pattern with a downside projection out of it near 730 which just so happens to be near its uptrend line from August 2004 by the time it gets there in April. Amazing how that happens.

BIX banking index, Daily chart

The banks were looking good last week and I thought they had a chance to push a little higher after a pullback. Well, that pullback led to a rout instead--breaking its 50-dma and uptrend line October 2005 in one fell swoop. The 200-dma at 390 makes for a perfect downside target if the market gets another small push lower before setting up a larger bounce into March.

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

The housing index landed into the arms of the 200-dma and uptrend line from July. Unless the market's decline is one big head fake to the downside this index should consolidate here for a bit and then proceed lower. A small bounce here followed by a new low would make it a 5-wave decline from its February high and the combination of that impulsive move and the break of support would be confirmation that the bear flag is complete and this index will head to much lower lows from here.

The bounce in housing over the past 7 months has been a result of bottom fishers. So many have wanted to believe that the housing market has bottomed that they kept insisting every small morsel of good news was a sign of the bottom. Even our own Fed has bought into the notion that housing is not in trouble, that it won't spill over into the rest of the economy and that the troubles in the subprime mortgage area are isolated to those banks. And these people control the country's money!

I've spilled so much ink on this subject that I know I've annoyed just a few readers with my bearishness on this subject. But unless we recognize the reality of what is about to hit us you won't be able to properly prepare for the downturn. The housing market became a bubble and bubbles don't land softly and they don't finish correcting in a short period of time. Here's an interesting chart that was done by Elliott Wave International:

Homebuilding Index and Copper, Weekly chart, courtesy Elliott Wave Intl

The purpose of the chart done by EWI was to show the timing of news stories in major publications and how they typically identify the end of a move. It also shows what happens after a bubble is created. Now look at the chart of the China stock market, again right at the time a major news story touts the strength of the Chinese market:

China Stock Market, Daily chart, courtesy Elliott Wave Intl.

The 9% beating that this market took on Monday is just the start of a major correction in that market. It's possible that it could consolidate and push marginally higher again but this week's drop was the warning shot for their investors. The people there are buying Chinese stocks as we were buying tech stocks in 1999-2000--throw a dart and where it lands, buy it.

Very briefly though I wanted to discuss some of the difficulties that will be faced by homeowners. After the huge run up in home prices I was astounded to learn that the average homeowner has less equity in their homes than before the run up started. I knew people were pulling out money in home equity loans but I had no idea is was that extreme. Homeowners have spent the entire run up, and then some. I assumed that people were sitting on huge asset value and that it will help many enjoy retirement when they sell and scale down their house. But in fact people have less equity than before the run up started. Amazing, and scary.

This is a scary statistic because Americans are also in debt up to their eyeballs. We have spent ourselves into massive debt, with record low savings, with the assumption that it will be better tomorrow. We have no rainy day funds. This chart shows household cash less liabilities:

Household Cash less Liabilities, in $billions

This chart doesn't need much in the way of explanations. We, like our government, have spent ourselves into trouble. Should the economy fall on hard times, which I think it will, people will not have savings to fall back on. Job losses will force home sales and we're in a market that can't afford to take any more homes on the market.

The significant changes to lending practices will squeeze out a larger number of buyers. Even those with good paying jobs, dual income, etc. will not qualify soon for expensive homes (average price homes in many areas). This will result in only one thing--drastically reduced housing prices. It's coming, you can count on it. How the Fed doesn't see this coming is simply mind boggling.

This is a chart of cash as a percent of household assets:

Cash as Percent of Household Assets

Once again, it's just a vivid picture of how low the availability of liquid assets are to us. We have our money in stocks and housing. If both take a tumble, and that's what's setting up, we are going to have a record number of people who will have to sell something in order to generate cash. The selling pressure from this is not something you're reading much about in the financial press. Why not?

The downward pressure on prices if our economy/housing fall on hard times, with the stock market and home prices in a downward trajectory, it could become a difficult downward spiral to stop. But in lala land no one wants to even consider this possibility. This is the epitome of complacency.

Bernanke testified in front of the House Budget Committee, saying essentially the same thing as he said last month to the Senate Budget Committee. He said worries about the subprime mortgage market was one factor in the unease in financial markets, but said he did not think the trouble in the sector was having a significant impact on the U.S. economy.

To which I ask "how could it not have a negative impact?" Ready access to credit is the lifeblood of the bull market and the subprime issues (dismissed by most, not surprisingly) are putting a halt to lending as we've seen it for the past few years. Lenders have been disregarding creditworthiness and making loans to people who could fog a mirrow. Even some pets were getting loans. That will stop in a hurry with the clamp down on these kinds of loans and Freddie Mac started that process with their announcement yesterday. This will result in a plunge in personal spending at a time when most believe the consumer to be invincible.

Oil chart, January contract, Daily

Oil broke above its downtrend line from August which should have resulted in a stronger rally than what I'm seeing so far. Perhaps it's been due to a stock market sell off that started last week and bulls will start to feel braver about oil once the stock market recovers some. Otherwise if oil tips back over here it will leave a bearish divergence at the new high. I continue to believe oil will head back down soon and break below $50 but I have no idea if it will rally some more, perhaps to the $65 area before it does. It's a tough short term call right here.

Oil Index chart, Daily

The oil stocks got hit with the sell off in the broader market but so far it doesn't look particularly bearish. In fact the choppy consolidation looks bullish. If it continues to hold above the 200-dma, where it found support yesterday, I'd favor the long side. Any break below 616 that stays there should see a test of 600 fairly quickly.

Transportation Index chart, TRAN, Daily

Another bearish set up last week--the push to the top of its parallel up-channel after a 5-wave move up from December was a good time to pull stops up on long plays and start thinking about shorting the Trannies. So far though it has the potential to get turned back up by its 50-dma. Not much lower is the uptrend line from September and then the 200-dma so the bears have their work cut out for them in this index.

U.S. Dollar chart, Daily

Last week I showed a weekly chart of the US dollar to give some perspective for what I think is playing out--a descending wedge that started from the high in November 2005. If this is the correct pattern then we should see the dollar work its way lower into the summer and from there it will start a multi-year rally up to around $100. In the meantime I'm looking for it to drop down to $80-81.

The problem I'm having with this intermediate term bearish view on the dollar is that I see gold having peaked. A declining dollar along with a gold decline doesn't fit its normal pattern. Therefore if the dollar rallies back above $85 then there's a real good chance the dollar is already in its rally up towards $100.

Gold chart, February contract, Daily

It seems so many symbols were setting up for a short play at the same time. Last week I had pointed out the Fibs and top of its parallel up-channel all coinciding just above 692. The two Fibs were 692.40 and 692.70 and gold's high was 692.50. Can't get much better than that. The larger pattern calls for a strong decline from here, at least down to the $500 area and potentially lower. If you like and own the shiny metal you might want to hedge your position to give yourself some protection. You do it for your house, car, health and other areas. But few think about insurance against your portfolio. It should be a standard part of your asset management.

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

Tomorrow will be a little busy with economic reports and considering the frailty of the market right now there's no telling what could spook some traders. Other than unemployment claims, each of the reports could get traders guessing how the Fed might react to them. With the Fed funds futures suddenly pricing in a better possibility for a rate decrease mid year, these reports could move the bond market which could in turn move the stock market.

SPX chart, Weekly, More Immediately Bearish

It's only one weekly red candle but it's a big one. It didn't make a new high this week so it can't really be called a bearish engulfing candle but it sure looks like it from here. In fact it's engulfing about 8 weeks.

I came across a couple of interesting statistics that I thought would be worth passing along:

History shows that after 4 years of a bull market that came out of a deeply oversold market, the next move was often very painful: 1932-36 (1937 crash); 1957-61 (1962 crash); and 1982-86 (1987 crash). We're well into four years in the current bull market that also came out of a deeply oversold market.

Over the last century every decade has seen a market crash/deep correction in the 6th or 7th year of that decade. We didn't get any kind of crash in 2006 so we're on borrowed time. Combine this with the above pattern following a 4-year bull market and the odds of a serious "correction" are quite high.

We've got chart patterns and history on the side of the bears this year and it could be very painful for those who refuse to protect themselves, convinced the bull market will continue to rally strongly this year. After all, we had an up January, it's the 3rd year of the presidential cycle, and well, we just deserve it. How else am I going to be able to buy my second BMW and vacation in Europe for two weeks?

If I'm wrong about all this I'll eat crow. If you're wrong and long without protection that crow could be a considered a delicacy.

Play the rest of this week carefully--corrections could be big swings and difficult to trade. If you're looking for a swing trade to the long side keep an eye on the support levels I outlined above. If you're looking for a good short entry I'd wait for another couple of weeks for the short entry that I also outlined above. In the meantime I'll keep updating that setup. Understand that we should get a bounce into March opex but I don't see it threatening recent highs so hopefully those of you in spread positions above and below recent market action (with perhaps a little lower to go), you should be OK. Good luck and stay aware--things could change very quickly now. I'll see you here next week and on the Market Monitor tomorrow.

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