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Market Wrap

Perished Feline Spring-Back

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After yesterday's strong rebound off the low on Monday many were hoping it was more than just a dead cat bounce. Most breadth indicators were as oversold as they've ever been and they were hitting numbers not usually seen except at capitulation lows following oversold conditions. And therein lies the problem for the bulls. With hard selling at the beginning of the move down, what must that portend for the end of the move?

So, based on the strong breadth numbers during yesterday's rally (also an extreme not normally seen except at the final flameout after a long rally) many were proclaiming that the strong breadth was a sure sign that Monday's low was the capitulation low and was a good time to buy. At the same time many were muttering under their breath "I hope this doesn't turn out to be a dead cat bounce." After today's feeble attempt to continue the rally there are likely many more picking up the poor dead cat and dropping it again to see what happens.

I of course have my opinions about what is happening, which I'll cover thoroughly with the charts, but in a nutshell I believe the bounce is of the belly up feline variety. There are several cycle studies, Fib time projections, along with myriad support levels broken that all suggest we've seen the top of the rally. And I mean THE top. We should be starting the painful process or removing the waste from the system.

I want to cover a lot with the charts so I'll try to be brief with all else. I think we're at a critical time with the market and I want to be sure I take the time to fully explain why I think we're headed down and headed down fast from here. But first let's discuss today's economic reports, of which there were few.

Economic reports
There were only 3 reports scheduled today--Crude Inventories, Fed's Beige Book and Consumer Credit. There was also a report out from ADP on employment numbers. This ADP report is beginning to take on more meaning (as in trusted more than the government report), especially as it tweaks its program and increases their sampling size.

Crude Inventories
Crude supplies were down 4.8M barrels to 324.2M, the first drop in 3 weeks. Distillate supplies were down for the 6th week to 123.2M barrels, down 1.3M. Gasoline stocks were also down for a 4th week, -3.8M barrels to 216.4M. All of these traded higher in price today.

Fed's Beige Book
This report showed the economy is growing at a modest pace but the Federal Reserve reports some slowing in about a third of the country. Specifically, NY, St. Louis, Boston and Dallas reported slowing while the others reported "modest expansion in economic activity". The Philly region showed some improvement. But the housing market remained weak although the Fed reported "signs of stabilization" in some areas. We're left to wonder what exactly does "stabilization" mean --getting ready to rebound? quiet before the storm (think eye of the hurricane)? I have my opinions on the housing market and they're all bearish.

As for the rest of the report, in short, manufacturing activity was "steady or expanding", retail sales were "growing steadily", auto sales were "sluggish", inflation was "little changed" and pay increases were "moderate." The market barely blipped on the release of the report.


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Consumer Credit
The mighty consumer is starting to push away from the table. Maybe that's because the consumer's belly has grown so large that it can no longer reach the table. Consumer credit card debt increased by just +1.1% annualized, the lowest amount since a year ago. Total outstanding debt rose $6.4B, +3.2% annualized, primarily from nonrevolving debt such as auto loans.

ADP Index
Private-sector employment grew by 57K while government employment is expected to grow about 20K. The nonfarm payrolls number to be reported Friday morning is expected to be 100K but that might be a little high if ADP is closer to the real number. The ADP numbers showed job growth to be about a third of the average 167K between October and December. Goods-producing businesses cut 43K jobs which included 29K from manufacturing. This was the largest loss of jobs since September. Job losses, a slowing housing market and rising mortgage payments is not a good combination. There will be negative consequences from all this. Services-producing businesses (typically lower paying jobs) created 100K in February which sounds like a lot but it's the weakest growth since last April. The last 3 months averaged 171K.

So much for the state of the economy. Let's see what the state of the stock market is.

DOW chart, Daily

After the sharp decline off the February high, which came just shy of a 38% retracement of the July-February rally, it looks like we're in the middle of a correction to the decline. Many on Wall Street are harping about what a great buying opportunity this is, and by Friday they'll probably be screaming from the roof tops that you're crazy if you don't buy this market. Ignore that siren call. Lash yourself to the mast and look away.

Once this correction is finished you'll want to be short for the next leg down. If the DOW were to rally above 12500 I'd become concerned if you're in a short play. Above 12635 would be greater than a 78.6% retracement, the line in the sand for retracements, and would be a good indication that it will continue (higher in this case). Using a 60-min chart I show how I think price will play out this week into next.

DOW chart, 60-min

I'm showing the high today completed wave-a of an expected a-b-c rally into the end of the week. It's possible that today's high completed the correction (out of a slightly different wave count for the bounce) and that means we should start to sell off hard tomorrow. A break below 12090 (78.6% retracement of the current rally leg) would suggest that more bearish scenario is happening. Until that happens I think we'll get a pullback, in wave-b, into mid day tomorrow to perhaps the 12150 area. From there we should then get another rally leg in wave-c. That should take us into the end of the day Friday or early Monday.

From a database of EW moves in thousands of stocks over many years I know that a typical retracement for a 2nd wave correction is 43%, so I added that on the chart (12368). If the DOW pulls back to 12150 and then proceeds higher, two equal legs up on the bounce (wave-c typically equals wave-a in time and price) would be at 12355 so just playing with these Fibs shows some good correlation for the projection. Notice too that that kind of move up would run into the downtrend line off the February highs. If price sets up as depicted here you'll want to back up the truck and load up on puts and short positions. This would be one of those MoAP (mother of all puts) opportunities.

DOW chart, Weekly

I wanted to show the relationship of turn dates for the DOW to time projections since the October 2002 low. Sorry for the crammed appearance of this chart but I wanted to show price action since the 2000 high. Drawing a Fib time projection based off the 2000-2002 decline shows where those projections fall. It's nearly impossible to read the Fibs at the bottom of the screen but they're your typical 38%, 50%, 68%, 100%, 138%, 168% and a couple of other lesser known ones in the middle.

I highlighted the turning points that matched up with the Fib time projections and almost without fail the DOW has made a turn at each one of these Fib time projections. The next one, 168% of the time it took for the 2000-2002 decline, falls on March 9th, this Friday. There's also an important Bradley turn date on March 10th. That makes this Friday/Monday a potentially important turn window.

One might say we already had our turn at the February high (which itself was around an important cycle date of February 27th) but very often it's the first correction to the turn that marks the turn date. Since I'm expecting a 2nd wave correction this week to correct the recent decline, the top of that correction looks like it will fall inside this Fib 168% turn window. This very long term chart is being supported by the short term charts that say we should be looking for a short play to set up by Friday/Monday.

DOW chart, Weekly (zoomed in a little closer)

This is the same chart as above but expanded slightly to better show the hits on the Fib turn dates. I have a hard time believing the DOW will not again turn on its next date of March 9th, +/- a day or two. If we're rallying into that date, which I believe we will be, then the turn should be back down. I only put in the price projection for the next move down in April, bounce into May and then hard down into October but notice how it would create a very bearish H&S pattern. Until I see a reason to change my opinion, this is how I expect price to play out this year.

SPX chart, Daily

I'm showing the same thing for SPX that I did for the DOW so I don't need to repeat myself here. After the current bounce completes (wave-2 on the chart) we should get a hard sell off in wave-3 which projects down to 1300 by end of this month. It would find support there at the uptrend line from August 2004. If this happens as projected then you can be sure there would be fewer people calling this a buying opportunity.

Using the Fib time cycle tool I'm showing the projection from the end of wave-(1) down near 1228 at the end of April. The "normal" retracement for a 2nd wave correction is a little less than 50% in price in about 62% of the time it took for wave-1. It makes it a bit messy to show on the chart but what I wanted to show is that I'm not haphazardly putting lines on the chart to show potential price action. They're based on the Fibs and the relationships between the waves.

I know many of you will scoff at these charts and call me a loony and I will admit I also am having a hard time believing a hard sell off is coming. The market has seemed too bullish for this to happen. And of course that's exactly why it could happen--too many believe it can't. For a longer term view of things see my OEX charts below.

SPX chart, 60-min

This week's price action, again if it will be the same pattern as for the DOW, calls for a dip tomorrow that will be good to buy if it holds above 1390 since we should see a run up to around 1415-1417 by Friday/Monday. Then back up the Allied Van truck and load 'er up with short positions. Opex week is looking ugly if it sets up this way.

I know many of you trade OEX options, particularly the spread trades that Mike Parnos does every month. I'm going to copy one of today's post on OEX where I was answering a reader's question about how I might play OEX.

I thought I'd show two charts to help you identify key levels for your trades. Even though volatility is picking up some, and eventually trading OEX options on a short term basis might work again (the slippage can kill you), I think it's best to use OEX options for position plays. If you want to trade directionally, such as long calls or puts, buy a lot more time than you think you'll need. Don't get trapped into being right about direction but wrong on the time factor and watch your premium decay to nothing.

The best plays in a low volatility market have been selling spreads such as the ones Mike Parnos does every month. But that environment is about to change and you'll need to be a lot more careful about selling spreads than you're probably used to. The higher volatility will mean much bigger moves against your position. You'll need to sell further OTM (out of the money) and still you'll have some gut-wrenching days as you see the market head right for you.

Selling bull put spreads could be particularly dangerous, and painful. The kind of downside move I see coming means you won't be able to sell far enough OTM to be safe. I do not recommend any bull put spreads at this time, period. Maybe in April but not now. If you're currently in any I would exit them on this week's bounce. If I'm wrong on this you will have lost some profit (maybe) or taken a small loss. If I'm right and you do not exit, you will feel some significant pain in a couple of weeks.

OEX chart, Weekly

And that's my public service announcement for the day. Now to the chart. OEX is nailing its Fib levels and this is very encouraging as we go forward. Its rally failed at the 62% retracement of the 2000-2002 decline (671) and it bounced this week off its 38% retracement of the July-February rally (just under 630), shown on the daily chart below. I see the potential to drop next to its 62% retracement of the rally (604), bounce and then continue down to about 586 as we head into April. That's shown in the above chart with that first leg down.

From there a bounce into May and then it'll get hammered down into the summer. We should find a firm bottom for the start of a big correction in October that runs into the end of the year. As always, these projections are only conjecture that's based on "normal" wave movements and I'm using the most common Fib retracements and time/price projections. This projection will clearly change as it unfolds and I'll use the short term patterns to keep it current but I'm hoping this will help you establish some initial trading plans.

OEX chart, Daily

The daily chart breaks apart that first leg down to about 586. We should be getting ready for a 3rd wave down in that first leg (larger degree 1st wave). This is why I think we're about to set up for a very nice short play. As for risk management if you enter some bearish plays this week or on Monday, any rally above 662, a 78.6% retracement of the decline, would tell me we're very likely going to continue rallying to new highs. That's not as helpful as I'd like (in trying to keep stops closer) but it's unfortunately the risk we have since a wave-2 bounce could go that high and not negate the probability that we've got wave-3 down next. If you want to sell some bear call spreads, sell them above 660.

Nasdaq chart, Weekly

As a gentle reminder for those who think the past 4 years has been a stellar bull market run, I think holders of the tech stocks from 2000 might disagree. The 100%+ bounce off the bottom doesn't mean much when it's from such a low level. The COMP hasn't even been able to retrace 38% of its loss and I seriously doubt it will. On this weekly chart the October 2002 low is wave-A, the February high is wave-B and now we've got wave-C to new lows ahead of us. Welcome to a real bear market.

Nasdaq-100 (NDX) chart, Daily

Different index, same picture as for the DOW and SPX. The price depiction shows downside potential by the end of the month to around 1540 area. Oversold would obviously get a lot more oversold with this kind of move. And that means ignore those kinds of technical tools during this decline. They will become meaningless.

Russell-2000 (RUT), Daily chart

The RUT also has the same pattern as the others. They all might have topped at slightly different times and dates but they all look to be in synch now and that adds to the bearishness of what is happening. A move down to 700 by the end of the month is a possibility, certainly down to the bottom of its parallel up-channel from August 2004, currently near 720. For those who might be in some bull put spreads on the RUT, this chart is showing you the downside potential.

Russell-2000 (RUT), 60-min chart

This week's price action also looks the same as the others. Preferably we'll see a pullback tomorrow followed by another rally leg to complete an a-b-c bounce off Monday afternoon's low. Note that a 43% retracement (most typical for a wave-2 bounce in a declining market) would take it right up to a gap closure (790.60) from February 28th

BIX banking index, Daily chart

The banks are getting hit hard. It's not just the subprime banks who are feeling the pain. It's spreading to the much larger banks as well. As with the broader averages I expect to see the banks get a little more bounce into the end of week before tipping back over in a nose dive. Currently the banks are finding support at the 200-dma. Closing above it will be accompanied with a sigh of relief by many. Once that breaks again (assuming is will), sell signals will be going off on every computer in every mutual fund.

The subprime lenders are taking the heat (as they should) for shoddy lending practices. But this was approved of, condoned and fully supported all the way up the chain, including the Fed. All of the liquidity sloshing around the monetary system needed a home and the subprime lenders were doing the job. The stink from this group will quickly poison the whole banking system.

Looking at the data for insider selling in the subprime mortgage companies sheds an interesting light on what's been happening. You can't find any significant purchases anywhere. While there hasn't been a lot of selling recently, nobody's buying. But the amount of selling in the past year is staggering. Countrywide Financial Corp.'s (CFC) CEO Angelo Mozilo has sent his CFO out to try to convince investors that the company is on sound footing. In the meantime Mozilo has sold $140M of his personal holdings in the company over the past 14 months. All told, CFC insiders have sold more than $600M while buying just $73K. Do you think they could see what was coming?

I've read about how much money people in the subprime lending business have made in the past couple of years (sounds like the money made during the dot.com era) and it's clearly one of the effects of too much liquidity being pumped into the economy (thank you Mr. Fed). The executives in these subprime lenders knew the writing was on the wall in this business. And yet most analysts were willing to look past the dangers of the very foolish lending practices in the mortgage arena. It was different this time was the thinking. When will we learn...

Some of these subprime lenders are currently trading for less than 2x earnings and many traders will be tempted to bottom fish. Do so at your own peril. Personally I'd short every bounce in those companies since most won't be in existence a year from now. If the insiders aren't buying, you shouldn't either. For a running tally on subprime failures you can go to www.lenderimplode.com. It's currently up to 33 and seems to tick higher on a daily basis.

The question on everyone's mind is what effect this subprime business will have on the broader market, particularly the larger banks. If you've read anything about this business you know many of the subprime loans were backed by the bigger banks. These bigger banks would then repackage the subprime loans with other loans and sell them as bonds to the public. For this reason you'll hear of the bigger banks being called "warehouse" banks--they warehoused the subprime loans until they packaged them up, put a pretty little bow on them and called them good investments.

Those "good" investments are now coming back to haunt the bigger banks. Freddie Mac just came out and said they will no longer be buying those loans. Almost all major banks now are balking at buying those loans. Major investment houses, especially overseas, are starting to ask questions about the bonds they bought and will start insisting the banks take them back. The first step by the warehouse banks, which include the likes of Lehman Bros. (LEH), Goldman Sachs (GS) and Merrill Lynch (MER), was to demand that the subprime lenders buy those miserable loans back. The homeowner default rate started to scare the warehouse banks and they wanted them off their books. The subprime lenders didn't have the capital to buy the loans back so they're going bankrupt.

For those who say the problem will be isolated to the subprime lenders (our Fed), wake up and smell the coffee! This has major repercussion possibilities throughout our financial system. It could be the grain of sand that finally takes the whole pile down. And now, as banks starting seriously reigning in their lending practices, credit availability will begin to dry up. As bank officers move from fear of subprime loans to fear of any loans, they'll start pinching off credit to even the more credit worthy. As credit dries up the Fed will not be able to stuff the money channels with more money--it will have no where to go. The Fed will be pushing on a string.

And with a drying up of credit we will fall into a recession or worse. The Fed in the short term will be fighting inflation and then suddenly be faced with a much bigger problem. I don't envy their position and Bernanke will get all the blame. He's not blameless but this has been setting up long before he was even a Fed governor. Thank you Easy Al.

And with that I'll get off my soapbox and get back to the charts.

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

After landing in the arms of the 200-dma and uptrend line from last July, the home builders must have felt like a hot potato--it was dropped faster than you can say subprime. I see nothing but downside for this sector.

Oil chart, January contract, Daily

Oil is baffling me at the moment. I thought sure a break of its downtrend line would see a spurt to the upside. But after breaking both its 50-dma and downtrend line oil is sitting there like a lost child. The bearish divergence at the last high shows there just wasn't much interest in buying oil at this level. So a turn back down is looking like the more probable direction but I can't say that with enough conviction to say that's the way I would trade it.

Oil Index chart, Daily

The price of oil has held up and the broader market has bounced in the past couple of days so oil stocks have seen renewed buying. Whether this will lead to more upside is doubtful in my mind if only because I don't think the broader market will support that. But it takes a break below 600 to say we've got something more bearish going on. If that happens then I see a quick move down to the 560 area before reasonable support will be found (and after a bounce from there it would probably continue lower).

Transportation Index chart, TRAN, Daily

The Trannies love the price channels. After a quick trip back to the bottom of its channel from September the Trannies are trying to bounce but haven't quite tested the 50-dma yet. A failure there (4807) would like see the longer term uptrend line from March 2003, currently near 4500, tested next.

U.S. Dollar chart, Daily

The decline in the US dollar since its high in January is not impulsive and that leaves open the possibility that the dollar will turn back up and head for new highs. But if I've got the larger pattern correct (descending wedge since the November 2005 high) then it would be expected that we'll have a very choppy decline over the next few months before finding support closer to $81.

Gold chart, February contract, Daily

Gold should continue to head south so its 50-dma could act as resistance now but that moving average doesn't seem to be used much by traders. The short term pattern though suggests that gold will probably fail beneath the 50-dma and head for the $620 level next. It should get a little larger bounce from there before turning back over and breaking its uptrend line from August 2005.

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

Today was a quiet day and tomorrow will be a snoozer as far as economic reports go. While the unemployment numbers are expected to be encouraging, this is a lagging indicator and rarely moves the market. I don't expect any influence from this tomorrow morning.

Friday will be a lot busier and there are some potential market movers in there. But if the wave pattern sets up the way I think it will then we should see a rally on Friday so whatever the numbers they will be spun in a positive light, or at least be credited for the rally. Phooey. The market does what it does because of human emotions and mass psychology. Then the stories are made to match the market. It's really that simple.

Speaking of a Friday rally, in fact a rally that could start Thursday afternoon, there's an opex pattern that I've mentioned before and it too supports the idea that a bounce into the end of the week could lead to a hard sell off next week. Typically we've seen the Thursday, and often Friday, act as head fake days. Except for May of last year we've seen a bullish opex week most times and the Thursday/Friday prior to opex have typically been down days.

I've mentioned this and pointed out how easily the Boyz (mega banks' trading teams) could push the market down, load up on cheap front-month call options and then drive the market higher into opex, reaping huge gains on their call options. Also selling puts for the option premium has been a consistent winner of a strategy.

So if we get a rally on Thursday/Friday might the Boyz load up on March put options and then drive the market lower during opex? That's the way I see it setting up. And since so many have gotten into the habit of selling put options to regularly collect their premium, if the market starts to tank during opex then you'll have a lot of players, especially the hedge funds, looking to cover or hedge their positions. A favorite hedge strategy when you see you naked put going under water is to short the stock. That adds selling to pressure and can really get the ball rolling downhill fast. Just what a 3rd wave down calls for.

SPX chart, Weekly, More Immediately Bearish

That's big ugly red candle from last week (beautiful to a bear). Months worth of hard-fought gains wiped out in a week. This is why I kept warning that a decline from the pattern that has been setting up since November will likely get retraced quickly. It happened even faster than I thought it would (I was giving it two to four weeks to happen, not one) but it just shows how complacent the market had gotten. And the complacency hasn't left the market! Just about everyone is preaching about what a wonderful buying opportunity this is. Not me. I'll short the bounces thank you very much. The weekly oscillators are hard down and this could keep the daily oscillators buried in oversold for a little while. Tread carefully here if you're long or wanting to get long.

I'll close with a long term view of interest rates, using the 10-year Note.

10-year Note (TNX), Weekly

I was playing around with the weekly chart and noticed an interesting setup that actually fits with a potential fundamental problem the Fed is facing. From an EW perspective, the decline in interest rates from the high in 2000 was a 3-wave move down that I labeled as wave-(a). From the bottom in June 2003 it appears we're in an ascending wedge, which is a very common pattern for b-waves. Within the ascending wedge I've got the move labeled as waves A through E to then give us wave-9b). This pattern says rates should be bottom now, on the uptrend line from June 2003 and head higher into at least the middle of the year.

If this interpretation is correct, so much for the Fed easing even if the stock market gets hammered to the downside. This fits the scenario I've been expecting where the Fed will have boxed itself into a corner fighting the inflation monster that it fed (no pun intended) and will have to slay before it can go after the slowing economy monster. Once it becomes more than apparent that we're already in a recession the Fed will pull out the stops and aggressively lower interest rates into 2008 and beyond. Also, if you're interest rate sensitive this may help you in your own planning.

As for the stock market, I've laid out as best I can, and probably in way too much detail for some, as to why I think we're due a bounce starting around mid day on Thursday (after a little more pullback that started at today's high) and the rally leg should be strong (wave-c is the expected leg up and they're often as strong as 3rd waves. From the low of the pullback I would expect to see a 200-pt rally on the DOW by the end of the day Friday or Monday morning. And then get shorty for a big ride down into the end of the month.

Good luck in your trading. Don't go overboard and by all means control your risk. I may sound very confident about the downside potential but this market has a way of humbling us all. I'm used to it but I don't want you to think that I'm so confident and correct in my analysis that you hold on in hopes that the market finally does what you or I thought it would do. One, it could take a lot longer to do it than we expect (hence buy much more time on your options than you think you'll need) and two, honor your stops.

It makes absolutely no sense to blow up your account (been there) only to find out you were right but now have no money to take advantage of it. Stops are the cost of doing business. You're not right or wrong, nor is the market right or wrong. It just is. When we trade in the same direction we make money. When we trade in the opposite direction we get stopped out. It's really that simple. Don't get hung up on "beating" the market and having to be right. You just want to trade with the market.

If you enter a bearish play this Friday/Monday at the levels I've identified, let's just hope that the direction will be down next week so that we're in synch. If not, make sure you stop yourself out. I'll be back here on Wednesday and we'll see how things are going. I'll see everyone else on the MM and we'll try to nail the top of this bounce.

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