Option Investor
Market Wrap

Just Another Wall To Climb

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Jim has a bad case of the flu bug so I (Keene Little) will be filling in for him tonight. I just finished an article in U.S. News & World Report, which is obviously read by more normal people than we who trade the market regularly, and it was about the stock market following the steep decline after the China sell off. The bottom line of the article is that were just going through a normal correction and that we should expect higher volatility. But keep investing for the long term because the stock market will always go up. The last sentence in the article said its just another wall of worry for the bulls to climb. Dont worry, be happy.

I guess that depends on your investing horizon. I remember a similar comment by the CFP (Certified Financial Planner) who my parents were using back in 2000. My parents were in their seventies at the time and the planner had them 60% in tech stocks, about 20% in banking stocks, a smattering of international and about 20% in bonds. When I politely (OK, not so politely) asked him why on earth he would have them in such an aggressive portfolio his response was the samedont worry, the stock market always goes up, even if it pulls back some in the process. As he told me, the market has been up in every 20-year period.

Needless to say that CFP was soon minus my parents IRA account. This took quite a bit of persuasion on my part as my mother (the money manager in the family) had done very well through the 1990s with this CFP. Thankfully she listened to her favorite son (so what if Im her only one) and moved the money to a different account and has been grateful for the move. Their portfolio would still be down over 50% had they stayed with him and they hardly have 20 years for the market to recover. Quite frankly I dont think the tech stocks will recover to where they were in 2000 even by 2027. Id love it if my parents were still around then but the odds of that happening are pretty slim.

Why do I tell this story? Because its being told a million times over and people are being set up for the big fall. Even a big sell off as we had from the February high, clearly something different than weve seen during the past 4 years, has just about everyone saying its just a normal correction and to ignore the signs of the perfect storm brewing off the coast. Even for those who dont like to time the market I ask them to at least consider insurance (put options, sliding a little more money into cash, etc.) and they just scoff.

The idea of buying insurance on our lives, house, car, pets health, you name it, we have no problem with. Money down the drain, but hey, its insurance! But ask people to insure their life savings and they look at you as if youre from Mars. The public has been fed the story about the stock market always going up, and weve had a good run since 1982 (which encompasses probably 90%+ of todays market participants, including analysts and money managers). Its easy to understand why its difficult to fathom the kind of deep deep correction to the stock market that is setting up.

And so the U.S. News article just reinforces my opinion that were in trouble. When everyone expects the market to keep climbing, even after a significant sell off, bulls should be worried. But theyre not.

Todays rally was the result of just another wall or worry to climb. Most of the signs were seeing lately point to a slowing economy. Housing numbers showed a jump in starts but permits were down. The first was weather related the second is economy related. And yet an economy that is slowing down must mean the Fed will be closer to reducing rates, right? To which I say so what! A slowing economy will hurt the stock market and we have a history with the Fed -- theyre always late to the party.

The Fed consistently chases the market instead of the other way around. My favorite analogy, which any pilot will understand, is called PIO (pilot induced oscillation). This is when a pilot tries to correct a move in the airplane but puts in too much correction too late and sends the airplane too far the other way. He then inputs the opposite correction and the plane overcorrects in the other direction. The pilot then tries to correct that and again does too much too late and before you know it the pilot is killing snakes in the cockpit by pushing the stick all over the place. As an instructor thats when Id tell the student to let go of the stick and magically the airplane would stabilize itself. Its a very impressive lesson to learn. Its actually pretty funny to watch when youre not the one in the airplane.

The Fed is doing the same thing -- they consistently put in a correction that is too late and then too much. By the time they recognize it they then start overcorrecting the other way. The average interest rate over the years is exactly where we are today and yet the Fed has cycled us all over the map trying to smooth things out in the economy. My guess is that if they left things alone the market would do a dandy job all by itself and stabilize quite nicely. Their effort to prop up the economy with massive liquidity (from money creation and easing of lending criteria) has created one bubble after another and were due for another correction the other way.

The popping of the housing bubble will be the most painful because it will affect the most people. The people least able to afford a dislocation in the financial market -- those who are the less well off home owners -- will be the ones who get hurt the most. Think of the poor, the immigrants and the retired. Were already hearing some sad stories about whats happening. And this comes not long after Greenspan said adjustable-rate mortgages were one of the best financing vehicles for homeowners (2002), only months before he started raising interest rates. He was more interested in protecting the banks than the little guy. Now those ARMs are a significant part of the problem and a big factor in the rising default/foreclosure rate and the subprime fiasco today.

The prime lenders are already starting to close their lending books. Pretty soon the only ones who will be able to borrow money are those who dont need it but borrow because they can get a better return on their money elsewhere (like foreclosed properties). The tightening of credit has already started and thats what will slow down the economy. A reduction in interest rates, even if it were to start this week (dont hold your breath) would not be enough to stimulate lending. The Fed will once again be late to the party and theyll start yet another oscillation in this PIO economy.

But dont confuse facts with emotion, and emotion is what drives the stock market. The worry about all this is just another wall of worry to climb, as stated at the end of the U.S. News article. The market will rally again, or certainly thats what many believe. Ill show in tonights charts why I dont believe that and in fact we have one of the best shorting opportunities setting up that youll ever see in your trading careers.

At least thats the way its setting up. Well take advantage of the setup if it follows through otherwise well simply exit the short plays if it doesnt. We will never argue with price as were entering a time where traders can make some serious money if the volatility continues to expand -- just try to catch the days moves and theres some money to be made in both directions, even in a down market. Follow it for trading purposes but investors need to look at their portfolios and think about how to play a little more defense.


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Economic reports

Economic reports are very light this week. The only one everyone cares about anyway is the FOMC meeting. But today we had a look at the home builders market.

Housing Starts and Permits

Housing starts surprised to the upside by coming in at an annual build rate of 1.525M units. This was a +9% increase over the revised lower number for January of 1.399M (revised from 1.408M). This was a strong rebound and I was surprised the home builders didnt get a bigger jump out of the gate. Unfortunately the headline number wasnt enough to overcome some other sobering numbers.

Starts were down 28.5% compared with February 2006 and most are aware that the increase in starts had as much to do with a weather break than anything else. Building permits, which are obviously much less weather related, were down 2.5% from January and at -28.6% compared to February 2006 they were down the same amount as starts. Economists had expected permits to be essentially unchanged, once again showing how theyre missing the signs of economic slowing pretty consistently now.

Permits for single-family homes dropped to a nine-year low. Completed homes is at the lowest number its been since August 2003 and its expected to be a difficult year as builders try to work down their excessive inventory. Cancellations rates remain high and giveaways are hurting the bottom line for most of the builders as they scramble to keep buyers from cancelling their contracts, and to even get them in the door in the first place. Buyers know theyre in the drivers seat now and theyre not being bashful about asking for stuff before they sign on the bottom line. Just from my own small sampling of friends and family trying to sell homes, and watching the number of contracts falling through, I can tell its going to be a tough period ahead for sellers.

With that lets move to the charts and see how the market is setting up as we head into FOMC tomorrow. One thing to take note of are the down-channels that I have drawn on the daily charts. Based on the correction to the decline from February taking longer than I had first thought it would, and bouncing a little higher, that changes the projection for these down-channels. The channels are still a best-guess based on where I think the bounce will end. Once the market turns back down, assuming of course that it will, Ill be able to redraw the channels based on where the current bounce finishes.

DOW chart, Daily

For now Im making the assumption that the DOW will bounce up to around 12400 before it finishes the correction to the decline off the February high. There is a chance that its very close to finishing its rally near todays high, and theres also a chance well see the rally last a few more days (so a post-FOMC rally) and reach up towards 12500. The important thing to take away from this chart is that the next leg down should be very strong and it should work its way down towards 11K by June (which is a change from last weeks projection which showed May as the month for the low before setting up a larger corrective rally).

If the rally were to press much higher than 12500 I would start to seriously question the bearish wave count. Any higher than 12635 and Id say were looking at new all-time highs. I do not expect to see this happen and believe weve seen market highs that will stand for years to come.

DOW chart, 60-min

As mentioned above for the daily chart, its possible the rally is nearly done and we could tip back over tomorrow. Thats not my preferred EW (Elliott Wave) count at the moment but instead think well get either one of the short term bullish counts (dark or light green). If we get a sloppy choppy sideways/down pullback tomorrow (not uncommon in front of an FOMC announcement) then look for a resolution higher and thats where the 12400 target comes into play. If we were to then get another sloppy sideways/down pullback then the 62% retracement of the decline from February, at 12509, could be the ultimate upside target and likely early next week.

It could be a little bit of a challenge figuring out which high will be the one we will want to short but thats what Ill be watching carefully and when I think its setting up Ill be calling it out intraday on the Market Monitor. This is a setup I would like very much to catch. However, if you dont like picking tops, or cant watch the market during the day, wait for a break of its uptrend line, preferably a retest of it, and then a new low will be your signal to get short.

You dont need to be super accurate here on your entry, especially with options, as the downside target is well below us and youll have plenty of meat to take out of the middle of the move. There are lots of ways to play it -- bear call spreads (preferably above 12600) and long puts (preferably no earlier than June and no further OTM than 12000) are just two examples. If you trade futures then shorting YM is the vehicle of choice.

SPX chart, Daily

Like the DOW I revised the down-channel based on where I think the current bounce will end. For now Im picking the 50-dma at 1423 which is also where some Fib targets are located. That would make for an excellent short entry. Any higher than 1440 and I would abandon the thought of short plays until we see whats happening. The downside target is near 1275 by June before setting up a larger correction into July/August. From there we would likely see some very strong selling to new annual lows into October/November.

SPX chart, 60-min

A Fib projection for the leg up from last Wednesday, March 14th, is just under 1423. This is where wave-c = 162% of wave-a (the first leg up in the bounce from the March 5th low). This is a very common Fib relationship between these two waves when wave-b, the drop into the March 14th low, drops near or below the start of wave-a (the March 5th low). This is between the 50% and 62% retracements of the decline from the February high so I consider the zone between 1418 and 1428 to be the target zone for the current leg up. Thats why the 50-dma at 1423 is rather intriguing. If price drops below the uptrend line, retests it and then drops to a new low, use that as your sell signal and get short. Use the bounce that retested the broken trend line as your stop level in that case.

OEX chart, Daily

Because of the change in the price projections since last week I thought Id show an update for OEX since I know many of you trade spreads on this one. I see upside potential to about 650 in its current bounce although its 50-dma at 658 could certainly get tagged. The downside projection from there should have it near 610-620 by April expiration and then below 600 by May expiration. If the current bounce changes the down-channel to something a little less steep then those numbers will obviously change. Keep an eye on its Fibs as this index trades them extremely well.

Nasdaq-100 (NDX) chart, Daily

As with the SPX, there are some Fibs and the 50-dma lining up nicely if price presses a little higher this week. Keep an eye on the 1785-1790 area for a very good setup to get short. It may fail earlier than that since the bounce has already met the minimums to be considered complete. Always keep in mind now that surprises in the market will very likely be to the downside. Theres still way too much bullish optimism out there and when the selling hits, the exit doors get very small.

This brings up an issue thats worth discussing. As was mentioned today on the Market Monitor, when the question came up about shorting ETFs, this is one of the differences in todays market that weve never had before. Weve heard about the risks from all the credit derivatives -- these have helped increase the liquidity in the global markets by exponentially expanding credit availability. People have tried to hedge their bets with credit derivatives.

The problem will come when credit shrinks and people try to collect on those derivatives. Theres still the question about whether or not people know who will owe whom. What inflated the asset markets over the past couple of years could drastically, and quickly, deflate the market on the way back down.

But back to ETFs -- theres been an enormous increase in these funds in the past few years and hedge funds are huge fans of them. One of the reasons hedge funds like them is because they can get in and out of baskets of stocks with one order instead of tens or hundreds of them. The other advantage is that you can short these funds on a downtick.

This is where the market will be truly tested in the near future, and it may have had an impact on the last sell off from the February high. If selling gets out of hand, these hedge funds dont need an uptick to exit their positions and can just unload their holdings on downticks. This can enormous selling pressure right at the point the market can least handle it.

That hard 200-point drop in about 6 seconds around 3:00 on the DOW last time? It might have been from something like this. The market has not had to endure this situation before and itll be interesting to see what happens this time around.

Back to the NDX chart, looking a little closer at its 60-min chart:

Nasdaq-100 (NDX) chart, 60-min

This is one of the charts that gives me the impression we may have topped out today. The rise off the March 14th low looks to have created an ascending wedge, which has the required 5-wave move inside. Any drop below this afternoons low near 1762 would be a warning shot across the bow. A drop below Mondays low near 1752 would be the shot that takes out the rudder and then a drop below 1733 would be the shot below the water line.

What I dont like about the bearish ascending wedge interpretation is the lack of bearish divergences at each new high. Without that confirmation this pattern is not reliable. Therefore watch for a continuation higher into the 1785-1790 area to set up a short play.

Russell-2000 (RUT) chart, Daily

The RUT is set up similarly to the NDX where todays high may have been the end of its bounce. Like the NDX, in order for that to be true we will have to see persistent selling right out of the gate. Assuming that todays high was the end of the correction, I have the down-channel drawn off todays high. That will obviously change if the RUT continues a little higher first. For now, based on this channel and the Fib projections for the waves I get a downside target near 680 in April and then the 660 area in May. Again, I know many of you use the RUT for your monthly spread plays. Bull put spreads are dangerous right now.

Russell-2000 (RUT)chart, 60-min

The ascending wedge idea for the RUT, especially with the lack of bearish divergences, doesnt look like the correct interpretation of price action here. Its also not at all normal for price to press right into the apex of a triangle (usually youll see price finish about 2/3 to of the way into a triangle and then break out of it). So a break of its uptrend line may not mean as much here. As with the other indices, if we get a slow sideways/down pullback tomorrow, look for a higher resolution. The Fibs near 804 make for a good upside target.

Before moving onto the other charts I wanted to show an update on the 10-year yield since everyone and their brother is guessing what the Fed will do so Ill toss my hat into the guessing ring as well. I think rates are headed higher and Ill show my reasons for why. I could get into all the business how the Fed is boxed in, cant let down their guard down on inflation (otherwise theyd have a credibility problem), how Bernanke has said in the past (not publicized very well) that he will sacrifice employment and an economic slowdown in order to maintain control over inflation (he even has a fancy term for it, the name of which currently escapes me), etc., etc., but Ill let the charts do the talking, starting with a longer term view and the weekly chart:

10-year Yield (TNX) chart, Weekly

Ive shown this weekly chart before -- the pattern is highly suggestive of a bearish ascending wedge playing out and it needs one more leg up inside it to complete the pattern. Its possible wave-C, the move up to the high in June 2006, ended the upward correction and now its downhill from here. Any break below the low in December (4.4%) would suggest much more bearish things for yields (bullish for bonds). Otherwise I see a rally in yields up to 5.5% by this chart. Does that mean the Fed will have to raise rates before they cut them? Thats what this chart is telling me. Unless and until it drops below 4.4% this chart is pointing higher.

10-year Yield (TNX) chart, Daily

The daily chart of the 10-year yield shows the two uptrend lines that appear to be influencing price at the moment. Its possible that yields will stay trapped in a larger sideways triangle (not shown on the weekly chart above) and a yield of 5% is the most well see. Regardless of whether it goes to 5% or 5.5% it means the Fed will not be cutting rates any time soon, and in fact just the opposite. I can only imagine the hissy fit from the stock market if the Fed so much as hints theyre going to raise rates.

Keep a close eye on rates as theyll tell us what the Fed is going to do next. First theyll try to talk the bond market into raising rates (which has been a challenge since Treasuries keep getting snapped up and the buying pressure has maintained a bid on Treasuries which has kept interest rates down. That could change soon if countries start shying away from owning too much of our paper.

BIX banking index, Daily chart

Because the banks dipped so hard on the 2nd sell off into the March 14th low, it looks to have a more bearish 1-2, 1-2 wave count to the downside. If this is the correct wave count, which means the high near 395 on March 12th cant be violated, then the next leg down is going to be a doozy. It would be the wake-up move that makes many realize this is more than just a correction. Right now the banks are fighting to get above the 200-ema so a failure here would be swift. If it can get above 395 then the next upside target is closer to 400.

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

Im still looking for a bounce in the home builders and thought todays news would be spun bullishly to get people buying. But several analysts came out and said this is not the time to buy. I had to clean out my ears to be sure I heard them right. If this index rolls right back over then the wave pattern turns very bearish and will scare the bejeebers out of people standing nearby. Im still looking for more of a bounce but stand back if it makes a new low.

Oil chart, May contract, Daily

The April contract has price back down and testing its broken downtrend line whereas the May contract is still well above its line. Im not sure what to make of this here. Bullishly its finding support at its 50-dma after finding resistance at its 200-dma. May the best average win and follow the break either way.

Oil Index chart, Daily

Oil stocks seem to believe oil will resolve higher again but Im not so sure about that. Right now the oil stocks look the same as the broader market with a 3-wave bounce off the March 5th low. Im thinking it will resolve to the downside with the broader market.

Transportation Index chart, TRAN, Daily

The Trannies finished with a very bullish looking dragonfly doji last Wednesday and had the follow through on Thursday to confirm the reversal signal. But now its about to face resistance at its 20-dma and 50-dma, with the 20 about to cross down through the 50 near 4863. That would be a moving average sell signal so well see how many traders bail on this index at that level. A turn back down to a new low would likely be fast and the uptrend line near 4500 wouldnt even slow it down.

U.S. Dollar chart, Daily

The US dollar continues to follow a very choppy path lower which says it could go anywhere from here. Im expecting lower over the next several months and so far see nothing to change that expectation.

Gold chart, April contract, Daily

Gold has been in synch with equities lately and thats not surprising. The same factors affecting equities, such as the yen carry trade and just general worries, will also affect gold traders and I expect to see gold sell off. Any rally back above 680 would say otherwise, with confirmation above 692 but until that happens I think the next strong move in gold will be down.

Gold chart, April contract, 60-min

On the Market Monitor I identified a setup for shorting gold (silver too). A Fib projection for two equal legs up from March 5th is at 662.30 and a 50% retracement of the decline from the February 27th high is at 663.80. Todays high was at 662 (662.60 for the YG e-mini futures) so I recommended shorting it this morning. It may not be quite finished rallying and could push a little higher tomorrow again to nab those Fib targets, but this one looks close to a very good short. I would not want to be short though if it gets much above 665 -- its a short here or get out of the way for now.

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

Its another quiet day for economic reports. Besides, no one would pay any attention to them anyway. Theres a real good chance the market will just go on hold tomorrow until the FOMC announcement at 2:15 PM.

As discussed with the charts above, any slow sideways/down choppy price action into the FOMC announcement and I would expect to see a rally out of it. Well get the usual cha-cha-cha around the announcement but I would look to be a buyer of the consolidation. That would be only for a scalp trade as I consider the upside very risky at this point, even for intraday traders. My preference at this point is to wait for a nice short play to set up and make it a swing, if not position, trade. You know, the kind you can hold for more than a day. Remember those?

If we rally into FOMC then just the opposite -- well probably see a post-FOMC sell off. But it may be short lived where well get another leg up to finish the bounce into the end of the week or early next week. Keep an eye on the levels I identified in the charts above and if they get tagged while were seeing some short term bearish divergences setting up on the charts, try the short side. If you want to be a little more conservative, wait for the breakdown and then play the bounces or just get short on the breakdown. The hard part is that it might start with an overnight drop again for a big gap down and that makes entries difficult.

Ill do my best to call it out on the Market Monitor. Ill also be back tomorrow night to see how the market handled the FOMC announcement so maybe well have a little clearer idea for the rest of the week. Good luck tomorrow and dont force trades where there probably wont be any.

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