Option Investor
Market Wrap

Don't Confuse Me With Facts

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That's the bulls' response to such things as negative breadth, weak market internals, an insufficient correction to a 7-month rally, etc. The bulls clearly have an agenda and it's not to accommodate the naysayers out there. I've been one of them and have been looking at the bounce off the March low, even though it was getting a little too large and impulsive looking to the upside, as simply part of a larger correction that we'd see.

While that scenario is still entirely possible, as I'll show in the charts, it is no longer my preferred EW (Elliott Wave) count. The bounce is quite simply too impulsive and some of the indices (NYSE for example) have exceeded the February high to comfortably call this rally as part of a larger correction. It was a good setup and it had the backing of weak internals, including weaker volume during the rally, but price is king or the final arbiter as I like to say. And price has spoken. For those who hung on for the additional rally, well done and you've been rewarded. For the bears who've tried to pick tops (as I raise my hand), your time will come and you'll likely be rewarded handsomely but for now it's clearly been a time to run with the bulls.

The interesting thing about the strength of the market here is that it is actually potentially very bearish. Sounds odd but basically the thing I was looking for was a correction to the Feb-Mar decline and then another leg down as part of a larger correction. Whether that larger correction led to new highs, a larger sideways consolidation or a larger drop later this year was the unknown. But it meant we could hold up around market highs for at least a number of months. Now that the market has blasted higher, into some potentially important turn windows, it sets the market up for a harder fall earlier rather than later.

As one reader said today, "The market has now replaced the housing market of 2005. Will it end the same?" That's the way I see it. The world is awash in liquidity. You've probably read that from many different sources. There are many opinions as to why we have so much liquidity but a big reason is easy and cheap credit. There are a myriad of ways we're seeing the global money supply expand at an extraordinary rate. The yen carry trade is one--borrow yen at a ridiculously low interest rate and invest it elsewhere. Relaxed lending standards is another--even non-credit worthy borrowers are getting money and businesses now get "covenant holidays" if they miss a quarter or two or three. Repackaging of loans is another--banks repackage their loans, such as mortgages, and sell them to investors and then lend the money out again.


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The central banks around the world have been busy inflating their money supplies but it's generally recognized that this probably has been a small part of the expanding money supply. Credit is the key. Even the borrowing to invest has hit record highs--margin debt has exceeded even the highs in 2000 and that is of course worrisome especially when all that margin is on a market where many of the indices are not challenging the 2000 highs. Any bout of selling could cause some serious damage as the margin calls go out. The collateralized debt obligations (CDOs) are a type of asset-backed security where the owners leverage their investment by borrowing against the portfolio. Everything is about borrowing more and figuring out ways to further leverage their money. The result has been a parabolic rise in debt over the past few years. This whole system has not yet been "tested" since the creation of all this monstrous post-2002. It should be interesting during the next large market correction.

And at this point of course most are asking "is there ever going to be a market correction?" As more and more people ask that question, or state emphatically, as many on CNBC are now doing, that we're headed for DOW 14K next and that we had our correction, well, you know we're skating on thin ice. The biggest thing to remember is that the strongest move in a bull market, other than the initial shot off the bottom, is the ending move. It's often when the last of the bears give up and cover all their short positions, which I know is happening, and the last of the nervous bulls finally jump in for fear of missing out on the rally. This combination usually results in a very strong thrust to new highs but typically lacks the market breadth and volume (except for perhaps a final capitulating volume day but that's hardly necessary). Sound familiar? Check out the lack of volume and breadth in the charts after the NYSE chart below (and the weekly SPX chart at the end of this report).

But first a reminder of another year that experienced a final flare up before trouble hit (which is the way it occurred in 1929 as well). This is what happened in 1987 and as a reminder I'll show again the chart of price action in 1987:

SPX chart, Daily, 1987

After the 9% correction in April SPX then rallied 23% to its August high. It then dipped, bounced and then crashed. That final rally was built on hype and fluff and I see the same thing happening in today's market. Worse it's built on excess credit. Instead of investing on value today's market participants are simply chasing a higher market. As Dave had commented to me, in his quote about money rotating back into stocks, investment dollars had run from stocks into real estate and now it's coming back to stocks. Where to next? Tulip bulbs? The blow off top in 2007 may be happening faster than it did in 1987.

The money is simply looking for a home and is not necessarily based on the stock market being a good place of value. In fact one could easily argue that the market is over-valued and chasing it higher here is simply relying on the "greater fool" theory (otherwise known as a Ponzi scheme) in hopes that someone will keep bidding it higher. Didn't we see the same thing happening during the dot.com boom and then in the real estate market? After the rush into real estate and the booming price appreciation in home builder stocks, since the July 2005 high the home builders have been cut in half.

Hot money is chasing stocks higher right now and there's a lot of bullish excitement in the air right. Our job as traders is to not get caught up in the emotions but instead try to see the subtle signals of what's coming. And that's what I'll try to show in tonight's charts. But first let's review today's economic reports:

Economic reports
Today's economic reports included durable goods orders, new home sales, crude inventories and the Fed's Beige Book (I'd like to know who the genius was who named this report based on the color of its binder). Generally speaking the market reacted favorably to these reports but in reality the market was going to rally anyway.

Durable Goods Orders
The headline number was very positive--up +3.4%. This was helped greatly by a strong showing by Boeing for new aircraft orders which were up +37.6%, receiving orders for 119 planes in March. Big Air (BA) must have had this baked into the stock's price though since today's price action was somewhat negative even though it finished in the green. The candle looks like a dragonfly doji (more bearish version of the hanging man). It even has a wave count that suggests this stock has topped out. BA reaffirmed their earnings outlook for 2007/2008.

But back to the report, the headline number was better than the expected +2.5% but separating out the big jump in transportation goods showed a milder +1.5% increase. February's number was revised higher from +1.7% to +2.4% so it's a good performance by the economy. The other good news was the increase in core capital equipment orders (reflecting companies' willingness to invest for the future) of +4.7%. But that follows a cumulative decline in January and February of -8.5%. The increase in the durable goods orders was the largest since September 2004.

<u>New Home Sales</u>
Warmer weather got the credit for an increase in the sales of new homes, up +2.6% in March to a seasonally adjusted annual rate of 858K units. Note that the new home sales number includes apartments and condos. That was the good news. The bad news is when comparing to year-ago levels. Sales were down -23.5% compared to March 2006. Economists were surprisingly gloomy after today's report (I say surprisingly since they're always looking for optimistic things to say).

There is general recognition that the spring selling season is off to a soft start and many are expecting the numbers to get worse before they get better. The home builders sank finished essentially flat on the day after an initial drop in the morning and then clawing their way back for the rest of the day. The sales pace was slower than expected and even sales for the previous 3 months were revised lower. This has to do with taking credit for a sale when a contract is signed but then has to be removed from the data if the buyer backs away, which we know is happening at a high percentage. This is also why we can't trust the new home sales data as originally reported--it will be higher than actual and considering how soft the numbers are, it's actually worse.

The inventory of unsold homes rose by 1000 to 545K in March which is a 7.8-month supply. That's down 1.4% from a year ago. The median sales price rose +6.4% to $254K as luxury homes continued to expand their market share (sales of homes greater than $750K accounted for 6% of sales, up from 4% in February). Just another example of the spread between the haves and have-nots which may have some real social consequences down the road.

Here's a chart of home sales I grabbed out of the MarketWatch report:

Existing and New Home Sales, 2003-2006

The peak in sales was in mid 2005, just when the home builders peaked. You can see the little jump at the tail end of the year and we saw the same thing in the home builders. Now the sales number has dropped to a new low. Home builders to follow? You can bet on it.

Crude Inventory
Crude supplies were up 2.1M barrels to 334.5M according to the Energy Department (up 5.5M to 339.4M according to API's numbers) which looks to have been a result of a drop in refining capacity which dropped from 90.4% to 87.8%. This also resulted in a drop in gasoline inventories--down for an 11th straight week now. Gasoline price (May contract) closed at its highest price since last August. Gasoline demand was +2.3% over year-ago levels. So much for conservation. Distillate levels were unchanged.

Fed's Beige Book
The Fed sees "only modest or moderate" growth at the present time. The good news is that they don't see any trouble in the economy that requires a reduction in interest rates to help prime the pump. Of course normally that would have been bad news for the bulls who have been wanting a Fed rate cut. But now no rate cut is also bullish. Pretty soon a rate increase will be bullish too because, well, that will mean the economy is strong. The Fed noted the continuing softening in real estate sales but "generally positive" retail sales. The mighty consumer is still consuming. Those businesses supporting the home building sector have softened more than general retail. Overall it was a report with no new news or surprises and the market barely stopped rallying when the report came out.

So let's take a look and see what the bulls have been up to. On the charts of the major indices we follow here I had identified bullish key levels for the price patterns. They've all been hit and therefore we're in a confirmed bullish move now. How far it will continue is the next question. I've got a lot of charts to cover so I'll try to get through them relatively quickly so that I can get this posted on time.

DOW chart, Daily

I've changed the EW counts on all the charts to reflect the greater likelihood at this point that we're in an impulsive (5-wave move) up from the March 14th low (instead of an a-b-c correction to the Feb-Mar decline). This is potentially very important because once a 5-wave move completes then we'll get at a minimum a larger pullback and more bearishly it will finsih the final 5th wave in the 2002-2007 rally. Alternatively, and shown in light green, is the possibility we'll get a long drawn out sideways correction, possibly as a sideways triangle as I've depicted. I don't like this particular count because it doesn't fit well in the larger pattern of the other indices but I'm showing it so you're aware of the possibility that the next several months could be a go-nowhere market.

But ideally the pattern in the rally up from March 14th calls for a small correction as the 4th wave in the move up and then a final 5th of the 5th wave to a new high. I show a potential Fib projection of 13338 based on a pullback that holds at or above 13K. We'll know better after a pullback and another rally gets started. As I show for the SPX weekly chart at the end of this report, the 13330 area fits well with the projection for SPX.

As I've depicted in dark red, this wave count scenario is looking for a high during the 1st or 2nd week in May. This fits the "sell in May and go away" crowd and it also fits some cycle studies. There's been a very reliable pattern that shows a 40-week cycle over the past 6 years. The next turn date based on this is May 2nd, +/- a few days. The next Bradley turn date is May 7th. So these turn dates are coinciding quite nicely with an expected top by the EW count. This will be another one of those times where you'll just have to test the high and watch for a good short entry.

DOW chart, 60-min

Because of the small wave corrections it's possible to call the rally complete today or very near today's high. This is not my preferred count at the moment but a break back below 12900 would be a bearish heads up. It takes a break below 12600 to confirm a high is in (that will be raised if we get a pullback and then new high, as shown in green.

SPX chart, Daily

Like the DOW there is a way to count today's high as the completion of the rally but my preferred count at this point is the green count which shows the need for a small pullback followed by another push higher. There are some Fibs pointing the possibility it would get as high as 1520-1530 but I think more likely it will fail to achieve 1520. On the weekly chart at the end of this report I show a Fib projection near 1510 and this fits nicely with the projections for the DOW around the 13300 area. Above 1460 the bulls are still safe (although that would be a big pullback from here) and it takes a break below 1438 to say the rally is done. That key level will be raised if we get a pullback and then a new high.

SPX chart, 60-min

A closer view shows the price pattern got bullish with a rally above 1487. We could see a pullback all the way to its uptrend line, currently near 1472, and not have it mean anything bearish. I suspect it will be something more sideways/down as depicted in green before we get the last leg up. But a break below 1464 would be a heads up that something more bearish is happening.

Nasdaq-100 (NDX) chart, Daily

The techs finally started leading the way here, after dragging behind the blue chips. Even the semis finally got it in gear and charged out of their consolidation. Like the blue chips now, the pattern would look best with a pullback and then a final high. On this chart I show a longer pullback into mid May and a final rally into the latter part of May. That's based on a parallel up-channel. But a steeper uptrend line could support a pullback sooner and higher and a trend line along the two highs since the March low could keep the final rally high lower than shown. The trend line from January 2004 through January 2006 may limit any rally to 1900 or below.

Russell-2000 (RUT) chart, Daily

I had mentioned around mid March that we could see the broken uptrend line from August act as resistance to any rally attempt. So far it has. And then the uptrend line from March 14th started to give it the appearance of an ascending wedge which is very common for a 5th wave as this is labeled. It even has the right internal 3-wave structure for an ending diagonal. I like this chart and its projection. While the others leave me guessing a little, the RUT is clear as a bell here. The only question in my mind is whether it topped today or has a little further to go, shown better in the 60-min chart:

Russell-2000 (RUT) chart, 60-min

Because these ascending wedges, and their 3-wave moves, can be difficult to figure out which is the ending leg, it's possible to count the a-b-c move up from March 18th as the final 5th wave (labeled in dark red) or if the pattern still needs a small pullback and then final high (labeled in green). If we get a choppy sideways/down kind of pullback, especially if supported by the uptrend line, then another leg up should be expected and that's the one where I'll be looking for a high.

NYSE (NYA) chart, Daily

The NYSE has shown stronger relative strength ever since the March 14 low. Its price pattern is also very clean at the moment and calls for a small pullback and then final high. The only question as I look at its pattern is whether the small choppy moves recently, as it works its way higher, is the ending pattern. In other words there could be a small 4th wave correction in there (which would be wave-(iv) as I have on the chart for the next pullback) and now it's in a small ascending wedge for its final 5th wave. This is how sometimes a final 5th wave can look like it's "missing". So the caution as I look at this chart is that we could see a tiny little pullback and final high followed by a strong decline. A break below 9600 would have me thinking a little more immediately bearish.

While price continues to press higher I constantly talk about looking under the hood to find out which cylinder is not firing, or why one of the belts is squeaking, or where the steam is coming from. Not everyone is participating in this rally.

NYSE vs. Total Volume, Daily

I've shown this chart the past couple of weeks and yet again the NYSE is making new highs but it's not being confirmed by volume (bottom chart). Not good.

NYSE vs. 52-week highs, Daily

Also, here the NYSE is making new all-time highs and yet there are fewer participants making individual 52-week highs. This is bearish non-confirmation. Not good.

The final 5th wave of any rally will very typically show bearish divergence and what I'm seeing in this rally is confirming that we're in the 5th wave. If we get a small pullback and then a final high you should see all kinds of negative divergences on the shorter term charts against today's high. It will be your confirmation to start getting out of your long positions and start thinking short.

Semiconductor holders (SMH), Daily chart

The semis finally, after 7 months, made their move. I feel like I'm watching the cicada bug here. That's the bug that has a long dormant period in its life cycle, finally comes out of the ground, makes a lot of noise and then dies. I'm afraid I see the semis dying soon. But first let's see what some upside targets are for its move. For the a-b-c move up from July (I know that it's an a-b-c move because of the long triangle consolidation which are either 4th waves or b-waves and the 4th wave doesn't fit here), the first target is where the 2nd leg upu (wave-c) is 62% of the 1st leg up (wave-a). That was at 37.43 and SMH got above that today. By doing so it also broke its downtrend line from January 2004. That's an important trend line which I'll point out in the weekly chart below.

The next upside price target is based on the consolidation pattern--take the widest part and add it to the breakout level. I show this with the blue lines and it's approximately 38.95. The third upside target is at 40.08 which is where wave-c = wave-a. Like the broader market this one looks like it needs a small pullback and then final high. I'd look for support to hold at or above 37.30.

Semiconductor holders (SMH), Weekly chart

The weekly chart (shown with the log scale so that the 2002-2007 "rally" doesn't look the EKG of someone who just died) shows what I believe is a large b-wave consolidation after the 2000-2002 decline, labeled wave-(a) on the chart. The triangle consolidation is labeled A-B-C-D-E and each of those waves is a 3-wave move or something more complex (but not impulsive). The final wave-E of this pattern is the a-b-c move up from July. A little throw-over above the trend line is very common for e-waves and that's what we currently got today (see the daily chart above). This says we're very close to putting in the final touches to this multi-year correction and the next move will be back down to below the October 2002 low.

BIX banking index (BIX), Daily chart

The banks could still bounce up to the Fib target for two equal legs up in its bounce off the March 14th low. But the bigger picture of course is the fact that the banks are nowhere near making new highs while the broader market is doing so. Not good.

Brokers index (XBD), Daily chart

The brokers are a little more bullish than the banks but like the banks they're struggling with making it up to where there are two equal legs up in its bounce from the March low. It's also struggling with its broken uptrend line from June. The choppy pattern as it works its way higher is an ending pattern and should fail soon.

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

I'm not sure if this has one more bounce left in it or not. If it does then it should be able to reach up and tag its 200-dma. But it looks vulnerable to an immediate decline from here.

Oil chart, ETF (USO), Daily

After breaking its uptrend line from January, which looks like the bottom of a bear flag, USO is struggling to regain that trend line. The short term pattern is not clear as to whether it will get a larger bounce or tip right back over from here. Based on the weakness in MACD it looks ready to tip back over.

Oil Index chart, Daily

Oil stocks got a nice boost today with the broader market. But now that it's chopping its way higher it's looking like an ending pattern. From a very short term perspective on its pattern it looks like it could do a small down-up sequence to finish it off but at this point I'm thinking it's vulnerable to a sell off. The bearish divergences on the oscillators support the bearish view here.

Transportation Index chart, TRAN, Daily

Same pattern as the broader market--would look best with a pullback and final high. The final high should leave lots of bearish divergences on the charts.

U.S. Dollar chart, Daily

After the rally from December 2004 through November 2005 the dollar has been dropping in this descending wedge pattern. This is another b-wave pattern (again a 4th wave correction doesn't fit here so it's a b-wave. And the leg down within the pattern fits well as wave-e, the final move within the triangle pattern. It's now down to the trend line along the lows of the pattern and while it could do an under-throw the point to be gleaned from this chart is that it's ready for a rally, one that takes it back above its November 2005 high (near $93). You can see the bullish divergences associated with a bullish descending wedge. Daily sentiment is as bearish on the dollar as it's ever been (and bullish the euro). This also supports a turn coming.

Gold chart, StreetTrack Gold ETF (GLD), Daily

A rallying US dollar will likely depress the metals and it's interesting that even while the dollar has been sinking hard the past two weeks the metals have been putting in what appears to be a rounded top. It seems smart money might be liquidating their holdings in the metals while bullish sentiment in gold is very high and bringing in lots of buyers. It would certainly be fitting, from a sentiment standpoint, to see gold turn down from here. Many will look at a dip in the price of gold as a buying opportunity. Just understand that you might have a real good buying opportunity closer to $500 ($50 on GLD), maybe even lower.

Gold and Silver sector (XAU), Daily

Following the XAU can be helpful for confirmation of your opinion on the metals and the failure for the stocks to make new highs when gold and silver did was a bearish non-confirmation. Furthermore, the sideways triangle pattern for XAU shows a potentially completed a-b-c-d-e wave count and a little throw-over last week followed by a price collapse back inside the triangle. That's a sell signal and a sell signal in the stocks should be a heads up for what's next for the metals.

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

It'll be a very quiet day tomorrow for economic reports. Friday will be a little busier and potentially move the market.

Thursday will likely be a very quiet day since very often a big day is followed by a consolidation day. And that fits the pattern as well. As I mentioned several times with the charts, ideally we'll get a small pullback as a 4th wave correction, followed by a final 5th wave up to finish off the rally. The first week of May is lining up nicely for a market top, both by the price pattern and the cycle/Bradley turn dates.

SPX chart, Weekly, More Immediately Bearish

With the impulsive push higher from the March low (and you can see how it looks like a blow-off top on the weekly chart) it actually does a nice job in finishing off the wave count for the whole move up from August 2004. For a long time I've been scratching my head as to how to properly count the overlapping price structure. I've now got it as an expanding triangle, otherwise known as a broadening top. Like all triangles, each of the 5 waves that make up the pattern will itself be a 3-wave move. For the 5th wave in this pattern, the move up from July 2006, which is an a-b-c move, wave-c = 62% of wave-a at 1510.54. Based on the shorter term pattern I like this as an upside target. That would put the DOW up near its 13330 target that I mentioned for its target.

So let's root for the bulls that they can drive this market a little higher after a brief consolidation since that will set up the next opportunity to test the short side of this market. In the meantime if you can trade quickly and watch the market, look for a pullback to buy but only for a day trade. The risk is that a final 5th wave for this rally could be very unreliable and fail without notice and quickly. If you've been out of the market for fear we've been topping be comfortable with the knowledge that the very best traders don't try to squeeze every nickel out of a their long or short positions--they take the bulk of the move and then watch and wait for evidence of a turn.

I like to identify the turning points and obviously that's risky business since by nature it says I'm going against the trend. But I continue to favor it for an entry technique because I can keep a very tight stop on my entries--enter the play and use the previous high or low for your stop. While I may miss a move like this last rally I learned long ago that there will be many moves I'll miss. The ones I catch more than make up for it. The beauty of our business is that there will always be another bus that comes along for us to try to hitch a ride. Be patient and wait for your setups.

Good luck in the next week. I'll be back for this weekend's Wrap as I fill in for Jim. Maybe we'll have a few more clues as to what's setting up here. I'll see everyone else on the Market Monitor tomorrow.

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