Option Investor
Market Wrap

Bearish Key Reversal Week

Printer friendly version

I (Keene Little) will be filling in for Jim for this weekend's Market Wrap. It's longer than usual so get yourself a cup of coffee, prop your feet up and hopefully enjoy.

When an index/stock makes a higher high for the week but then closes lower than the previous week's close that makes for a bearish key reversal week. It's of course no guarantee but it's often a reliable signal that that index/stock topped out and you should prepare for further selling the following week. Same thing at bottoms but obviously reversed. This week we had bearish key reversals for the DOW, SPX, MidCap 400, Nasdaq, NYSE Composite, Wilshire 5000 and many other sectors. In other words, it's nearly unanimous. Interestingly the index that did not have a bearish key reversal week is the small cap index, the RUT. This signal doesn't tell you how significant the top will be (or whether it will in fact be a top) but it creates enough doubt in market participants who then begin selling to lock in profits.

I've mentioned before that we are in a position where selling could simply beget more selling. The market has climbed so fast that many fund managers have become nervous about their positions. Most have been hanging on for the ride but with their collective finger resting over the sell button. Most know that a meteoric rise as we've had can't go on forever and in fact these straight up rallies usually pull back quite strongly.

Most fund managers are probably becoming more anxious to lock in gains rather than chase the market higher. They know we're heading into the weakest part of the year (between May and October) and they're probably anxious to lock in gains here so that they can come back in towards the latter part of the year to buy them back and enjoy the run into the end of the year.

So what happens when you have 10,000 long-only mutual fund managers ready to lock in gains? And another 10,000 hedge fund managers who want to short the market? You get a red flushie. The DOW could drop 500 points in the blink of an eye and everyone will be looking around for news that caused all the selling. The pundits will be able to find something or someone to blame (Greenspan and China have been favorite targets lately) but in fact it could be nothing more than a large fund deciding it was time to start rotating their investments from stocks into bonds. All of a sudden a 50-point decline spooks a few more people and they sell. Then the 100-point decline convinces more that it's time for them to lock in their profits too and before you know it, one red flushie coming right up.

We're at the brink of a sentiment change in the market. Elliott Wave (EW) analysis identifies repeating patterns (fractals) which are essentially mirroring investor mood swings. We all know the market reacts differently to the same piece of news at different times. We scratch our heads and wonder why the market is rallying on such bad news. We say the market loves to climb a wall of worry. And then all of a sudden the market sells off on good news and we wonder what soured the mood of the investors. Sometimes sentiment indicators will point out these shifts but very often sentiment can stay overbought or oversold just as long as price does. So I look for these repeating patterns to help me identify what "phase" of the market we're in.

We have clearly been in a bullish phase of the market. Each phase can be measured with impulsive wave counts--a 5-wave move in the direction of the trend. Then there might be a temporary pause in the primary trend and you get a correction. These are typically 3-wave moves but can be something that's a little more complex with overlapping highs and lows (such as in bull and bear flags and sideways consolidations). As I had pointed out in Wednesday's Wrap when I made the call that the market had peaked, it was based on the completion of 5-wave moves on multiple degrees (time frames).

I've also mentioned that the world is in synch. In fact most assets worldwide are in synch. This is unprecedented and we've been experiencing a very strong bull market in just about everything and just about everywhere (except Lebanon and Zimbabwe which are in a recession at the moment). The enormous increase in liquidity around the world has lifted all boats. Even the relationship between gold and stocks, typically counter-cyclical to each other, have been trading in synch for quite a while now. Gold has in fact become a speculative commodity just the same as stocks. Normally if the stock market sells off then gold will rally (fear drives people into the "safety" of gold). It won't happen this time--all assets and worldwide markets will sell off together.

Here's a chart of the World MSCI since the bottom in 2003:

World MSCI chart

From the March 2003 low there's a clear 5-wave advance and the final 5th wave is up against the top of its parallel channel. For you Elliotticians out there, this move even has alternation between wave-2 and wave-4 (wave-2 is a flat correction and wave-4 is a sharper zigzag down) which helps identify the wave count. This is about as clear a setup as you'll get for identifying the top of a market.

Using parallel channels is also a great way to help identify where in the rally (or decline) we could be. When a move completes a 5-wave rally within a parallel up-channel, as shown on the MSCI chart above, then the correction to that 5-wave move will break down from the channel. So there are two ways to play these patterns--try to pick a top (my preferred method) or wait for a break below the bottom of the channel (which gives up a lot of points) which is absolute confirmation that the rally has completed its 5-wave move.

It can certainly press higher, as could our markets as I'll point out on their charts, but the point of this chart is to show how the world's markets are in synch and I believe topping together right here and now. We've all rallied together and we'll all drop together. There will be nowhere to hide except cash (US Treasuries). What this wave pattern tells me is that we're about to have a mood shift and it will not be a market-friendly mood change.

Speaking of treasuries, they had a big move up in the past two weeks:

10-year Yield (TNX) chart, Daily

The 10-year yield broke its downtrend line from July 2006 and then rallied to the point where it was just short of two equal legs up from March. I think we'll see a pullback but then a continuation higher. The impact from this will not help our economy or the stock market. Higher interest rates will of course put a damper on economic growth and the higher yields will entice fund managers to lock in gains in stocks and park their money where they can get a nice safe return. Rising rates will significantly slow down the housing market even more and make it even more difficult for ARM holders.

With bond yields breaking their downtrend lines (bond prices breaking their uptrend lines) from July we have a heads up that stocks will likely follow (those uptrend lines for stocks are still well below current prices). So it's another piece of the puzzle for us to consider as we try to determine where in the cycle we're currently located.


The Most Profitable 4 Letters in Trading

Master them with Hotstix QQQ Trader. We'll show you exactly when to buy and sell the QQQQ and turn you into a master trader who knows how to cut your losses, nail short term gains and rack up some incredible profits.

30-Day FREE Trial:


Economic reports
The only report on Friday was for existing home sales which were a disappointment after the big improvement to the new home sales we got on Thursday.

Existing Home Sales
After the upside surprise in new home sales on Thursday, existing home sales disappointed. Sales fell -2.6% in April to a seasonally adjusted annualized rate of 5.99M. This is the slowest pace in the past 4 years and slower than the 6.13M (for a -0.2% decline) that had been expected. April's sales were down -10.7% as compared to a year ago. Also dropping again was the median sales price--down -0.8% to 220,900 from a year ago. Not helping the sales prospects was news that the inventory of unsold homes on the market is up +10.4% to 4.2M which is an 8.4-month supply, the highest in 15 years. So sales were down roughly 10% while inventory was up roughly 10%. Not a good combination looking forward.

The past two week's housing numbers point to a problem that continues and will likely continue for quite a while. The prior week showed housing starts increased in April from the previous month and while the new home sales number was up it's still not enough to keep up with the new supply coming onto the market. Here's a chart showing the rate of new home completions as compared to sales since 2001:

New Home Completions vs. Sales

This chart shows the period between 2001 and 2005 to be in a good balance between supply and demand between new homes being built and sold. But since 2006, even with fewer homes being built, the drop in demand has created a glut of new homes on the market. While new home construction was up in April the number of permits issued for new home construction dropped and this chart shows why, and why new permits will very likely continue to drop over time.

Demand for new homes continues to drop faster than the new supply coming onto the market. Even though new construction is dropping over time it continues to run about an annualized 100K over demand so the excess inventory problem will likely be with us well into next year. The latest numbers were 1.528M housing starts in April. If history is to be our guide we should not expect a bottom for the home builders until housing starts are below 1M. Because of the bubble we had in home building I suspect the drop will be even greater this time around. I'll keep saying it until I see evidence to the contrary--the housing market and home builders' stocks are a long way from the bottom.

With this week's bearish key reversals let's see what the charts look like. From a daily perspective it doesnt look like anything other than a blip in the uptrend. It certainly makes it hard to justify a call for a top to the market. But all big moves start out small and the small move is what I'm trying to identify.

DOW chart, Daily

It was a light volume day on Friday, and the day before a 3-day weekend which is typically bullish, so it's hard to tell whether or not it has much meaning. But after the drop into Thursday's low, which completed a small 5-wave move down, I had pointed out on the Market Monitor at the end of the day on Thursday that I expected a corrective bounce on Friday and into next Tuesday. So far that looks to be playing out. The bearish divergences on the daily chart, oscillators rolling over, the bearish key reversal week, breaking the uptrend line from April, and the impulsive 5-wave decline into Thursday's low all continue to point to a top for the market on Wednesday. Remain short the market against last Wednesday's 13624 high.

The 30-min chart shows the bounce potential for Tuesday.

DOW chart, 30-min

After the sharp drop from last Wednesday to Thursday's low it would appear it's in the middle of a 3-wave corrective bounce. A break below the short term uptrend line from Wednesday's low would be a good indication that the correction is finished. I show two Fib projections for the 2nd leg up--13507 (62% of the 1st leg up and tagged on Friday) and 13542 (equal to the 1st leg up). The higher Fib projection is near a 62% retracement of last week's decline (13548) and therefore this area makes for a good upside target if the bounce continues on Tuesday. Watch that level for a short entry. The next leg down, wave-3 on the chart, should be very strong.

SPX chart, Daily

SPX has all the same sell signals as I mentioned for the DOW. In addition to those mentioned it also fell back inside the parallel up- channel from July 2006 after rallying above it. The bounce stopped at the top of the channel on Friday. If last week's decline was just a correction within the rally then I see potential to rally up to 1538 and then a higher Fib projection at 1565. I don't believe we'll rally higher but don't argue with price--stay short against a new high. Assuming the top is in, look to get short the bounce that started on Friday.

The SPX 30-min chart looks very similar to the DOW's:

SPX chart, 30-min

Another leg up on Tuesday should complete the 3-wave correction to last week's decline. Two equal legs up from Wednesday's low is at 1521.92 which is right on top of a 62% retracement of the decline. Many people feel a 62% retracement is "excessive" and means it will continue to head higher. But 2nd wave corrections, as this should be, very typically retrace that much. It's why they're nicknamed "sucker" waves--they suck in the bulls (in this case) thinking they've once again successfully bought the dip and will ride the market to new highs. Then when most of the buyers are convinced they were brilliant to buy the dip (and weaker short sellers have been stopped out) the selling hits again. All those new buyers then scurry to cover and short sellers scurry to get back in short and it's one of the reasons why the 3rd wave is so strong.

So if the bounce makes it up to 1522 I'd watch it carefully for a short entry. The stop has to be at a new market high but anything over the 78.6% retracement near 1527 would have me exiting short plays. It's also possible the bounce will not make it as high as 1522 based on how the 2nd leg is progressing. Perhaps a 50% retracement near 1519. A break of the uptrend line from Wednesday would be a good clue that the bounce is over.

For all you OEX traders, its daily chart is also a good setup for the short side (bear call spreads):

OEX chart, Daily

Similar to the World MSCI chart I showed above you can see a nice 5-wave advance off the October 2005 low and it stopped right at the top of its channel. As I had mentioned above, the completion of a 5-wave move like this means the coming decline will break below the channel. In the larger (weekly pattern) this 5-wave advance completes the 3-wave correction to the 2000-2002 decline.

To keep things in perspective for this rally, here's the weekly chart to show where that 5-wave rally fits into the larger pattern:

OEX chart, Weekly

After the high in 2000 we need a very large bear market correction to the 1982-2000 bull market (it could be relatively quick 3-wave move down or stretch out sideways as it did in the 1970s). The 2000-2002 decline, labeled wave-(a) on the chart, is the first leg down. From there we needed a 3-wave correction of that decline, labeled in bold A-B-C on the chart, to complete wave-(b). This will then be followed by another leg down as wave-(c).

The wave-(b) "bounce" off the 2002 low has certainly taken its sweet time but I think it just completed. For the move up from the low in 2002 we've had wave-A up, a sideways triangle wave-B and since October 2005 the wave-C (this is the 5-wave move up in the parallel up-channel shown on the daily chart). All c-waves are 5-wave moves and this is why it's been so important for me to identify the end of the 5th wave.

This is how significant this high is--it will kick off the next bear market leg down. Are you ready for it?

Taking a longer term view of the Nasdaq also shows it tagging the top of its parallel up-channel for price action since the January 2004 high. Notice a common theme about now?

Nasdaq (COMP) chart, Weekly

The rally from 2002/2003 isn't nearly as "pretty" on the techs as the other indices and this only reinforces my belief that the 2002-2007 rally has been only a correction to the 2000-2002 decline. The fact that the DOW has made a new all-time high in inflated US dollars (but not when measured in euros or gold) doesn't change that interpretation. What does matter to me is that the Nasdaq has tagged the top of its channel with bearish divergences against the new price highs since November 2006 while at the same time I'm seeing some good sell setups on the other indices. This week's candlestick looks like a version of a bearish harami cross and this is a bearish reversal signal.

We've often heard that you want to see the techs leading a stock market rally. A rally in the techs, and other smaller high-beta stocks (those with higher volatility and hence outperformers in a rally, and decline), is usually a good indication of the bullishness in the stock market. So without the techs leading the charge in a rally you should be suspicious. This next chart compares the strength of the Nasdaq to the S&P 500:

Relative Strength (RS) of Nasdaq (COMP) vs. SPX chart, Weekly

This is a weekly view to show how the tech stocks have either led, or not, during the stock market swings. No surprise, they clearly led the way higher from 1998 to 2000. They certainly led the way lower from 2000 to 2002. Remember, this chart doesn't show direction of either the Nasdaq or SPX but only relative strength. Therefore when the line is dropping it means the Nasdaq is underperforming SPX. They could both be heading higher but the Nasdaq would not be leading the way if the RS line is dropping. With the line sloping downward since the 2003 high it's another sign that the bounce off the 2002 low has only been a correction to the 2000-2002 decline and not the start of some longer term bull market.

The line is now approaching the uptrend line from 2002. I expect that uptrend line to be broken and when it is it will be confirmation that once again the techs are leading us to the downside. On the other hand if that uptrend line were to act as support and the RS line rallied up and broke its downtrend line from 2004 then we'd know we're in a more bullish market. I'll believe it when I see it since there are too many other bearish signs confronting us.

Nasdaq-100 (NDX) chart, Daily

NDX broke its uptrend line from March during the Thursday decline, and bounced back up to it on Friday. Could be a kiss goodbye in the making right there. But if it can bounce a little higher on Tuesday then it might be able to make it back up to just above 1900 for another test of the trend line along the highs since January 2004, which is close to a Fib target as shown on this 30-min chart:

Nasdaq-100 (NDX) chart, 30-min

Two equal legs up for a 3-wave correction to last week's decline would take NDX up to 1901.91, just shy of a 62% retracement of the decline. So watch for that potential setup. But the short term pattern has me thinking it may not get quite that high. First there's the broken uptrend line from March near 1895, just above the first Fib projection for the 2nd leg up (62% of the 1st leg up) at 1894.10. If the bounce continues to chop its way higher into mid day on Tuesday then the broken trend line will be closer to 1896. I've drawn in a small ascending wedge (light red lines) for the 2nd leg up in the bounce and this is common to see. If that pattern continues to hold then it's quite likely we'll see the broken uptrend line hold as resistance in which case look to short it there.

Russell-2000 (RUT) chart, Daily

The RUT is showing the same sell signals as the others even though it didn't give us a bearish key reversal for the week (thanks to the strong rally on Monday and Tuesday). I show bullish potential back up to the top of its wedge pattern but my preferred EW count is the bearish one which is looking for the bounce to fail on Tuesday and then continue lower. Stay short this index against Wednesday's high (although 840 would be about my personal limit).

Russell-2000 (RUT) chart, 30-min

The broken uptrend line from March, two equal legs up off the Thursday low and a 62% retracement of the decline all line up around the 835-836 area for Tuesday morning. I'd short that area with a stop just above 840 as it would be one of the better setups you'll find.

Semiconductor Holder (SMH) chart, Daily

Since my last update on this chart the semi's dropped lower and SHM came very close to testing the top of its sideways triangle pattern from 2006, currently near 35.80. This is also the location of its 50-dma so watch to see if this area offers some support over the next few days. If it consolidates near 36 it will likely break down. If it drops right through that support level then it will likely become resistance on any subsequent bounces. I think the battle lines are now 37 and 36 and we'll let the market tell us which side will win. Going back to that relative strength chart I showed between the Nasdaq and SPX, I suspect a break of the uptrend line on that chart would be accompanied, if not led by, the semis breaking down.

BIX banking index, Daily chart

The break of the uptrend line from April is likely the sign that the rally in the banks is finished. As with the major indices, I'd say you want to be short the banks against last Wednesday's high. If this manages to push back up then it will probably do it right underneath its broken uptrend line and possibly get up to a double top at 415. I would expect the bearish divergences to continue if that happens. But until this manages to push back above 408 I'd say this one is heading lower.

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

The traders in the home builders got whipped pretty good last week. Between Secretary Paulson's call for a housing bottom and the new home sales numbers, the shorts ran for cover and new buyers were eager to buy the "bottom". Then the buying spikes stopped on a dime and reversed right back down for negative closes on the day. That's what makes it look like it was short covering more than anything else. Flaming shooting stars were left in its wake on Wednesday and Thursday and then Friday was more of an indecision day (light volume) but still negative. Each of those two rally days I was thinking it could tag its Fib level near 692 but each day failed to make it. It's still possible, perhaps even a bounce up to its downtrend line near 700, but price action the past week makes it appear now that it won't happen.

Oil chart, ETF (USO), Daily

Oil (USO) was looking ready to make a move up but the sellers took over and drove price back down inside its down-channel. The move down from the April high hardly looks impulsive and has me wondering still if it's going to get another rally leg out of this and for that reason I can't get real bearish oil here. But as long as that down-channel holds I certainly wouldn't get bullish.

We've had a disconnect between oil stocks and the price of oil since early April where the price of the commodity has declined while the price of the stock index continued to climb, quite sharply in fact. There is a disconnect here and it doesn't bode well for the stock index.

Oil Index chart, Daily

I show the possibility for one more small leg higher in the oil stock index, perhaps for another tag of the top of its up-channel, but it's definitely in the twilight of its rally from an EW perspective. After a 5-wave move up and tagging the top of its up-channel the next big move will be a break down through the bottom of its channel, either from here or after a minor new high. After Friday's bounce any drop back below 717 now would confirm the high is in. Protect any long positions you have in this index if that happens. A break below 680 would confirm the end of the rally.

Transportation Index chart, TRAN, Daily

After showing the small ascending wedge pattern on Wednesday for price action in May the Trannies broke down out of it and of course broke its uptrend line from March in the process. After the bearish divergences at the May highs and now breaking its uptrend line this is a sell signal. While it could work its way higher to perhaps 5300 it would likely just be a better short setup.

After showing you the relative strength chart of the Nasdaq vs. SPX I thought it would be interesting to look at the same thing between the TRAN and DOW since DOW Theory requires confirmation between the two.

Relative Strength of TRAN vs. DOW, Daily

If the DOW is chugging higher we want to see confirmation with the Trannies chugging higher with it. It confirms that business is good (shipments are healthy) and that helps justify the continuing rally in the underlying stocks. I provided some data in Wednesday's Wrap that showed a slowing in railcar and truck shipments in the past year and that it doesnt support a continuing rally in the stock market. The continuing rally in the stock market has been proof positive that emotions drive the market and not the economy.

So the fact that the line on the chart has been trending lower since the February high says the Trannies have been underperforming the DOW. In other words we're not getting the confirmation of the DOW's new highs. This is not a timing tool but more of a heads up that something smells fishy about the rally since the Feb-Mar decline and that it's more than likely a momentum run that will end badly.

U.S. Dollar chart, Daily

The rally in the US dollar from its April low is funky. That's that technical term meaning I don't know how to count it. It looks choppy and corrective and has me thinking it's just another corrective bounce that will fail and we'll see the dollar turn back down and make another test of the bottom of its descending wedge (at the Fib projection near 81). That would likely give gold a boost back up. But as long as the up-channel holds then the dollar remains bullish (and gold bearish). Obviously the dollar needs to break its downtrend line from March 2006 to confirm it's into a new leg up, which should take it back up towards 95 over the next year or so.

Gold chart, StreetTrack Gold ETF (GLD), Daily

Gold (GLD) continues to have relatively small bear flag corrections and then drops a little lower, small correction, drop lower. It's currently in another small bear flag from its Thursday low and I expect it to drop lower again. Its downtrend line is currently near 65.20 so a little higher on Tuesday would set up another shorting opportunity. Until I see something that changes the picture I expect GLD to head down to its uptrend line from July 2005 where it should also meet its 200-dma near 63. Multiply by 10 and add about $6 to get the price of the actual metal. The setup here continues to support the view that gold and the stock market remain in synch.

Tuesday and Wednesday will be relatively quiet as far as economic reports go:

I doubt we'll have much in the way of market moving reports for the early part of the week. Other than maybe an earnings update or two, there just won't be a lot to drive the market, leaving it on its own. Could be trouble. But then the pace picks up considerably for Thursday and Friday:

There's enough in there to get lots of people either excited or worried about the state of the economy. Mix in a little end-of-month activity (either buying or selling, depending on what the fund managers are trying to accomplish) and we could get some fireworks and a little volatility. Depending on how the wave pattern is set up by the end of the day Wednesday I'll offer my best guess in Wednesday's Wrap about how I think the market will react the rest of the week.

SPX chart, Weekly, More Immediately Bearish

The weekly chart of SPX is by now familiar looking, especially after discussing the OEX chart earlier. The completion of the 5th wave for the rally up from October 2005 did a little throw-over above the top of its up-channel and then closed back below it this week. So we have that sell signal along with the bearish key reversal week. It seems early in year for it but this pattern says we're going to see some strong selling this summer.

So we've got a plethora of signals that tell me the market has topped and that you should be looking for opportunities now to sell the rallies (and certainly protect long positions). But it doesn't mean the signals are 100% guaranteed. Stops are extremely important when trying to pick tops (or bottoms) as the market is usually being driven by momentum at that point and it can continue far longer than one would think possible. I rely on EW patterns and you can see on my charts that they're littered with wave counts. The thing to remember is that it's just another tool and when I'm counting a 5th wave completion it's a good setup but we need to see confirmation that it was in fact the completion of the 5th wave (with a break down below the 4th wave bottom). The reason is because 5th waves can "extend" higher. That's why I'm making the recommendation to be short the market against last Wednesday's highs.

If this market rallies this coming week, which would actually be typical for a month-end run and into the first week of June, then the setups I've been talking about on the charts will have been busted. But that's what we do--we look for and trade our setups and then use appropriate stop levels to protect our accounts if the setups are busted. It doesn't mean we were wrong (OK, maybe a little), it just means the setup didn't work. It's the cost of doing business. Look for the next one. A new bus comes by every day to offer you another ride.

So if the market rallies higher then I'll simply be looking for the next place for the market to fail which probably won't be much higher since the 5th wave we're in shouldn't extend much further. Rallying higher underneath broken uptrend lines seems to be a favorite thing this market likes to do. If it does that I'll try my best to follow it from an EW perspective and if I miss the top then I'll follow price action up with a shorter term uptrend line--break it and I short it. Simple, no?

So that's my warning for where we are--I like the short side here and do not like the long side even if the market presses higher. When the break comes, either Tuesday/Wednesday or after new highs, it will come very quickly and I just don't like the risk:reward for a long play. But then I'm looking more for swing and position trades and not day trades. But listen to the market and don't argue with price. Take your shots, place your stops and sit back and let it work, or not. Let's see if we get a little more bounce on Tuesday to set up the short play.

If and when price breaks back below Thursday's low then we have a good short term confirmation that we've probably seen the high. I'll follow it the best I can on the Market Monitor and I'll be back here on Wednesday where I hope we'll have that confirmation and we'll set up some longer term plays. Good luck and see you then.

Market Wrap Archives