Option Investor
Market Wrap

One and Done

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I (Keene Little) want to thank Linda for switching nights with me as she took last night since I was just arriving at my destination after a long cross country road trip and hadn't quite set up my "eastern office" yet.

It was another one of those one and done kind of days--shoot higher in the first part of the morning and the rest of the day is nothing. These kinds of days are maddening to try to trade for an intraday trader because the only way to do it is to close your eyes on the first move up in the morning and hope it keeps going. You of course know what rhymes with hope when it comes to the market. I'll give you a hint--it's one of the dwarves in the Snow White story. It's also what happens to your account when you trade with hope--it gets dwarfed by larger losses.

Traders wait for a pullback (in the case of a ramp up) which are typically very small to non-existent and so never manage to get on board. Then the pullback finally happens and your trade sits there as the market goes sideways. You then get antsy and start chasing the micro-moves only to get whipped out of your trades because your stops are too tight. Maybe that's only happened to me (wink).

I had mentioned on the Market Monitor this morning that today would probably be a bad day to trade because I expected to see a consolidation day before pressing higher on Friday. I don't see any significant change to that expectation (rally on Friday after a brief morning dip) but there are a couple of things that happened into the close that have me wondering if we're topping out in the bounce off last week's lows. I'll cover all that in the charts.

As most of you know, I like to look for repeating patterns in the market as they tend to repeat again. They're called fractal patterns and my EW (Elliott Wave) analysis is based on the same phenomenon where these repetitive patterns can be very good at forecasting where the market goes next. It is of course not fool proof, as no technical indicator is, but it helps improve the odds for seeing something happen. And at the very least when the pattern doesn't follow through then you know the market is clearly doing something different this time.

I've mentioned similar patterns in the past that are being duplicated this year, primarily with the strong rally we've had since July 2006 and what the market had done before that. There are many similarities to the patterns that were seen in both 1929 and 1987, not to mention 1957, 1967 and 1987. In fact each decade since the 1880's has seen a major market correction (if not crash) during the 6th or 7th year. We didn't have one in 2006 so...


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But that's all speculation about what could happen this year. For now I'm sticking with the short term charts in an effort to identify at least short term tops which could then turn into longer term tops. On the Market Monitor I've been calling for an additional rally, including a good possibility for tomorrow, but as I've mentioned before, I think the risk is clearly on the bulls' side now and I'm not comfortable recommending long plays to anyone who can't watch the market every day now. And that's why I'm looking for potential tops.

With the big move in yields in the past month it has certainly sparked fears in the hearts of the bulls (not that you'd know it by the continuation of the bull rally). Here's a look at the updated daily chart of the 10-year Note:

10-year Yield (TNX) chart, Daily

Note that the yield jumped up to the Fib projection based on the first leg up from the December low (2nd leg up from March hit the 162% projection). This could result in a much deeper pullback from here but as I've depicted on the chart I think we'll see a sideways/down choppy consolidation over the next month before getting another leg higher. I'm speculating about the pullback and next high but I'm showing on the chart the next high will be around 54.35 (5.435%).

The weekly chart puts this move into perspective:

10-year Yield (TNX) chart, Weekly

I show yields from the January 2000 high and the important point here is that I believe the bounce off the March 2003 low has only been a correction of the initial decline (sound familiar?). The ascending wedge pattern should be bearish and I think Bill Gross was right when he initially said the 10-year should peak around 5.5%. Now he's saying 6.5% but I don't think so, based strictly on this EW pattern. He knows a LOT more about economics and all the fundamental reasons why rates should do what they'll do. But I had been calling for higher rates when most of the bond market was looking for lower rates. I felt the bond market was going to be surprised soon and we'll get a spike up in rates.

Now I think we'll get a small pullback consolidation followed by the push higher to the 5.5% area and top out. From there I think we'll see a strong rally in bonds and drop in yields--eventually below the March 2003 low. Very likely we'll see the Fed once again chasing their tail, er I mean the market lower and be aggressively dropping rates right behind the bond market.

While on the subject of bonds, their prices peaked in December 2006 (rates found their lows) and have been selling off ever since (and yields have been rising). An interesting observation that a reader sent to me (thanks John) fits in the same category of past patterns that we should pay attention to. John writes, "I was reading an interesting article in which the author was pointing out that the rally in bonds in 1987 ended about six months before the market crashed in October of that year. Our bond rally ended in December 2006. Six months would put us in June if history repeats."

And oh by the way, the first important Bradley turn date for 2007 was today, June 14th, +/- 1 day. Just an FYI.

Economic reports
Thursday was relatively quiet as far as economic reports go, with only unemployment claims and PPI data. The PPI data has the ability to move the market but there were no surprises in the data.

Initial Claims
The number of new claims filed was unchanged from the previous week, remaining at 311K. The 4-week average rose by 3,750 to 311,250 which was a 5-week high. Continuing claims dropped by 43K to 2.487M while its 4-week average also rose, up 4K to 2.501M. Initial claims are down about 1% from last year at this time while continuing claims are up about 3%. The first reflects job destruction and the second reflects how difficult it is to find a new job.

PPI and Core PPI
PPI rose +0.9%, greater than the +0.6% that had been expected. Energy prices led the way with a +4.1% increase (the biggest increase in 6 months). Wholesale gasoline prices were up +10.2%. The good news for consumers is that food prices dropped -0.2%, led by a huge -35% drop in vegetable prices. Load up on them veggies! That was the biggest drop for vegetables in 5 years. Unfortunately dairy prices rose +4.5% (and I've heard recently that milk prices could double or more in a few months). There is still the belief by many economists that we're not going to see the higher energy prices translate into higher core PPI but that remains to be seen, especially if oil continues to rally higher (it broke up out of its down-channel today).

The closely watched core intermediate goods prices, a measure of inflationary pressure in the supply pipeline, are up +2.9% in the past year, the lowest rate in more than 3 years. But it remains higher than the Fed's comfort zone of 1%-2% so they'll remain on inflation watch.

Now let's take a look through the charts, starting with the long view with a DOW monthly chart:

DOW chart, Monthly

From an EW perspective the rally from October 2002 can be counted two ways but in the end it doesn't matter much because they both will end similarly. My preferred count shows it as an A-B-C move up and it has two equal legs (wave-A = wave-C) at 13712.60. Last week's high came within 20 points of that level. If the current leg up makes another stab higher then it will probably be exceeded but it's interesting that the short term wave count looks to be finishing at this long term Fib projection level. And the monthly candlestick (so far) looks like a hanging man doji at that Fib resistance level.

DOW chart, Daily

I show a completed 5-wave move up from the March low. Each 5-wave move gets a correction of that move so the only question here is whether last week's high was the end of the 5th wave or if we have one more new high to give us the 5th wave (the green count). If last week's high was it, then this week's bounce is simply a correction of the decline from last week's high, and that's my preferred wave count at the moment. That's shown a little better on the 60-min chart:

DOW chart, 60-min

Since the decline into last Friday's low we've got a 3-wave correction to that decline. It could certainly turn into something more bullish but right now it's counting out well as just a big correction to the decline (one that has many turning very bullish in thinking that it was just another dip to buy). By this pattern I'm looking for a quick move down on Friday (perhaps as a reaction to the economic data coming out) followed by another rally leg. In other words it could be a bear trap. The upside potential is to about 13600 where I'd look for a shorting opportunity (an excellent one if this bounce will be followed by a 3rd wave down next week). That would be a MOAP opportunity (mother of all puts).

There is a way to call a high today so it will take some careful observations of tomorrow's move to try to determine what's playing out. See the SPX 3-min chart below for a better description of that possibility.

SPX chart, Daily

The daily chart (sorry for the mess of lines, numbers and Fibs all over the place--looking for a lost top here) shows the same setup as the DOW. The bounce has taken price up to the mid line of the up-channel from March, a natural resistance level after a top has been found. If this has topped out then SPX should stay below 1532--any higher and I'd say there's a very good chance we'll see it head to new all-time highs. In the more bullish case the 5th wave up (starting at last week's low) would equal the 1st wave up (off the March low) at 1561.12. But any break back below 1493 would just about nail the coffin shut on this bull market rally.

SPX chart, 60-min

I highlighted two places on the 60-min chart to show a potential fractal pattern playing out. The first, on the left side of the chart, shows the choppy rally into the June 4th high which was followed by the steep decline into last week's low. Now we have a similar pattern that played out today. Therefore the risk is that today's high was the end of the bounce (shown better in the 3-min chart below) and we'll see an immediate sell off tomorrow.

But the risk here is that the consolidation pattern from this morning's high requires a sharp leg down to finish it and then another rally leg higher (shown in dark red). Ideally that's what we'll see--a quick drop in the morning followed by another push higher that tags the broken uptrend line again near 1529.

SPX chart, 3-min

I show an ascending wedge pattern for price action since this morning's low. Because of the potential fractal pattern playing out, similar to the one into the June 4th high, this would be immediately bearish tomorrow, especially since it broke down from it into the close. If it drops much below 1517 then I'll be getting more bearish but until then I'm looking for the sharp drop down to get reversed and head higher again. The DOW's pattern better supports this short term bullish expectation.

Nasdaq-100 (NDX) chart, Daily

The pattern in the NDX isn't nearly as clear since it's basically been going sideways for the past month (another sign that it's been underperforming the blue chips). It's flopping around uptrend lines like a dying fish. The important levels to watch at this point are 1960 to the upside and the recent low at 1888--follow the break of either.

Nasdaq-100 (NDX) chart, 60-min

The bounce pattern since last week's low is the same as SPX and DOW and therefore they're all in synch at the moment. I expect the same thing here--a quick spike down tomorrow morning followed by another rally leg. It can't exceed the previous high near 1940 otherwise the pattern turns more bullish. So short any further rally against the June 1st high.

Russell-2000 (RUT) chart, Daily

The RUT also broke its uptrend line from March and then recovered back above it. If the RUT, like the others, can push a little higher then trend line resistance and a couple of Fibs point to 844 as the upside target as shown in the 60-min chart.

Russell-2000 (RUT) chart, 60-min

The type of 3-wave bounce from last week's low (expanded flat correction in EW terminology) points to 844 for the current leg up. This is right on top of a 62% retracement of last week's decline. And it's at the broken uptrend line along the lows from May. I like the setup for a short play there.

NYSE (NYA) chart, Daily

I showed this chart last week to show the fractal patterns between the run up to the February high and the one to the June high. Now the decline has dropped price below the bottom of a parallel up-channel and has come back up for a retest of it. Even though that lower uptrend line is not a true uptrend line I've seen it act as resistance time and again. Today's high, or a little higher on Friday, makes for a good spot for the end of the correction to the initial decline.

NYSE vs. New 52-week highs, Daily

Looking at an update to the NYSE vs. new highs chart shows a quick spike higher in new highs at the June high and then a quick collapse back down. The 20-day moving average shows the bearish divergence. This continues to look like a classic short play setup.

Semiconductor Holder (SMH) chart, Daily

The semiconductor stocks got a bigger bounce than I expected to see after it marginally broke below the support line at the top of its consolidation pattern from last year. But there is a way to count the corrective bounce since the end of May that has a projection up to 37.40 for the end of it, which was tagged today. But the overall pattern is unclear at this point and I see an equal possibility for the rally to continue higher, to new highs. If that happens then I'm sure the broader market will be following.

Before looking at the banking index, just a brief comment on the financial reports from the Big Banks this week--Goldman Sachs and Bear Stearns have both mentioned that the persistent subprime mortgage problems have had a negative impact on their bottom line and will continue to for the foreseeable future. But not to worry since the subprime problem is self-contained. Goldman's CFO said the subprime problems are not over and to expect "more pain" before the problem is purged. The reduction in market activity is rippling through the financial industry since repackaging and selling of debt portfolios is not nearly as easy or lucrative as it had been.

In fact Bear Stearns has a hedge fund called the High-Grade Structured Credit Strategies Enhanced Leverage Fund (first thing I'd do is shorten that significantly) and they're scrambling to sell about $4B in mortgage-backed bonds in order to raise cash in anticipation that they'll need to meet investor redemptions. The $6B fund has dropped -23% in value this year alone. And now with higher rates and more mortgages in trouble I'm not so sure they'll find eager buyers for that debt, which will likely knock the value of the packages down significantly.

The banks have been leading the way to the downside, or at least not participating in the rally to new highs in the broader market. They're still looking weak here:

BIX banking index chart, Daily

After breaking down from the bounce high in May, the banks have been attempting to bounce back up with the broader market. If the broader market is able to put in new highs then I suspect the banks will grudgingly follow and could even make it back up for a retest of the February high. Any break back down below 395 will likely see some swift selling.

Mortgage rates rose in the past week (naturally with the increase on the 10-year yield) with the national average on the 30-year fixed at 6.74%, up from 6.35% last week. This is the highest level since July 2006. The rest of the rates rose as well--the 15-year, a popular refinancing choice, is up to 6.43% from 6.22%. The 1-year ARMs (still surprisingly popular) are at 5.75%, up from 5.65%.

The trouble of course comes for those who are already in financing plans that will reset soon and with rates increasing rapidly there will be a lot of pain felt by those who get hit with large monthly payment increases. Jim did an excellent job in his Tuesday Wrap outlining the challenges for home owners and the home market in the coming year.

While we're still getting many "bottom" calls for the housing market I'm seeing more and more analysts recognizing reality about realty and saying we shouldn't be looking for a bottom until sometime next year. I like the way Frank Nothaft, Freddie Mac's chief economist put it, "Higher mortgage rates may weigh on the housing market's gradual recovery." The phrase "gradual recovery" is being used instead of "continuing decline before recovery". That's like when Greenspan wouldn't use the 'D' word (deflation) but instead said "significant slowing in inflation". Whatever floats your boat. I like to say it so people understand what I'm saying. So I'll say it again--the housing market is a long way from finding a bottom.

Also troubling the banks is the amount of money they have to set aside, in reserve accounts, for bad loans. They've been very lax over the past several years and it may catch up to them. Here's a chart showing the percentage of real estate loans held by banks and the reserves they hold against those loans:

Real Estate Loan-Loss Provisions at U.S. banks

As you can see, the loan-loss provisions at U.S. banks are historically low at a time when banks are more exposed than ever to real estate loans. This is not a healthy combination when you see what's happening in the mortgage market. As soon as banks start to increase their loan-loss provisions they will be reporting greater losses and/or a drop in their earnings as they build up their reserve accounts. This is probably one factor for the relative weakness in the banking sector today.

And with that let's look at the home builders:

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

The pattern of the move down from the May high supports the idea that this index could get another bounce back up and as depicted in light red (pink), it could rally back up for a test of its 50-dma and broken uptrend line from April. But it's equally possible that we'll see this index continue to sell off right from here.

Oil chart, July contract, Daily

The down-channel in which oil has been chopping lower was broken convincingly today, and took out last week's previous high. Unless we're going to see a larger sideways consolidation it looks like we should expect higher oil prices from here.

Oil Index chart, Weekly

This weekly chart is shown this week to give some perspective for the rally from 2003. It's got to be one of the ugliest looking rallies I've seen--there's so much overlapping chop in there that it's been threatening to break down for quite a while. But now with the strong leg up since March you can see price has tagged the top of the parallel up-channel. The weekly oscillators are as overbought as they've ever been. So I'd say the risk is on the bulls' side now--this will likely correct from here. If it does just a sideways/down correction then I'll be looking for it to head higher again. The risk is another big red candle like the one in mid 2006.

Transportation Index (TRAN) chart, Daily

The internal Fibs for the bounce pattern off the June lows suggest the Trannies may have topped out in the bounce correction. The next big move should be down. But if it manages to rally a little higher then watch for resistance around 5250 where it could retest its broken uptrend line from May.

U.S. Dollar chart, Daily

If you're a dollar bear don't look now but I think it's breaking its downtrend line from March 2006. Either that or its a small head fake break (bull trap) and it'll drop back down to a new low from here. The bounce off its April low is only a 3-wave bounce so any drop back below the last pullback in early June would be a bearish move.

Gold contract (August), Daily chart

With the US dollar breaking its downtrend line from March 2006 (just barely so far) that could spell further trouble for the metals (and other commodities, including oil). As the chart for gold shows, it's now in a down-channel and the current bounce has been struggling with the broken 200-dma (kiss goodbye?). I'm always leery of an EW count that shows multiple sets of 1st and 2nd waves (each in one degree smaller wave pattern) since more often than not it's a corrective wave structure instead.

So what that means here is that gold has either been pulling back in a corrective pattern which says we should look for a rally out of this soon, or else the bearish wave pattern is set up for a very strong sell off right around the corner. It could drop $50 in the blink of an eye. It takes a rally above 670 to break the downtrend otherwise I suspect it will easily break below the current down-channel.

The weekly chart shows what I'm expecting to see for the move down in gold:

Gold contract (August), Weekly chart

The pullback that started in May 2006 should get another leg down, which is what I show on the chart. Two equal legs down gives us a downside target of 514.20. If it gets more bearish than that then the next Fib projection is near 400.

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

Friday will be a busy morning for economic reports. The NY Empire Index, Industrial Production and Capacity Utilization all reflect economic growth and inflationary pressures. They all have the ability to move the market. The CPI data for obvious reasons could spook the bond market which is already on edge. So be careful about any early spike move--it could be a head fake or overreaction.

The CPI is expected to rise 0.7% for overall inflation, and 0.2% for core inflation excluding food and energy prices. It would be the second largest increase in the CPI in the past 16 years. The higher energy prices and other factors have been increasing the pressure in the supply pipeline so Friday's CPI might contain an upside surprise. If that happens then it would clearly confirm the Fed's inflation concerns and the bond market could sell off on the news (spiking yields). That in turn could spook the stock market to sell off as well. The Fed likes to watch the personal consumption expenditure price index (PCE) which won't be released until the end of the month.

SPX chart, Weekly

The drop last week in the SPX has turned the oscillators down and we've got a sell signal with the crosses. Whether that leads to further selling after the current bounce finishes or instead after a minor new high is the question tonight. If we do get the new high then the weekly Fib projection for two equal legs up from October 2002 is at 1562.80 and makes for a good target (and a new all-time high).

To wrap this up, the short term patterns suggests a quick drop in the morning, which likely be a reaction to the economic reports. Then the market should turn right around and rally higher to finish off the bounce from last week's low. The new high is when and where I'd be looking for an opportunity to short the market. I believe we have a MOAP here--a mother of all puts opportunity. Shorting the market against last week's highs makes for a low-risk entry.

It's possible we could just chop our way higher which would potentially top out sooner rather than later tomorrow. It's also possible we saw the high for the bounce just before today's close. But in my opinion those are both lower odds scenarios. Let's hope for the drop-bounce scenario so as to set up a great shorting opportunity into next week and beyond. Good luck and I'll follow it closely on the Market Monitor for those who can watch. Be back here next Wednesday.

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