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Drop n Pop

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The stock market did a mirror version of the gap n crap move and caught the bears asleep at the switch. It was stealth rally at first with a very choppy move higher this morning. It looked just like another bear flag and the bears were only too happy to short it. The noon pullback then set the trap and the afternoon rally sprang it. All the way into the close you could hear the bears whining "not again". Masterfully done I must say.

The above table shows the strong market breadth with advancers all over decliners today. The new 52-week lows beating new 52-week highs is interesting. We're still near all-time highs for the major indices and yet new lows beat out new highs. Something smells funny.

The techs and small caps were especially bullish today and their daily charts show very bullish engulfing candles for a key reversal day (open lower, make a new low and then close higher). I had been recommending on the Market Monitor to look to buy this morning's dip as it looked like it was going to be a picture perfect ending to the descending wedges that were forming over the past week. I'll review that setup in tonight's charts. But as the bounce progressed this morning it started to look bearish and I began to wonder if the bulls could do it this week.

As many of you know, the last week of June is typically bullish and many were beginning to wonder what happened to the rally. In fact it's typically the last half of the week that's bullish, following a down beginning of the week. Assuming the market continues to rally then the rally started exactly at the middle of the week. This afternoon's rally had a bit of the "too much too fast" look to it, especially the techs and small caps so either it was made up primarily of short covering or else the fund managers are trying to stuff their portfolios with the sexier stocks that they know their customers like to see. If it's the latter then there will probably be a hangover in those stocks next week, maybe after the holiday.

As I usually do, I'll show both the bullish and bearish setups on tonight's charts and identify some key levels to keep an eye on in order to help us determine the next move. Basically we're at the edge of the cliff, which we peered over this morning before getting pulled back. Now the market will decide to either climb higher before jumping or make the jump from around the current levels. It could get interesting over the next week or so.

The banks are looking ugly right now (if you're a bull) and that should give all of us some reason to be very cautious about any additional rally. I'll review the banks and Merrill Lynch's (MER) charts since they could be telling us something. In the meantime I recognize the short term potential for this market to rally to a new high. The behavior of the market is amazingly similar to past periods where the rally continued beyond most expectations until it didn't. In other words the sharp spike up over the past year, and since March, is very reminiscent of past blow-off tops and that's what makes me cautious about forecasting new highs.

I came across some interesting information from Jeff Cooper whose analysis and pattern recognition, in both time and price, I've come to respect over the years. I've mentioned a couple of these things in the past but they're worth repeating:

Every year ending in 7 since the mid 1800's has experienced a sharp decline or panic. One could argue we've already had that in the February-March decline but that was a mild correction by historical patterns. Therefore one could easily argue we're still due.

The market tends to move in cycles, from decades long to ones measured in days. You've no doubt heard much about the presidential cycle which is the common 4-year cycle and then half that, so the 2-year cycle. There's a 50-year cycle, referred to as the Jubilee Cycle, and the 54-year Kondratieff Cycle which is currently being skewed by an effort by the Fed to fight the winter portion of the cycle through massive liquidity creation (Greenspan once said he wanted to be known as the man who stopped the Kondratieff Cycle--not too arrogant).

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The 50-year cycle has marked the dates of big moves. The two biggest lows in the 1900's were July 1932 and August 1982, 50 years apart. More interestingly for us right now is the fact that in 1957 there was a brief sharp price correction in February which was followed by a very strong rally into June/July of that year. Following that climb the DOW dropped from 520 to 420 for a -19% correction. The same correction for the DOW today would take it down to just under 11K.

Prior to 1957 was a collapse of the DOW in 1907 from 96 to 53, or a -49% drop. That whole year was down but the bulk of the decline happened in July. And of course 50 years from 1957 lands us in this year, which is the year of the decade that has always seen a major correction.

Following the 50-year cycle is the 20-year cycle (a multiple of the 4-year cycles). July 2002 saw a hard sell off and this followed 20 years after the end of the bear market in August 1982. Before that there was a hard decline in 1962. August of 1987 was the top before the market crash that followed. Twenty years from that date is around the corner.

Many people scoff at cycles but they tend to be accurate enough to require at least paying attention to them. So, regardless of how bullish you might feel about this market currently, just keep in mind that there are some cycles about to complete which could make for a nasty bite for complacent investors. Getting off margin should be priority one right now.

A reason that was given for the sell off since June 1st was inflation fears. This is ridiculous since the market has been rallying in the face of inflation fears. Now all of a sudden it sells off because of it? It's another example of analysts looking for a convenient excuse for why the market does what it does. Could it be investor mood? Nah, there's nothing there the analyst can hang his hat on and make the big bucks with silly explanations. Supposedly the bond market has been selling off on inflation fears as well. But why would gold sell off on inflation fears when exactly the opposite is usually the case?

All the selling we're starting to see is more likely a result of a drying up of credit. I've discussed in the past, ad nauseum, the huge increase in liquidity through the use of a massive growth in credit (debt). Jim did an excellent job again in his Tuesday Wrap in his discussion about the abc's of CDO's (credit derivatives) and I could certainly add a few pages more but his explanation was very good. Reread it if you have to because I think this will be the downfall of the market. Where there's smoke there's fire and where there's one cockroach there are more. Bear Stearns and their hedge fund fiasco with mortgage back securities fits the bill here. And the banks' charts are showing it.

Getting back to stocks, bonds and commodities selling off--it's a result of the credit expansion starting to slow. When it reverses then all asset classes will suffer this time, as will the global stock markets. They've benefitted from the massive liquidity expansion and they'll all suffer from the contraction. The bond market has quieted down after the large drop (spike in yields) but I don't think the selling is done (meaning higher yields to come).

10-year Yield (TNX) chart, Daily

The pullback in yields might be close to finishing, which would be a little faster than I thought. For EW followers, notice the alternation between the 2nd and 4th wave corrections in the rally from March. Wave-(ii) was a flat correction and wave-(iv) looks like it will be a sharp zigzag. This alternation doesn't always happen but it helps identify the wave count when it does. Two equal legs down for its correction from the recent high is at 49.73 which would be a retest of its broken downtrend line from January 2000. Currently I expect that area to hold for support (resistance for bond prices) and then see another rally in yields. Right now I have projections to a retest of the recent high and then up to 54.6. I'm not sure if that will end the yield rally or if a new high will be followed by another correction before pressing higher again. But the short term pattern is still pointing higher.

Today's rally in equities crushed the VIX. People were willing to pay significantly more for put options during the past few days and they couldn't exit them fast enough today. Assuming the rally will press a little higher, it'll be worth watching the pullback in the VIX:

Volatility Index (VIX) chart, Daily

Since last December VIX has been steadily making its way higher. As volatility in price movements has increased so has the VIX. If the stock market can continue its rally then watch for VIX to pull back to its uptrend line since that could very well mark the top of the stock rally.

Economic reports
It was a quiet day for economic reports, neither of which had any impact on the market (no real movement in the futures at 8:30 or stock prices at 10:00).

Durable Orders
There was a surprisingly large drop in durable goods orders, falling -2.8% in May, led by a large (-22.7%) drop in civilian aircraft orders. The expectation for the durable orders number was for a drop of -1.7%. This was the largest decline since the -4.2% drop in January. The slowing in business capital investment dampened the enthusiasm of those who have been saying business investment will continue to power the economy forward. It seems the only thing businesses are really investing in lately are their own stocks or the stocks of other companies. For the year, through May, orders are up 0.5% compared to the year-ago period. This report is not expected to have much of a bearing on the Fed's position.

Crude Inventories
Despite a capacity utilization rate increase for the refineries, from 87.6% to 89.4%, distillate stocks (includes heating oil and diesel) and gasoline inventories had an unexpected decline. Typically refinery utilization rates for this time of year run between 92% and 94% so that's quite a shortfall. Distillate stocks were down 2.3M barrels to 120.4M and gasoline stocks were down 700K barrels to 202.6M. Crude stocks increased (waiting for refineries) 1.6M barrels to 350.9M. The price of oil and oil products jumped higher today on the news.

And with that let's take a look at the charts to see where we go from here.

DOW chart, Daily

The daily chart shows the possibility for the market to have topped out on June 1st or has another high to go before topping out. Based on the short term pattern for the decline from last week I believe the pullback ended at this morning's low. I show a key level for the bearish wave count at 13250--any lower and it will likely be a bearish move. Theoretically the pullback could drop to 12992, the 162% projection for the 2nd leg down in the pullback from June 1st. But as shown on the 60-min chart below, the descending wedge pattern says the pullback is finished. Therefore if the DOW drops back down below this morning's low I would interpret that to mean we'll see a strong decline follow (dark red bearish wave count).

The bigger question at the moment is what happens next. If today's low marked the end of the a-b-c pullback from June 1st then we'll rally to a new high from here (green bullish wave count) for the 5th wave in the move up from March. I show a Fib projection for the 5th wave where it would equal the 1st wave (13793) and if it did it in the same amount of time as the 1st wave took then we should get there by July 9th (7 trading days). I'll be able to update this next Thursday (the market is closed on Wednesday and I'll be taking Linda's Thursday Wrap) and hopefully we'll have a better sense as to which wave count is playing out by then.

The 60-min chart zooms in how the move from here might look over the next few days:

DOW chart, 60-min

For an impulsive move higher for the 5th wave (bullish wave count), we'll need to see the small move off this morning's low turn into a small 5-wave move. That requires a small pullback tomorrow followed by a minor new high and then a larger pullback (shown in green). For the bearish wave count I show a larger pullback (could happen immediately on Thursday or after a minor new high) to be followed by another leg up (for a larger a-b-c bounce) into next week before rolling back over and heading for new lows.

The bottom line is I think you need to be bullish for at least the next few days--look to buy the dip (I'm talking about intraday traders here) but be aware that the rally could end quickly. Keep the exit door ajar. Any bounce from here that is followed by a break back below today's low will be a bearish signal. Until that happens I think the odds are that we'll see the rally to a new high. At the completion of that rally will be the next MOAP setup (mother of all puts).

SPX chart, Daily

The SPX daily chart continues to look very similar to the DOW's. The same analysis holds here--it looks like SPX completed an a-b-c pullback from the June 1st high and now a 5th wave projection from this morning's low (to equal the 1st wave) is at 1557.89. This would get the bulls their new all-time high. They won't like what comes after that but we'll worry about that when the time comes. Just keep in mind that it could be soon. In the meantime, any bounce here followed by another move below this morning's low near 1484 would likely be very bearish.

For another view of where SPX might be headed, which is more bullish than what I show above, this daily chart shows price action for all of 2006 to the present:

SPX chart, Daily, 2006-2007

I want to keep this chart in mind because of the potential for it to be pointing to another rally that goes longer and higher than the daily chart projection above. Based on a potential wave count for the rally from July 2006, it's possible we'll see SPX head for the 1600 area by mid August. The Fibs and trend lines crossing in mid-August is eery when you think about the cycle studies I mentioned in the beginning of this report. The 20-year cycle points to August of this year for a top (20 years from August 1987). Keep this chart in mind when you're planning your longer term trades. I'm not saying this will happen but at this point I can't deny that it could.

SPX chart, 60-min

Again, similar to the DOW's 60-min chart, SPX holds the same potential. Considering the fact that the market often stagnates in front of the FOMC announcement, it would be fitting to see the market pull back correctively into the afternoon and then get a relief rally post-FOMC. That should then be followed by a larger pullback correction (or worse) before rallying into next week. The bulls do not want to see SPX near 1485 again.

OEX chart, Daily

The OEX has tended to trade very well technically and the reason for showing its chart tonight is because it could be the best forecaster for what's to come. Like the DOW and SPX, it looks like an a-b-c pullback correction from the June 1 high completed at this morning's low. A projection for the 5th wave up, for equality with the 1st wave, is at 716.39 and it crosses the top of its parallel up-channel (for price action since July 2006) on July 10th which is very close to equality with the 1st wave in time as well as price (as it typically is). This is the one index that may give us our answer over the next week.

Nasdaq-100 (NDX) chart, Daily

This NDX chart looks like a mess, just like its price pattern. The choppy mess since the beginning of May is just pure ugly (technical term for "difficult to put a wave count on"). So I'm showing a few possibilities. The first, the bearish count (dark red) says we'll get a bounce, perhaps into early next week, followed by new lows; i.e., a top is in. The dark green bullish count shows price continuing higher in a parallel channel into August up to a Fib projection at 2032 (there's that August again). In between is the light green bullish count that shows price chopping its way higher in an ascending wedge (which could also take us into August), topping out at the Fib projection (5th wave = 1st wave) pf 1972.67. I'm leaning towards one of the bullish scenarios until proven otherwise (which would be a drop below this morning's low).

Nasdaq-100 (NDX) chart, 60-min

While it's possible today's bounce was all we'll get before heading lower again (dark red bearish wave count), I'm leaning towards a pullback, either right away or post FOMC, and then a resumption of the rally into next week. The dark and light green price paths are a closer view of what is shown on the daily chart.

Russell-2000 (RUT) chart, Daily

Like the NDX the RUT is pure ugly. Just look at that choppy mess over the past two months. Good volatility if you caught the moves right. Great for credit spreads if you had your spreads above and below the range. But as far as figuring out direction from here it's almost a coin toss. But the pattern as of late is similar enough to the others where I'm thinking they're all in synch now and should act in concert. Therefore the same comments for the others hold for the RUT. If we're to get new highs, the first upside Fib target is near 860 and then 880-890.

Russell-2000 (RUT) chart, 60-min

Like the NDX we could see this roll right back over and head for new lows. If it breaks this morning's low you'll want to short every bounce in that puppy. Meanwhile look for a pullback to buy and take the run higher over the next week or so.

BIX banking index, Daily chart

Unless the banks are in a large ascending wedge, where price will continue to chop higher (and probably into August), the price pattern is bearish. A pig with lipstick is still a pig. It takes a rally back above 405 to turn this around and tell me that in fact it's looking like this will chop higher. Otherwise a bounce here should fail and head for new lows (dark red bearish count). The significance here is that the bearish wave count is building a set of 1st and 2nd waves down and when it lets go (assuming it will) it's going to let go with a vengeance.

What could cause that kind of selling in the banks? Oh, perhaps another Bear Stearns hedge fund collapse that starts to seriously unravel the mortgage-backed securities and all the CDO's (Collateralized Debt Obligations). I've said it before and I'll say it again--the massive credit expansion over the past several years, and the huge leveraging of debt, is a bubble waiting to be popped. The collapse will be mind-numbingly fast and take several banks down with it. Helicopter Ben had better have those helicopters with their buckets of cash on the 5-min alert pad.

Mother Merrill (MER) has consistently been a good forecaster for market direction. There's a reason floor traders watch MER, even on an intraday basis. They'll fade the market if MER is not participating. It's showing the same potentially bearish setup as the banks' chart:

Merrill Lynch (MER), Daily chart

After a clean impulsive move down from its January high, indicating a change in trend to the downside, MER got a corrective 3-wave bounce into the May high. It's now looking like it could be setting up a couple of 1st and 2nd waves to the downside. When the 3rd waves start to unwind in this count (assuming it will drop instead of rally) we should see a wicked sell off. So far MER has not been participating in the new highs in the broader market (such as the June 1st high) and when the banks don't participate that should always be a reason for concern. Keep your eye on Mother.

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

I keep expecting the home builders to get a bounce but each day they drop a little lower. Perhaps this morning's low was it for the first leg down from the May high. If so we should see a stronger bounce develop, maybe back up to the 50-dma/50% retracement around 611, before resuming its southbound trek.

Oil chart, ETF (USO), Daily

I'm back to showing the USO fund rather than the oil contract. I've drawn several parallel channels on the chart because I've noticed that oil tends to trade them well. Assuming we're going to see oil make a move higher, two equal legs up from the January low is at 59.03 and it's off the chart to the right, but that could occur in August. There's that August again. Remember, all asset classes will sell off. It takes a break below 47.39 to negate the bullish potential I see on this chart.

Oil Index chart, Daily

The oil stocks index broke down below its parallel down-channel(s). Today's bounce took it back up to potentially retest the bottom of the lower parallel trend line. It could certainly continue higher again, especially if oil does, but I get a bearish sense from this chart (daily oscillators look bearish as well).

Transportation Index chart, TRAN, Daily

The choppy pullback in the Trannies since mid June looks corrective, meaning it looks like another leg up is coming. Whether that turns into a new high (green count) or a lower high (dark red count) is hard to say. It might form a choppy ascending wedge to a marginal new high but regardless, I don't think the Trannies have much left before they start a more serious decline.

U.S. Dollar chart, Daily

The US dollar trades channels and trend lines very well also. Therefore I remain bullish the dollar as long as its short term up-channel from its April low continues to support price. A drop below 82 would start to look more bearish but until that happens I expect the current pullback to lead to a strong move up and over its downtrend line.

Gold chart, ETF (GLD), Daily

If the US dollar can rally and break its long term downtrend line then it won't be good for gold. I've been bearish the metals since the beginning of the year and I don't see a reason to change that opinion. But it wouldn't take much for me to switch sides (I have no loyalty to the bears or bulls, just the winning side). If gold rallies back above its recent mid-June high then it would also be a confirmed break of its downtrend line from May. That would leave the choppy looking decline over the past 2-1/2 months as a setup for another run higher (probably within the ascending wedge pattern you can make out on the chart), as per the green bullish count.

But if that choppy looking decline is instead a series of 1st and 2nd waves to the downside then gold is about to get hammered. Right now GLD is finding support at the 200-dma (the August contract has broken that support) and a break of it is what could usher in the strong selling. Keep an eye on the US dollar since a break of support there could get the gold bulls back in and get gold to break resistance above.

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

Tomorrow will be a little busier for economic reports but nothing that should move the market. I expect the market will be mostly on hold while waiting for the FOMC announcement. Most expect no change to rates and no change to policy. The only thing holding traders back is what-if. That's why I think we'll see a relief rally follow it. Whether that holds into Friday is a different question (I'm thinking probably not).

SPX chart, Weekly

The weekly chart of SPX looks bearish when I look at the sell signals from the oscillators. It's possible we'll get the minor new high (light red) that gives us all kinds of bearish divergences (as it should for a 5th wave) but this chart says it might not be wise to expect a new high from here. As per the discussion above, tighten up your stops now--just below this morning's low is an ideal place. Then let the market take you out, or enjoy the ride to a new high.

So in summary I expect some consolidation of today's rally, especially in front of FOMC. If we get a slow sideways/down choppy pullback then that will make the setup look better for a post-FOMC rally. But as with this morning's bounce, which looked like a bear flag, if a bull flag pattern forms tomorrow then beware a drop out the bottom. Failed flag patterns tend to fail hard. This afternoon's rally was evidence of that. So play the bounce but be ready to bail quickly if price drops below any consolidation pattern (it might form a sideways triangle consolidation instead of a flag).

After the post-FOMC rally, assuming we get it, we should then be ready for a larger pullback which I'll be looking at to buy for another rally leg into next week. Once we get a larger 3-wave move higher (again, assuming we'll get it) that's when I'll be testing the waters on the short side just in case it fails and we start heading lower. But if we again see a choppy consolidation after another leg up then that will be a good sign that we're going to get the new market highs. But before that happens I should be able to provide some updates next Thursday.

Until then good luck in this choppy whipsaw environment. Swing and position traders keep your powder dry. We might have a nice short setup (again) by the end of next week or early the week after. In the meantime I'll be on the Market Monitor trying to figure this out as we go. See you there.
 

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