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Market Wrap

Subprime Jitters and Shake Off

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The subprime problems were cited as one of the problems that traders had to deal with yesterday and was partly to blame for the sell off. Today there were a number of officials who came out to calm everyone's nerves and assure us (cough) that the subprime problem is indeed contained and that there's nothing to worry about. Here, would you like some more Kool-Aid? Ignore those bodies laying on the ground over there. They're probably just drunks sleeping it off. Drunk on credit maybe.

Whenever they sound out the clowns, er excuse me, the Fed officials, to tell us everything is OK, the more we should run the other way with our hand firmly over our wallet. With all the news lately about the blow up in hedge funds that are exposed to mortgage-backed securities and a slew of other credit derivatives, we're now getting officials coming out and saying things are just fine, not to worry. Federal Reserve Governor Kevin Warsh and a Treasure Secretary financial official, Robert Steel, came out to assure investors that the losses experienced by a minor few from the subprime-mortgage delinquencies aren't posing any broader risks to the financial market. My question to them is whether or not they believe their own, um, words.

These officials are of course doing their job and I shouldn't disparage them. But listen to them (and the clowns on CNBC) at your own peril. Trust me, they're not out to help you make money. They're working for corporate/banking sponsors and that's where their loyalties lie. As long as you understand that then you can use their information to your advantage. But apparently the market liked the soothing words and the rally was attributed to their kind and reassuring words.

Jim has been doing a great job in keeping us up to date on the mess that's been created with many of the credit derivatives. It takes a Ph.D. in something to be able to follow what has been happening over the past several years. And even the experts are stymied in trying to truly understand what has been created and what the ramifications could be if there's a failure of the system. All the credit, debt, investment vehicles, etc. that's been created since 2002 has not been tested. By that I mean there hasn't been one significant drop in the market to see how this will fare during the hard times.

I've mentioned several times recently that the credit explosion over the past few years will very likely be followed by a credit implosion. It's credit that businesses need to expand their businesses (not to mention buy their own stock and other companies, as we've seen lately) and consumers need loans to buy homes, cars, boats, etc. Without the easy availability of credit there will be a significant drop in demand and with that there will be a drop in prices. That defines a recession if not worse--the dreaded 'D' word, or as the Fed likes to say, "a significant slowing in inflation". That's like crashing into a wall at 100 mph and saying you experienced a significant slowing of your vehicle.

I do disagree with the Fed officials who came out today to assure us that all is well in the financial system and that the "unwinding" of the subprime problem will be contained with no harm to the economy. I think they're either sadly mistaken or just saying things to keep everyone calm. The last thing they need is for panic selling of the massive amounts of credit derivatives.

The problem with these financial creations is that they're illiquid and therefore "priced to model". Some brilliant people do nothing but analyze risk and return and come up with a value for all these mortgage backed securities. When they started failing faster than expected the models have apparently not been updated. Therefore most investors are carrying these financial instruments on their books at inflated values when you compare them to what they're selling for.


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If more funds start selling these funds loaded with CDOs (collateralized debt obligations) and other creations, which they have to do once they start getting downgraded and the pension funds are no long allowed to own them, then the prices will be determined by the market and not by someone who is good with a spreadsheet. Then they'll be forced to "mark to market" and investors will be forced to take their losses. This is essentially what happened to Bear Stearns and other hedge funds who are closing their doors to redemptions. It's a mess and it's going to get messier before it gets better. In fact it's going to get ugly. As I said, listen to the Fed officials at your own peril.

This mess is certainly being reflected in the banking index, which I'll review later. First let's review the plethora of economic reports that came out today--Crude Inventories:

Crude Inventories
There was an unexpected decline in crude inventories, with supplies falling 1.4M barrels to 352.6M. Supplies are down 11.8M barrels over the past 5 weeks and analysts had been expecting supplies to build up a bit. But crude supplies are still near a nine-year high and 5.1% above last year's level at this time.

Gasoline supplies unexpectedly increased by 1.2M barrels to 205.6M. Typically gas supplies drop about 900K barrels per week in July so that's a 2M barrel swing from expectations. That pressured the price of gas which dropped 2.7%, finishing at $2.3063/gallon wholesale. Cry me a tear.

Distillate stocks rose by 800K barrels to 122.4M. There was a slight improvement in refinery capacity, ticking up to 90.2% from 90.0% the previous week.

And now onto the charts. Every once in a while I think it's worth reviewing the bigger picture in order to help us keep current price action in perspective. Tonight I'm going to show two versions of the DOW's weekly chart in order to show why I've got the bullish and bearish EW (Elliott Wave) counts on the daily chart. Starting with the more immediately bearish view of the DOW, this chart shows the 2002-2007 rally as only a part of a larger secular bear market that started in 2000:

DOW chart, Weekly, 2002-2007 bear market rally

There are certain corrections within the many EW patterns that allow for a correction to exceed the previous move. So in this case the previous high in 2000 has been exceeded (only in terms of the US dollar) but it can still be counted as the middle of a larger pullback correction (called an expanded flat correction in EW terminology). So using that interpretation, the 2002-2007 rally is wave-B in a large A-B-C pullback correction of the 1982-2000 bull market rally. Two equal legs up within that 2002-2007 rally is at 13712.60 and the June 1st high came within 20 points of that target. By this wave count the rally could now be called complete.

The next chart shows the 2002-2007 rally as part of the bull market rally:

DOW chart, Weekly, 2002-2007 bull market rally

The wave count for this chart shows the 2002 low as the end of a 4th wave correction and we've been in the 5th (and final) wave of the bull market that started in 1982. It has an extended 5th wave which is common in a blow-off top. The wave count is looking for a relatively small push higher to complete the count and the top of a parallel up-channel for the rally from 2002 is currently just above 14K.

These two versions of the weekly charts is what has me tracking both the bullish and bearish wave counts on the daily (and intraday) charts. I'm letting price dictate where the market is likely headed and trying hard not to let my bias influence the wave counts.

DOW chart, Daily

The weekly bearish chart says the DOW made its high on June 1st. The daily chart shows that (in dark red) and has two sets of 1st and 2nd waves to the downside since that high. The significance of that wave count is that it means a strong 3rd of a 3rd wave down is about to hit us. It would be marked by very strong selling for days on end. A break below 13425 would be a heads up and a break below 13250 would be confirmation that that's what we're getting. In that case you'll then want to be short and hang onto your hat.

The bullish wave count (green) says the DOW has been consolidating since the June 1st high in preparation for a final move up to finish the rally from March which would finish the rally from July which would finish the rally from October 2002. There's a Fib projection at 14052 which matches very closely to the top of the channel shown on the weekly charts. A break above 13690 would confirm the bullish wave count in which case you'll want to be long for a potential ride up to the 14K area (it could be a choppy ride with lots of whipsaws).

The 60-min chart then zooms in on price action to see if there are any clues as to which way this will go.

DOW chart, 60-min

The leg up from June 27th is finished so now it's a question as to whether the pullback from Monday, July 9th, is a correction to that rally leg up or instead the start of the next big leg down (3rd of a 3rd wave down that was mentioned for the daily chart). Here the key levels are a little closer but not much. A break above 13670 says the bulls have got the ball whereas a break below 13316 would say the bears have got it. A break of the uptrend line from March, currently near 13450 would be a heads up that something more bearish is happening. Just be careful of the head fake break like SPX did yesterday and today before recovering.

SPX chart, Daily

The SPX chart remains very similar to the DOW's chart with some minor differences. I show the possibility for the last rally leg that ended Monday to be the end of the THE rally. I show a Fib projection for the 5th wave based on the size of the 1st wave, which is the first leg up from March. Typical Fib relationships between these two waves are 62%, 100% and 162%. The first Fib target was reached just under 1530. It would mean the same as the bearish wave count on the DOW chart--both are pointing lower--but it would mean the initial decline might not be a screamer of a move down. But if the 5th wave isn't finished yet then the next upside Fib target is just shy of 1558. That would be just above the previous all-time high and another test of the top of its parallel up-channel from 2006.

On the 60-min chart I show the possibility that Monday's high was the end of the rally (dark red wave-(5) on the chart):

SPX chart, 60-min

If THE high was recorded on Monday then we've seen the 1st wave down and we're into the 2nd wave bounce. There are a few reasons I don't like this count, one being the form of the decline from Monday's high (it looks more like a 3-wave move). But I've been fooled many many times by the form of the 1st wave and I have to respect the possibility that this bearish count is correct. A drop below 1493 would help confirm it, with a drop below 1484 as absolute confirmation. Otherwise a continuation of the rally should be expected. Not shown but one other possibility (especially as part of a choppy whipsaw market) is for price to drop back down to support at the uptrend line from March, currently near 1500, before resuming the rally into opex week.

Nasdaq-100 (NDX) chart, Daily

The choppy mess in May and June leaves the pattern messy and subject to several different wave counts. I show two, one (the bearish red one) showing Monday's high was the end of the rally. It might have one more minor new high which should not get much above 2000 before starting to head back down in earnest. A break below 1901 would say the bears are in control, with a break of its up-channel near 1925 as a heads up. Otherwise I expect to see some consolidation around the current level followed by another leg up as shown in green. That count calls for a high around 2025-2035 some time by the end of July/beginning of August. That would then complete THE rally for the techs.

Nasdaq-100 (NDX) chart, 60-min

Similar to the SPX chart, we might have seen the high and today's bounce could lead to the start of a stronger decline. But a further consolidation could also lead to another leg down before setting up another rally leg. Therefore there aren't enough clues here to help determine which price path is the more likely. Beware the chop and whipsaws until a direction becomes clearer.

I don't follow many individual stocks but when you have two big players in the NDX, Apple Computer (AAPL) and Google (GOOG) as the #1 and #3 players, it's worth taking a look at their charts for some clues. Microsoft (MSFT) looks like it's either in a corrective pullback and will be heading higher soon or else it's getting ready to waterfall lower. That one could get interesting. GOOG and AAPL are also at levels where they could be topping out soon, if not already. If the Big 3 (not the auto manufacturers) top out here then I have to wonder what's in store for NDX.

Google (GOOG) chart, Daily

GOOG appears to be in the finishing touches of an ascending wedge, with the bearish divergences to go with it. If it can push a little higher then it will run into the top of its wedge just above 550. But it is currently just above the trend line along the highs from January 2006 which is the top of a larger ascending wedge that can be more clearly seen on a weekly chart. If this is a little throw-over we're seeing then a drop back below the line at 540 would be a sell signal. A drop below 519 is needed to say the rally is probably finished.

Apple (AAPL) chart, Daily

AAPL is showing a very nice 5-wave move up from February. A 5-wave move will always be followed by at least a correction of that move. If it's finishing a larger degree rally then the correction will be that much larger. The question here is whether the 5th wave has completed. After a triangle 4th wave, which always identifies the next move as the last one, I show a Fib projection for the 5th wave where it equals the 1st wave at 133.13. Since this level has been reached, form and price have been met to call a top in AAPL. It has the negative divergences supporting this call. It doesn't mean it will top here but it does mean that's the risk for longs and an opportunity for those who would like to try shorting it.

Russell-2000 (RUT) chart, Daily

The price action between April and July in the RUT makes the NDX pattern look clean. What a mess. I'm having a devil of a time figuring out a wave count and getting trend lines or Fibs to help out here. I did notice that the uptrend lines (the red fan lines) have shown support and resistance for subsequent moves but other than that it's a big question mark where this is headed next. If the broader market has more rally left in it then I show a Fib projection to the 860 area and then 871. It takes a break below 820 to tell me the bears are firmly in control. In between is a mess.

BIX banking index, Daily chart

The banks are leading the way, down. Bulls turn your heads away since this isn't pretty. No bullish divergences, a break of the uptrend line from October 2005, nearing the March lows. What's to like about this chart? If you're a bear you of course love this chart--it's showing where the broader market is likely to follow. I show a bullish possibility but it has to rally now--it must get back above the broken uptrend line and back above 395 very quickly in order to salvage a chance at another rally leg. Otherwise the banks are showing us that the subprime problem is priming the bearish pump. A break of the March lows remove even the slightest hope for a bullish resolution out of this.

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

After testing the broken July 2006 low the home builder index sank to new lows. At this point it looks like it should head at least down to a Fib projection at 487 before getting a larger bounce. It could head lower before bouncing so I definitely would not be interested in playing any countertrend bounce in the home builders. Keep shorting the bounces.

Oil chart, August contract, Daily

Oil continues to press higher although it's been consolidating the past couple of days. I don't see anything yet to negate the possibility we'll see oil test its old high. The Fib projection at 79.25 is for two equal legs up from the January low. If it hits that level at the top of a parallel up-channel then we should see oil peak out in early August.

I say peak out because of the longer term EW pattern that calls for the possibility, even likelihood, that once this bounce is finished we'll see oil head for new lows. This is counter to what Jim is calling for so understand my opinion here is based strictly on the EW pattern and my belief that we're going to head into a worldwide economic slowdown. That will depress the price of oil if it happens. So for a longer term view of oil, here's my weekly chart:

Oil chart, August contract, Weekly

After the July 2006 high oil had a 3-wave pullback and since that time has had a 3-wave bounce (so far). That defines a larger degree a-wave down and b-wave bounce (labeled dark red wave-(a) and wave-(b) on the chart) and calls for a strong decline in a c-wave. The type of pattern playing out here calls for an equal leg down (Fib projection at 52.75) or more likely a 162% leg down (Fib projection to almost 36) in 2008.

Again, this is definitely a different forecast from Jim's and others who maintain the shortage in oil will continue to press the price higher. If oil rallies much above 81 then I think the bearish price pattern becomes negated. A drop back below 63 at any time now will say we've probably seen the high for the bounce.

Oil Index chart, Daily

The pattern in the oil stocks is looking good for the completion of a 5-wave move up from March. If it can press a little higher it could hit the top of its parallel channel at a Fib projection at 820.46 (for equality between the 1st and 5th waves). A break below the bottom of the channel could indicate a high has been seen.

Transportation Index chart, TRAN, Daily

For the bearish wave count on the Trannies, the rally needs to stop here and turn right back down, leaving a corrective 3-wave bounce in its wake. Otherwise a small consolidation could lead to another push higher towards a Fib projection near 5415 by the end of the month.

U.S. Dollar chart, Daily

The US dollar has in fact dropped back down to the bottom of its descending wedge pattern. It dropped below it today and then bounced back up to close at the line. If this is the end of the move down then it should waste no time rallying from here. But from a short term basis it looks like it could use one more minor new low. At any time it rallies back into the wedge pattern that would be a buy signal (sell signal on the euro). It needs to break above 82.15 to declare a major low is in.

The weekly chart of the US dollar helps keep this decline in perspective:

U.S. Dollar chart, Weekly

You can see the positive divergences at each of the new lows in the dollar. It's just a matter of time when the dollar comes blasting out of this wedge pattern. A complete retracement of it, so a rally back above 92, should be expected. The opposite is true for the euro.

And if the dollar is going to get a big bounce that will hurt the prices of commodities, including oil and gold.

Gold chart, August contract (GC), Daily

I widened the parallel down-channel a bit to better accommodate the lows in gold for the decline since May. Gold could press a little higher to a Fib projection just above 671 but the larger pattern still looks bearish for gold. Any further push up to that 671 area could make for a good shorting opportunity.

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

Tomorrow's reports should not be market moving. Friday's reports should also be relatively tame, with perhaps the retails sales reports having some influence.

Not much of a change yet to the weekly SPX chart:

SPX chart, Weekly

It looks like consolidation over the past several weeks and the weekly oscillators are hinting at turning back up. Other than the 1558 Fib projection that I showed on the daily chart, the weekly chart shows a projection to 1562.80 (for two equal leg sup from October 2002). So the 1560 area holds some potential for a major high if it pushes higher from here.

I think if the market is going to push higher it's going to do it in a choppy fashion, probably creating ascending wedges from the June 27th low. It would mean lots of chop and whipsaws. That would of course mean tough trading for short term traders. If you're a longer term trader and long the market then we haven't seen anything yet to spook you out of your trades. If you're wanting to short the market then we haven't seen anything yet to confirm a break of the uptrend, so hold your fire.

We might have made an important high on June 1st but in order for that to be true then we'll need to see selling pick up speed from here. Opex week would likely be ugly (for bulls) in that case. But if we're going to see the market press higher then I suspect we'll have a bullish opex week. Just be careful of a choppy move higher.

Good luck and I'll be back next Wednesday. See you on the Market Monitor.

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