Option Investor
Market Wrap

Safety in Numbers

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I (Keene Little) will be filling in for Jeff Bailey for tonights Market Wrap.

After leading the parade higher the past two months, techs were a noticeable no-show in today's rally. In fact they were leaders to the downside last Thursday and now they've been laggards during the bounce from Friday's low. It may be early to identify a trend here but this looks like a flight to safety in large caps. Today's rally had the DOW up over 100 points while the Nasdaq was flirting with the flat line. Between the banks (BIX) having another dismal day and the techs and small caps starting to hold back, it could be a warning sign that the rotation into the blue chips may be a defensive measure.

It's a good idea to look at a relative strength (RS) chart now and again to help you see which sectors/indices are leading and lagging. When I compare the Nasdaq to the S&P 500 this is what it looks like:

Relative Strength of COMP compared to SPX, Daily chart

You can see that the COMP outperformed to the upside since the end of May and that's what bulls like to see. The amount of buying in the techs and small caps is oftentimes a good measure of bullishness in the market since is measures the aggressiveness of the buyers and their willingness to take on more risk in the higher beta stocks. I showed the weekly RS of the COMP vs. SPX a little more than a month ago and suggested we could get one more bounce in the RS of the techs in order to finish its triangle consolidation pattern, as shown here:

Relative Strength of COMP compared to SPX, Weekly chart

After the initial bottom in 2001, showing the techs were clearly leading to the downside, the RS chart has been essentially flat, consolidating in a sideways triangle. Triangle patterns are continuation patterns and in this case it suggest the RS chart has another leg down coming and it should be right after the little bounce from May finishes. That interpretation says techs will either fail to keep up with a rally in SPX, which wouldn't be bullish, or that the techs are going to once again be leaders to the downside, which would clearly be bearish. I think it will be the latter scenario.

Economic Reports
The were no scheduled economic reports today (first ones are scheduled for Wednesday).

There were some more recent reports trying to assuage fears about the subprime meltdown that's been in the news recently, especially with Bear Stearns (BSC) informing the investors in their two failed subprime bond funds that they longer have any money left in the funds. The U.S. Treasury Dept. said on Friday that the recent problems in the subprime market appear to be contained and not to worry about any systemic problem. The senior Treasury official said they're monitoring the situation but believe the problem in the mortgage market "appears contained".

This official could very well be correct but I have some serious doubts about that. First of all, no one really knows the values of the thousands of funds that contain this toxic waste (again, that's a Wall Street term, not mine). The reason for that is because the market is so illiquid. There are thousands of people at this very moment sitting on pins and needles wondering what the damage will be to their account since they can't determine a true value. The only way to determine that value is to sell the bonds and what sellers are finding right now is that there are few buyers (and they're not offering very much).


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So in one respect I guess the Treasury official is correct--the problem is contained, for now. As long as no one tries to sell any more bonds then there is no problem. That's like sitting on a paper loss in your own account where you bought a stock for $100 and today it closed at $50. You make yourself feel better knowing it's just a paper loss right now and that surely it will recover (known as the slippery slope of hope). But the pit in your stomach lets you know that you have a problem. Is the problem contained? Well, sort of, but only until you have to sell.

The other thing that's depressing many banks and hedge funds right now is that not only can they not sell these bonds (without taking a confirmed loss and bath), they can no longer use them for collateral. First, the value of that collateral is significantly reduced and second, no lender wants it as collateral, fearful of what they could be stuck with.

This collateral is what has enabled banks and hedge funds to leverage up their holdings and buy even more of these subprime mortgages. They would either repackage and sell them to other investors (getting their money back and lending it out to more home buyers, and then taking those loans, repackaging them, selling them to the market, rinse and repeat) or they'd use them as collateral for yet more subprime loan purchases. This is how they leveraged themselves up 10:1, 20:1 and even 40:1.

The growth in these subprime mortgages is shown in this chart:

Mortgage-backed Securities issued 1996-2006, courtesy Inside Mortgage Finance MBS Database

Not only has the growth in these mortgage-backed securities (MBS) grown at an exponential rate (reflecting the rapid rise in credit) but the subprime portion of these skyrocketed between 2004 and 2006. These are the loans that were repackaged, blessed by the credit agencies as AAA-rated bonds and then sold to the market (hence the drop in value in AAA-rated bonds in the next chart below).

So the subprime market is currently on hold and is contained--as in everyone is holding their breath. As soon as someone, like another BSC, exhales and sells, boom, there goes another one. Here's the problem displayed in a picture of the ABX indexes that track the value of rated bonds:

ABX Mortgage Indexes, courtesy markit.com and elliottwave.com

The three different indices shown are AAA-rated bonds at the top, A-rated in the middle and BBB-rated (subprime) and at the bottom. The most obvious one is the drop in the BBB-rated bonds. As shown in the previous chart, the bulk of these mortgages were sold between 2004 and 2006 and were funded to a large extent by Wall Street making money available to lenders who literally scrambled to find people to lend money to. "Can you fog a mirror? Here, sign this form. Don't worry what it's for, we'll take care of the rest."

As you can see on the chart, the BBB-rated bonds are currently less than half their value from where they were last fall. This is huge when you're talking about bonds. Next up the list are the A-rated, which are supposed to be relatively safe bonds (at least not junk status). But their value is now down about 25% in just the first half of this year. Compared to BBB, the AAA-rated bonds are obviously holding up well. But the 5% drop in AAA-rated bonds is also a huge drop. Look at the flat line before this year--that's typically how AAA-rated bonds progress. The fact that they've now dropped 5% tells us the problem is NOT contained. The problem is in fact spilling over into the good stuff. People are becoming afraid of the bond market.

I've often talked about why the market cycles up and down and I've said it has nothing to do with fundamentals. Fundamentals follow the market and not the other way around. What causes buying and selling cycles (bull and bear markets) is human psychology and emotions. When people feel good the feel bullish and they buy. When they become afraid, angry and frustrated they feel bearish and they sell. So the significance here is that people are becoming afraid of the bond market. Without a strong bond market there will be a loss of credit availability. With a loss of credit there will be shrinkage in all asset classes.

In other words we're witnessing the start of a credit contraction. But because the credit expansion was so rapid and so huge (faster and larger than anything seen in the past), the opposite will also be true--a credit collapse will be painful to go through but it's simply a necessary cleansing step and the cycles will continue. Your task as a trader/investor is to identify those cycles and trade with them (or stand aside during the down cycle).

The chart above shows the risk to Wall Street, businesses and anyone who borrows money (including homeowners). Money greases the skids of the economy and it's been slicker than goose sh.. for a few years now. Someone will soon be along to hose down the skids and clean all the "grease" off. That'll slow things down but again it's a necessary step in the process.

The other impact out of this is obviously the housing industry. Not only did all that easy money make it easy to get into a house, it ended up trapping many who thought they could take those teaser rates and then refinance before their rates went up. Two things have happened to thwart that: one, housing topped out at the same time the subprime lending was peaking and people can't depend on inflated values to refinance their way out of an expensive mortgage; two, money is no longer available like it was even just a year ago. Without the flood of new money coming from Wall Street, through the resale of the bonds backed by mortgages, the lenders have no money to lend. On top of that the bankers have tightened up their lending standards and they've cracked down on fraudulent loans.

By the way, these fraudulent loans is what has made the problem worse. Risk assessment is based on many factors and is used to rate the bonds. One of the factors NOT in the equation is dishonesty in how the loans were made. Now that this has been uncovered, and the foreclosure rate is shooting higher, the rating agencies are scrambling to reassess the situation. Their downgrades will force hundreds of investors to force the sale of their holdings. At that point the problem will no longer be "contained".

So now we've got people who can't get new loans, including new home equity loans. The home equity loans are either too expensive now (interest rates rising) or they've already tapped out the equity from their homes. The chart below shows the amount of household cash vs. liabilities. For many, their home values less what they owe is what defines their net worth.

Household Cash less Liabilities, courtesy contraryinvestor.com

The significance of this chart is to show how much in debt homeowners have become. While home values skyrocketed, so to did homeowners' liabilities. Today homeowners have less equity (as a group) than they did in 2000. The scary part is what happens when home values drop. And a homeowner who is cash poor is a non-spending consumer. A non-spending consumer is one who will not go out and help prop up the economy. A combination of a credit contraction and a slowing in consumer spending will be a nasty one-two punch to the economy's midsection.

I hate to sound all doom and gloom but with the plethora of "good" news out there and the popping of champagne corks with DOW 14K I want to be sure you keep your wits about you when dealing with this market. I think the parallels between 1929 and 1987 at the moment are downright eerie.

So let's see what the charts are telling us tonight.

DOW chart, Daily

The DOW clearly remains in an uptrend. The trick has been trying to find a top to this rally (for some time) but sticking with the trend has obviously been the best trade. It just depends on how much you're willing to give back as to where you want to place your stop or try for a short play. The upside Fib projection at 14052, for two equal legs up from July 2006 is matched by a Fib projection for the 5th wave in the move up from June 27th where it will equal 62% of the 1st wave (shown more clearly on the 60-min chart below).

If the DOW rallies above that level (assuming it will rally from here) then the next upside Fib projection is where the 1st and 5th waves would be equal at 14208. Somewhat in between is a Fib projection at 14184 where the 5th wave in the rally from March would equal 162% of the 1st wave. So it's a bit wide but that gives us a target zone of 14052-14208. If we do get another leg up then the end of it should become clearer as it develops further.

If the bulls are finished and we've seen the high then the market should waste no time in selling off tomorrow. As shown on the chart, the key level for the bears to break is 13670--that would signal we've seen the high and very likely THE high.

DOW chart, 60-min

Between trend lines and Fib projections I'm showing what a continuation of the rally might run into and again the target zone between 14052 and 14208 looks good. By the way the rally from last Friday has developed I get the feeling that it could be the lower end of that zone that caps off the rally but it will take a break below 13800 on this chart to say the bears have wrestled the ball away from the bulls.

SPX chart, Daily

The decline to Friday's low overlapped the high on July 9th and that negated an impulsive wave count from the June 27th low. That opens up a few possibilities, including a longer-lasting choppy rally into August, which I show as a potential ascending wedge for the bullish wave count. Otherwise it means we've seen the high and after today's bounce there should be no delay in heading for new lows.

SPX chart, 60-min

Just like the rally from June 27th where Friday's low dropped below the June 9th high, so too do we have overlap of Friday afternoon's 1541.67 high. That negates the possibility for an impulsive wave count to the upside from Friday's low. Once again we could get a choppier rally that forms a smaller ascending wedge within the larger ascending wedge on the daily chart. That would mean a difficult-to-trade rally as it makes what should be a minor new high, potentially around the 1560-1563 area.

But if all this overlapping of previous highs means we've seen THE high then the bounce off Friday's low was the perfect setup for a short play (hence the "MOAP" on the chart--Mother of All Puts). If in fact the market has made its final high then we should waste no time in dropping below Friday's low from here and I'd short it.

While I get more of a bearish sense from SPX, I'd have to give the nod to the bulls when I look at the OEX chart:

OEX chart, Daily

Unlike the SPX, OEX has not overlapped its 1st waves within each leg up in the move up from March and the smaller one from June 27th. This leaves open the possibility, in fact likelihood as I look at this chart, for one last leg higher as shown. The Fib projection just shy of 724 by the end of the month looks good by this chart. If it tops out a little sooner (as in this week) then it might find resistance closer to 720. There's another internal Fib projection pointing to 722 and therefore I like the 720-724 area for a top if we get another rally leg out of the market. This would be a very clean finish to the rally from March and would be an Outstanding short play setup.

Nasdaq-100 (NDX) chart, Daily

The rally for NDX looks finished and if so then we'll waste no time tomorrow in a sell off. But if it continues to chop sideways/down then I can see the need for one more leg up in its rally too. If we get the rally leg then I see 2070-2075 as the potential high.

Nasdaq-100 (NDX) chart, 60-min

The bearish wave count shows a 1st wave down from Thursday's high and a 2nd wave bounce since Friday's low. That interpretation says get ready for a stronger 3rd wave decline which will waste no time getting started tomorrow. Either that or we'll see it continue to chop sideways/up for a bit more and then sell off on Wednesday. There are some big earnings coming out this week and one could lay a stink bomb on the techs. Otherwise the bullish count calls for another high which some of the other indices, like the OEX, easily support.

Russell-2000 (RUT) chart, Daily

Welcome to the chop zone. Try figuring this little bugger out and when you do, let me know. My goodness, trade the trend lines for support and resistance and don't overstay your welcome. The only way I see this going higher is in a continuation of this choppy pattern into an ascending wedge to minor new high, maybe. A break below 820 would say it's all over for the bulls.

BIX banking index, Daily chart

Follow the money. That's what I posted on today's Market Monitor. And the money is flowing down hill. The banks have not kept up with the broader market average (stating the obvious here)--getting ready to test the March low while the major averages are close to testing all-time highs. Whenever there's a disconnect between the banks and the broader market, follow the banks. It's obviously not a good timing tool but it does tell you to keep a close eye on any long positions you might have. The broader market will follow the banks, no doubt about it. It's just a matter of when.

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

The Fed and Treasury may be trying to convince the market (and themselves?) that the subprime mortgage problem is contained and won't spill over into the rest of the economy, but try telling that to home builders and their investors. But if there are some bullish divergences as it nears the Fib projections at 487.56 (for two equal legs down from February) then we could see a larger bounce set up. But that should lead to stronger selling into the end of the year. I don't show it on this chart but the pattern that looks to be playing out could get two equal legs down from its July 2005 high (1st leg down being the low in July 2006) and that gives a downside projection to 215. As I've been saying, there's a lot of pain to be felt yet by the home builders.

Oil chart, September contract (GC07U), Daily

Two equal legs up for this contract is at 80.67 and the current small parallel up-channel from June says price could get there by mid August. The larger bearish pattern for oil then calls that the end of a large b-wave correction and we'll be due a c-wave down which should take the price of oil below $50. The only thing that would do that is lack of global demand, which is what I foresee. Otherwise the bullish scenario says we'll see just a pullback stay within the larger parallel up-channel and then watch price climb well above $80.

Oil Index chart, Daily

The oil stocks look to have peaked--oscillators have turned down since price hit the top of its channel and at the Fib projection for equality between the 1st and 5th waves in the rally from March. This one looks done, stick a fork in it and get short. If by chance the oil stocks rally for one more new high (perhaps with the broader market) then we should see all kinds of bearish divergences against that high.

Transportation Index chart, TRAN, Daily

The Transports have left a clear throw-over above its ascending wedge pattern. Sell signal #1 was when it dropped back down into the pattern. Sell signal #2 comes with a break of the uptrend line which is the bottom of the wedge. Sell signal #3 would be a failed retest of the broken uptrend line. We'll see how well that plays out from here. As with the others, if there's one more new high to come then I see upside potential to 5564.

U.S. Dollar chart, Daily

Help, I've fallen and can't get up. The poor US dollar, the currency everyone loves to hate right now. No change of opinion on this--we should see a fairly quick reversal soon and nice rally. It just needs to get up off the mat and start defending itself against more punches and start punching back.

Gold chart, August contract (GC07Q), Daily

BIG bounce in gold, much bigger than I had expected. But after its big bounce from March to April I guess I shouldn't be surprised. Gold is traded on emotion and can therefore see some wild swings. While it's due a pullback it's not certain whether it will just pull back and then head for new highs (bullish wave count) or instead continue on down to new lows. I'm still leaning towards the bearish side of gold and one of the reasons is silver:

Silver chart, September contract (SI07U), Daily

Notice that silver hasn't had nearly the bounce that gold has had. In fact it was stopped rather nicely at its downtrend line and oscillators are threatening to roll over. Silver is a better barometer of the economy because of its industrial uses. Gold is more emotional and gets more attention as a supposed safe haven, is used in jewelry (discretionary spending) and of course does have many industrial uses as well (not to mention currency and is hoarded by many). But always keep an eye on silver for a "reality check" on whether gold's rally should be trusted or not.

There were no scheduled economic reports for today or tomorrow. The rest of the week includes the following:

There are some potentially market-moving reports this week so if the market is either perched on the edge of a cliff or about to break resistance then an economic report could provide the catalyst for the move. The same for some high-profile earnings this week. The market could get a little jumpy so be careful around these.

SPX chart, Weekly

The weekly chart of the SPX looks weak. The negative divergences are telling bulls to be very careful chasing this any higher, especially with price up near its Fib projection of 1562.80 (two equal legs up from October 2002) and the top of its two parallel up-channels (the larger one is from the October 2002 low). If the market can press a little higher this week, perhaps next, then the top of the larger channel will be at 1576 by the end of the month. I do not see any further upside than that and even that high is questionable as I see where we are in the shorter term patterns. We've either topped or we have another leg up to go and that could be over in a matter of days.

This market has rallied beyond the expectations of most people expected, whether you're a bear or a bull. The rallies in the face of weakening market breadth, very shallow pullbacks and the relentlessness of it all speaks of a blow-off top and they are rare events. Therefore trying to find the top of the move can, and has been, an exercise in frustration. I keep showing upside potential, especially on cleaner charts like the OEX, to show why trying to short the market right here could be another failed play. But the top is not going to be identified with the ringing of a bell (although I'll do my best to ring it if I see it occurring) with a yell from the conductor "all aboard the southbound train as it leaves the station."

Therefore I keep looking for evidence of topping by the wave pattern. It's just another technical tool and like the rest of them it's subject to interpretation. With the addition of other tools (Fibs, trend lines, oscillators, market breadth, etc.) I'm hoping to be able to identify the MOAP (Mother of All Puts) opportunities. We might have had one today and it was worth a test. If it doesn't work then we'll simply try again at or after the next high in the market. In fact the next high could be an outstanding opportunity. See the OEX chart for what I like there.

The bottom line though is that we're still in an uptrend and you should stick with that until it's no longer an uptrend. How much you're willing to give back is the key to that strategy. I like to find market turns and keep my stop levels tight by doing that. I will often exit at target levels rather than accept a big move against me. We all have our style of trading and it's important to recognize what kind of trader you are and trade that way. Make a trading plan and stick with it--consistency is the key to winning at this game.

Good luck and I'll be back here on Wednesday. See some of you on the Market Monitor tomorrow.

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