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Market Wrap

The Flight of the Eagle

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That would be the silver eagle, as in the coin. With the credit markets drying up it would appear the money supply is becoming a little more dear and the stock market never does well when capital starts to shrink. It does remarkably well when money is being created and the past couple of years proved that out very well.

The DOW tagged and dropped below 13000 today which it hasn't seen since April 25th when it left that millennium marker behind and headed for 14000 which it tagged on July 17th. The DOW took 57 trading days to go from 13K to 14K and 21 days to reverse that. This fast reversal is another sign that the market has very likely peaked for a while. Most are probably thinking that we'll get at least a long overdue correction to the bull market and then resume the longer term rally but there are lots of opinions as to how much of a correction we should expect.

Most everything you read right now about the market blames the credit crunch on the subprime mortgage problem. What's happening around the world now has everyone pointing to the evil homebuyers who are defaulting on their loans. The homebuyers are pointing to the evil lenders and the lenders are pointing to the evil investment banks and the investment banks are pointing to the evil credit rating agencies. We're all victims you see and no one dares to stand up and take the bullet. Even the cartoonists are getting involved in blaming the subprime mortgage brokers as in this cartoon I saw in Slate Magazine:

House of Cards, cartoon courtesy slate.com

One thing you'll find is that cartoonists have an uncanny ability to identify the primary cause of a problem that everyone is talking about. The problem of course is much bigger than the subprime mortgages and the skyrocketing default rate among them. It's certainly the poster child for the credit problems we're starting to face and is indicative of how far off kilter the investment banking community got when it came to assessing, and selling, risk.

The "subprime" problem is apparent in the covenant-lite loans to corporations and in the highly leveraged buyouts and mergers. When companies borrow money to buy back their stock, in order to inflate their earnings numbers, you have to ask why and what could be happening here. We've had multiple signs for a very long time that something's not right with this stock market rally nor with the very low credit spreads between high-risk investments and US government bonds (considered to be about as safe as you can get, which is becoming more questionable in my mind). Lack of volatility, which signifies stability in the markets, lulled investors into complacency and had most believing the good times would just keep rolling. Have you checked out the VIX lately? I'd say a little fear has reentered the market:

Volatility Index (VIX.X), Daily chart

I'm showing the Bollinger Band on this chart (gray bands and the green 20-dma in the middle) to show how far it has pushed up against the band. Notice how it had dropped to its mid line, the 20-dma, on August 8th, which was last week's high in the stock market, before shooting higher again. If this were a stock you would say that was very bullish price action. Bullish price action for the VIX is of course bearish for the stock market. Pushing the envelope of the BB higher is also "bullish" for VIX here. Jumping above the top of a parallel up-channel for VIX since February is also "bullish". So VIX fully supports the current bearishness we're seeing in the stock market and is not hinting of a reversal.

But there's some real fear in this market right now and the number of new lows vs. new highs in the table at the beginning of this report as well as the strong selling vs. buying says we could be nearing some short term oversold conditions that calls for at least a relief rally (of the dead cat variety). Look at the equity put/call ratio at the bottom of the table--1.05 is very high and says more puts than calls are being purchased and with the high VIX they're paying a dear premium for them right now. This all screams for a relief rally.


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As I'll show on the charts, particularly the DOW and SPX 60-min charts, it's possible we got a throw-under of some bullish descending wedges which could mark at least a short term bottom. An immediate and strong rally on Thursday would confirm that. But as I'll also point out, the EW (Elliott Wave) pattern points to the potential for a very strong selloff on Thursday. This could be one of those times where we'll get a crash leg down out of oversold conditions (which is when crash legs typically happen). Needless to say it could be an interesting day on Thursday.

A bit of good news came out today from Goldman Sachs (GS) when they announced that they're cutting their management fee (2%) for their troubled Global Equity Opportunity hedge fund as an enticement to attract more investors. But wait, there's more. If you sign up now they'll also halve their normal 20% skimming off the top of the profits and take only 10% but not until the fund appreciates 10%. Let's see, a 25% loss (or whatever) and not add another 2% fee on top of that. Wow, what a deal.

Thanks GS but I think I'll keep my money in a Safe money market account (there are many unsafe ones so check carefully). The audacity of these firms and managers, who took billions of dollars and stuffed them into their pockets when the credit market was zooming (and making money not from their brilliance but only because they couldn't lose), to now offer up their 2% management fee and take less of the profits is mind boggling. The greed on Wall Street has a long way to go before it's flushed from the system.

GS added another $2.0B of their own money into the fund, which has dropped 25% just this month, in hopes of stemming the losses. Isn't that averaging down? Isn't that a violation of one of the golden rules of trading/investing? Only add to a winning trade and never to a losing trade. I think that might be rule #1 and if I'm not mistaken, rule #2 is to see rule #1. Guess what will happen to that $2B...

GS, like the many others who own these hedge funds that are filled with mortgage-backed securities, CDOs (Collateralized Debt Obligations, which are derivatives of the securities) and more derivatives of derivatives have a common problem of not being able to identify the true value of their holdings. Their computer models are proving to have been overly aggressive and optimistic in identifying a higher value and lower risk than what the market is declaring.

Until these funds can mark their prices to the market, which is so illiquid as to make that virtually impossible at the moment, many are being forced to tell their investors they can't have their money until they figure this all out. I suspect it could take quite a while and the reclassifying (changing the ratings) will cause untold losses to these funds.

Sales of CDOs, which are used to pool various bonds, loans and derivative packages into new debt that was sold to investors, rose fivefold from 2003. In many countries individual and institutional investors bought these packages and that's why so many foreign central banks got panicky last week and started injecting massive quantities of money into the market so as to help banks meet the demand for cash.

Even highly-rated funds, such as Basis Capital Fund Management, which had a 5-star rating from Standard & Poor's, are being de-rated. Their rating was put "on hold" on July 17th and now Basis is telling their investors the fund is frozen from redemptions while they reassess the value of their holdings. The firm managed $1B in March and told their investors that the fund may decline more than 50%. I suspect it will go the way of the Bear Stearns' funds and drop to zero.

Now, as many of the mortgages supporting those bonds have gone bust, and bankers are backing away from financing new mega-buyouts, money has suddenly gotten a lot more expensive. The rise in market interest rates, and the evaporation of demand for some of these riskier bonds, has left many bond holders with big losses. And the shift in psychology from the days of easy money to fears about credit risk has come faster than even the worst-case scenarios suggested by Wall Streets computer models. This is why I'm a bit surprised to read that GS is throwing another $2B of their capital into this mess. Easy come, easy go is what they must be figuring.

Last Friday the market bounced as people breathed a sigh of relief that the central bankers of the world were stepping in to save the day, or so they thought. The last times the central banks acted in unison like this was after the 9/11 attacks and before that it was the LTCM hedge fund collapse. The interesting thing about those previous times was that the banks injected large quantities of cash near the bottoms of major declines in the stock market.

This time the central bankers were injecting massive quantities of cash (the European Central Bank, ECB, was up to almost $300B euros) and this when the stock market is just off its all-time high. And it didn't last as the market has been sinking lower ever since Monday. The big difference this time is that the credit bubble that has been created over the past several years is something we've never seen before. The central banks can't pump enough money into the market to compensate for the coming collapse of this bubble as credit simply dries up, at least not without causing a severe inflation problem. It's going to be the proverbial rock and a hard place for them.

The economy doesn't warrant a rate cut (my condolences to Jim Cramer and his buddies who need one in order to protect their ass.ets) and if the Fed makes a rate cut now it will be obvious they're doing it to help the Wall Street gang and they'll be threatening higher inflation if they do it. It's not going to happen as long as Bernanke has the intestinal fortitude to take a whipping from Wall Street and Congress. The market is going to have to work through this one on its own and while the Fed will eventually be forced to cut their rate (because the economy will finally start to reflect the coming recession) it will be ineffective and they'll chase the market all the way down as they always do.

As traders we don't want to rely on what the Fed does or doesn't do. Our job is to identify what the market is doing and try to get on the right side of it. Depending on our trading timeframe we'll play the little intraday moves, weekly moves or only the monthly moves. So I try to identify the small and potentially larger trends, and more importantly changes in the trend so that you can at least protect your positions or enter new trades with a new trend.

Economic reports
It was a busy morning for economic reports but it didn't seem to have much of an effect on the early morning futures which had already been down prior to the market's open.

CPI and Core CPI
Falling gas prices got the credit for a CPI increase of just +0.1% in July, the slowest inflation rate in eight months. The core CPI, which excludes food and energy prices, increased by +0.2% (+2.4% annualized) for the second month in a row. For the past year the CPI is up +2.4% and core CPI is up +2.2%, both just above the Fed's comfort zone and a reason the Fed has to be careful about even hinting about a rate cut for the market.

NY Empire State Index
Manufacturing activity held relatively steady in August, falling to 25.2 from 26.5 in July but better than the 19.0 that economists had expected. Of the businesses surveyed, 40% reported improving conditions while 15% reported deteriorating conditions. A declining number for this index gives a heads up that the ISM (Institute for Supply Management) will likely drop as well. That number comes out in early September and was last at 53.8 after having dropped from 56.0 in June.

Among the components of this index, the new orders index fell to 22.2 from 26.5, shipments dropped to 28.8 from 29.2 and unfilled orders fell to 1.1 from 2.5. Prices paid dropped marginally to 34.4 from 34.6 but prices received dropped more sharply, down to 3.2 from 8.6 and the lowest level in two years.

Net Foreign Purchases
Net foreign purchases of long-term U.S. securities were $148.6B for the month, dropping from $163.7B a month earlier. That was more than enough to cover the U.S. current account deficit of about $65B for the month. From private investors, capital flows to the U.S. in June dropped sharply to $58.8B from a revised $107.3B in May.

Industrial Production and Capacity Utilization
U.S. industrial output rose +0.3% in July, helped primarily by business equipment and auto production. Auto production surprised many since sales have been down. The assumption is that the auto companies are building up inventory to carry them through union negotiations this fall. If true then industrial production will likely take a hit in the next month or so.

Capacity utilization was up to 81.9% in July, the highest level since last September. This is another threat to inflation and another reason the Fed is not going to be anxious to even hint about a rate reduction. Sorry Jimbo.

Crude Inventories
The Energy Dept. reported crude inventories fell by 5.2M barrels to 335.2M while gasoline supplies fell by 1.1M barrels to 201.9M and distillate stocks rose by 200K barrels to 127.7M. Refinery capacity was 91.8%. Oil products posted gains for the day.

Home Builder Sentiment
While not an economic report per se I think this sentiment index can be just important as the Consumer Sentiment numbers in helping us gauge how the economy may be fairing. There's no doubt the credit market is drying up funds for buying homes and the home builders know it. They grew even more pessimistic in August and drove the sentiment gauge to its lowest level since 1991, dropping 2 more points to a reading of 22. This means only a fifth of the builders think the market is "good". A year ago the index was at 33 and two years ago it was at 67.

Tomorrow, Thursday, we will get the housing starts and building permits numbers and starts are expected to fall about 5% to 1.40M while permits are expected to drop 1% to 1.40M. This number needs to drop well below 1.0M before the housing market finds a bottom so there's a lot more pain to go for the builders, and our economy since so much is tied to the health of the housing market.

With the stock market perched on the edge of a cliff I'll review why it's very important for the bulls to get this rallying immediately Thursday morning. Otherwise this market could be in for some significant selling.

DOW chart, Daily

Based on what I'm seeing in the price pattern and other things happening in the market I'm now projecting a more significant decline that's coming. Based on Fib projections and time relationships between waves I'm showing the bearish wave count that calls for a drop below support at the 200-dma and uptrend line from July 2006. Note that SPX has already broken these support levels and broke them again this week.

The bullish possibility here is that support will hold at today's low and will start another rally leg that takes the DOW to a new high. I show this because it's still possible if I look at only the price pattern and consider nothing else. Take any rally tomorrow seriously because of this potential.

Because the DOW is sitting on support here it's one of the reasons why I say the bulls need to rally the market immediately tomorrow morning. Another reason is the short term pattern as shown on the 60-min chart:

DOW chart, 60-min

As the market headed lower this afternoon I was watching carefully to see if price would do a small throw-under below the bottom of a potential descending wedge for price action since the August 8th high. There were even some bullish divergences showing up that supported this bullish pattern. But the drop into the close went lower than what would be a typical "throw-under". Again, this is a reason the market must rally immediately tomorrow which would then support this bullish pattern. Rallies out of these descending wedges are usually strong.

But if price even consolidates at today's low then it will be bearish. It must rally or it's bearish and it's that simple. And if it's bearish it's very bearish as the wave count calls for a strong decline from here (a series of 3rd waves to the downside). A breakdown from this descending wedge would also be bearish.

During the rallies of the past few years bears will remember the bearish ascending wedges that formed at various times when it looked like we might be forming a top. When those ascending wedges failed with a rally out the top of them the rally was usually very strong. We now have the opposite setup here. Many traders will be seeing this same bullish pattern and thinking it's a buying opportunity (and they could be right). But if the pattern fails and price drops out the bottom it's going to be a strong drop, helped by a lot of the bottom pickers bailing out of their positions, just as the bears did on the way up.

SPX chart, Daily

We have the same price pattern on SPX as the DOW so the commentary is the same. The difference between the two is that SPX is relatively weaker when measured against the 200-dma and uptrend line from July 2006. The bearish case calls for a quick drop down to the uptrend line from August 2004, near 1345, bounce and then drop well below that support. The bullish case, which I don't believe at the moment, calls for a rally to start and head up to a new all-time high in September.

SPX chart, 60-min

The SPX 60-min chart shows the same descending wedge but with the closing price having dropped more than a typical throw-under. It must rally tomorrow to support this bullish pattern otherwise both the EW count and the bottom of the parallel down-channel for price action since last week's high will have price heading for the 1350 area in a hurry. Even getting down there tomorrow is a possibility.

OEX chart, Daily

For you OEX spread traders I thought I'd show a projection and timing for the bearish case. Down to near 560 by the end of September is the potential.

Nasdaq-100 (NDX) chart, Daily

NDX presents an interesting possibility for a small dip tomorrow followed by the start of at least a bigger bounce if not a rally higher into September. The 200-dma is just below 1850 and as shown on the 60-min chart below, that's also where the move down from its July high would have two equal legs down. If this pullback really is just a correction of the long term uptrend then the 1848 level is where you might want to consider buying support. Obviously if the market is selling off hard then you won't want to step in front of the southbound train.

Nasdaq-100 (NDX) chart, 60-min

On the flip side of the bullish expectations for the DOW and SPX if we get an early and strong rally, this 60-min chart of NDX shows potential resistance from its downtrend line if it rallies Thursday morning. It will take a break above 1900 to turn this pattern bullish.

Russell-2000 (RUT) chart, Daily

The RUT is also at support again at its uptrend line from August 2004 so it's possible we'll see another bounce back up to create a larger upward correction from the August 6th low. But a break lower tomorrow will be a confirmed break of support. So this too shows why the market must rally tomorrow in order to keep this from turning very bearish.

Russell-2000 (RUT) chart, 60-min

The 60-min chart shows a closer view of the A-B-C bounce (pink wave count) that could take the RUT back up to recent highs before turning south again. But if the market sells off immediately tomorrow then the bottom of a new parallel down-channel could have the RUT tagging 700 very quickly.

BIX banking index, Daily chart

The banks did a quick reversal from last week's bounce. I show support just below its last low to be followed by a consolidation/bounce into September but based on what I'm seeing for the broader market I'm not as confident of that move. But we've seen the banks doing their own thing (sell hard while the broader market rallies and vice versa) so it's entirely possible.

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

The bounce in the home builders didn't last very long and didn't even make it back up the July 2006 low. It now looks ready to head for new lows. A break below the bottom of a parallel down-channel for price action since the February high would be a bearish signal that the selling is going to accelerate.

Oil chart, September contract (CL07U), Daily

Oil held its uptrend line from January 2007 so we know that uptrend line is significant--any break of it will be a sell signal for oil. It's still possible we'll see a final leg up to the 80.67 Fib projection.

Oil Index chart, Daily

Oil stocks look ready to roll over with the broader market. Any rally from here could break its downtrend line so once again a market rally could spoil the bears' party. Otherwise a quick drop to the bottom of a steep parallel down-channel and the uptrend line from October 2005 around 640 looks like the next move.

Transportation Index chart, TRAN, Daily

The Transports are leading the way down. This index has firmly broken support at its 200-dma and uptrend line from September 2006. This should be headed much lower from here.

U.S. Dollar chart, Daily

While the US dollar may pull back from its downtrend line from March 2006 it's looking like it may have finally found a bottom. I expect to see the dollar rally above 82 very soon and over the next many months it should rally up into the 90s before starting another large decline to new lows next year.

Gold chart, December contract (GC07Z), Daily

If the US dollar rallies strong it should crush the prices of the commodities (which is why oil might not make its Fib target above 80). The bearish wave count that I've got on the chart calls for a strong decline as a series of 3rd waves to the downside starts to unfold.

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

I mentioned the housing starts and permits above with today's economic reports. These two reports could move the market if there's a surprise either way. The market will need to be rallying well before 12:00 so I don't see the Philly Fed report having an impact

SPX chart, Weekly

The monthly chart (not shown) has the oscillators turning back down for the first time since January 2004. The weekly chart shows stochastics (fast setting) now in oversold but no hint of reversing back up (it could go flat in oversold which would be a sign that we're in a strong downtrend). The bottom of its parallel up-channel for price action since the October 2002 low is near 1350 and is where I think price is headed next. I think it will consolidate for a bit there and then break support but we'll worry about that if and when it gets there.

By the EW pattern it's do or die time tomorrow morning. In order to prevent the bearish wave pattern from becoming pretty much set in stone the bulls have to rally this market out of the gates tomorrow and they have to rally it hard. If today's end-of-day selling was just an extended throw-under below the descending wedges shown on the DOW and SPX 60-min charts then that bullish pattern calls for an immediate rally and the rallies out of descending wedges are typically sharp.

If price even dilly-dallies tomorrow morning around today's low then it will simply look like a little bit of consolidation before heading lower. That's why the bulls need to take the reins and get this thing rallying again. Whether that rally then turns into something more than a bounce will have to be determined later. But if the market continues to sell off out of the gates tomorrow, as the bearish wave count calls for, then we will likely see some very strong selling. Forget about buying the dips in that case and look to short the consolidations/bounces.

Just keep in mind that the bearish wave pattern is set up where the DOW could give up 400-500 points by the end of the day. It wouldn't surprise me to see the market start with a big gap down (which would have the DOW gapping below its 200-dma) which would obviously answer the question as to whether the market will immediately sell off or rally instead. To keep things simple I'm almost tempted to say just follow the initial move out of the gate (as long as it's not a head fake move).

Good luck and be careful of the volatility. Managing stops is a real challenge right now. I'll be back next Wednesday when we'll definitely have an answer to tonight's question. For those of you on the Market Monitor we should be able to follow the initial move and make some money from it. I'll see you there.

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