I (Keene Little) will be filling in for Jeff tonight. It was another light volume day as most of this week is expected to be. This week is the last week of the summer and probably many senior traders are out at the Hamptons with specific instructions for their junior traders to hold the market up since bonuses and jobs are dependent on it.
The market slipped back a little today and junior probably got a call at the end of the day asking what happened. He (she) didn't do too well holding it up although price action was certainly tame as compared to recent volatility. But as the table above shows, market breadth was worse than one would have thought based just on what the DOW did. The DOW held up better than the others though. The S&P 500 was down the equivalent of about 120 DOW points and the small caps (RUT) dropped an even higher percentage (-1.2%). Declining issues and declining volume was better than 2:1 over advancing. New 52-week lows beat out new highs.
The question of course is what to make of today's pullback. Whether we'll get a just a small pullback correction before heading higher or something larger is on everyone's mind. Many are talking about the need for a retest of the August lows before we should expect the market to proceed higher. That of course sets us up for an immediately higher market if too many are expecting a pullback.
But the flip side says too many are expecting a test of the lows as an opportunity to get long for a rally to new market highs (thinking that all previous pullbacks, including the sharp one in May, were great buying opportunities). That potentially sets up the market for a strong decline to new lows. As usual I'll show both scenarios in the charts.
There's still a lot of buzz about what the Fed might do with interest rates when they meet September 18th (Tuesday of opex week which should be fun). I've been following TNX for a long time and have shown the charts for it before. The decline from the high in June now looks impulsive and it has broken the uptrend line from June 2003:
10-year Yield (TNX), Daily chart:
I've labeled the decline from June and show a 5-wave move. I also show where the 5th wave equals the 1st wave at 45.61 (4.561%). The bullish divergence at the new low helps confirm the wave count and suggests we're very close to getting a big bounce to correct the June-August decline. This suggests to me that the Fed will Not reduce the Fed funds rate from 5.25% this September. The stock market will surely have a little hissy fit over that.
But the significance of the 5-wave decline is that it could be defining the next trend which is down. A 5-wave move needs to be corrected and that's the bounce that I show heading into September/October (the bond market will probably start to whiff out the Fed's intentions before the September 18 meeting). But after the bounce we could see yields tip over and head south at a high rate of speed. I can only assume at this point it will be because the stock market is falling hard and people are running to the safety of Treasuries and the slowing economy will have people guessing that the Fed will be forced to lower rates (to follow what the bond market will already be doing).
From a longer perspective, this weekly chart shows the pattern I've shown a few times:
10-year Yield (TNX), Weekly chart:
The ascending wedge pattern of the rally in yields since 2003 is bearish. I thought we'd see a final high near 54 (5.4%) but it appears that the June high may have been it. As discussed for the daily chart, a bounce should be followed by a clear break down from this wedge and head much lower. Ascending wedges typically retrace relatively quickly and I believe the same thing will happen here. A drop below 3% over the next year or two should be in the cards.
I'll continue to watch yields carefully and update as we move forward. Before getting to the rest of the charts let's look at the only economic report today:
Existing Home Sales
Inventories of unsold homes rose by +2.2% to 3.85M, so at the July sales pace it represented a 9.2-month supply, the highest level since October 1991 (16 years). Inventories of unsold condos rose significantly by +20% to 742K, an 11.9-month supply. Together unsold homes and condos rose +5.1% to a record 4.59M, representing a 9.6-month supply.
Most analysts now recognize that the inventory glut is not going to go away soon. The expected improvement in sales in spring and summer did not appear and the extra homes put on the market this year are now mostly sitting with very little buyer activity. After getting through this summer there will very likely be many sellers who simply pull their houses off the market and sit tight. There are of course many sellers who can't afford to do that (literally) and will be forced to sell at whatever price they can get.
And now with mortgage companies having swung rapidly over to the other extreme (from lending to anyone who could fog a mirror to only lending to those who really don't need it), even better qualified buyers are finding it difficult to find a mortgage. A realtor friend told me she's been in the business for 30 years and for the very first time was just denied a mortgage.
Sellers will now find themselves in a real pickle--they'll need to drop their selling price drastically in order to get a buyer interested in a "good deal" but even the good-deal price may not get funded by a mortgage company if the buyer doesn't have a stellar credit rating and has more than enough income (preferably two).
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The glut in the number of homes being put on the market for sale has been more or less a result of normal buying and selling (less buying these days)--younger people trading up to larger homes, empty nesters downsizing to smaller homes, job changers swapping houses in different cities and the rest of the reasons for the usual buying and selling. Now we're getting more selling because more people can't afford the mortgage. Whether their eyes were bigger than their wallets and simply can't afford that new house or because of mortgage resets, the net result is that this problem only adds to the unsold inventory of homes on the market.
I've been warning for a long time that the housing bubble would not have a good ending. Many people kept saying housing is not like stocks and can't suffer the same thing as the stock market. Those who said this did not study history and they forgot the Economics 101 lesson about supply and demand. Take away demand or add supply and there can be only one consequence--the price will go down. Right now we're getting an increase in supply AND a reduction in demand as people hunker down and wait for the storm clouds to pass. This means that more homes will be on the market because they need to be. There will be motivated sellers and motivated sellers will accept lower prices. This will drop prices for everyone.
We've discussed mortgage resets before but many are not aware that the majority of these resets are yet to come. It is expected that $27B per month of subprime loans will hit their first reset over the next 12 months. In other words the subprime mess has only just begun since all of those repackaged mortgage-backed securities will continue to suffer and be downgraded as defaults on these loans continue to rise. And I don't think the ratings agencies will be nearly as complacent now about downgrading these repackaged bond portfolios now that they know the lawyers are eyeing them as one of the evil-doers in the mortgage arena.
The next time you hear the media declare that the worst in the housing market is behind us, keep the following table in mind:
ARM resets, data courtesy
As you can see in the chart, mortgage resets year to date have just started to tick up. The real hammer doesn't come until the first 6 months of 2008. So whether those loans are subprime or not there are going to be a lot of people who simply will not be able to afford their mortgage once it resets to a higher payment, which is sometimes double their current payment. For the many home buyers who got into their home because they could barely afford the low rate this means they'll be immediately placed in the penalty box. Banks and mortgage lenders will be saddled with more homes than they care to own. Want to see a motivated seller?
With the tightening in lending standards I would say a majority of those people who get their mortgages reset will not be able to refinance their mortgage. They'll be stuck and if they can't afford the higher mortgage then they'll have two choices--either sell the home themselves or default on the loan and turn the house over to the bank to sell. I think intuitively we all know we're a long way from a housing bottom but very few are willing to come out and say so. They don't want to labeled as un-American.
As long as housing continues to suffer and head down hill there's very little hope that the stock market and our economy can stand up on its own. The falling housing market will be so depressing to all of us and that will cause the fear and frustration when it comes to spending or investing. People will hunker down and start saving again (a good thing but not for our immediate economy). Spending on Chinese goods will slow drastically and China's economy will take a hit. We're a global economy now and we'll all work through this one together.
I hate to sound all doom and gloom and would be much happier talking about a bullish market and why I see us exploding higher. But let's face reality instead of living in a dream world. The next year or two is going to be painful period for our country (and everyone else). So let's prepare for it instead of dreading it. For those who believe everything will be all right because the Fed will do everything in its power to not let the stock market crash and not let the economy fall on hard times I say "you can wake up now".
The Fed's tools are designed to handle supply. They can't do anything about demand. And by supply I of course mean money supply. But just as you can lead a horse to water you can't make him drink it. If people become fearful they'll refuse to borrow and will finally stop their profligate spending. Bankers who are fearful of their jobs won't lend out money to those whom they deem too risky. And the judgment of risk will be much different than it has been. The Fed can offer all the money they want, including at cheaper rates, but if the banker doesn't want to risk bad loans or people don't want to take on the risk of having a loan, then the Fed is completely powerless. They'll be pushing on a string and when fear takes over the string goes limp.
Speaking of limp, the market felt limp today. Low volume and slow trading made it boring to watch. But let's see what the price pattern looks like and what it might be telling us.
DOW chart, Daily
The chart looks a little messy because I've added both a Fib retracement and Fib time projection off the July-Aug decline. Price bounced up to just shy of a 62% retracement, which is at 13444, in about 38% of the time it took for the decline. The reason I'm showing the time projection is because of the a-b-c bounce projection in dark red. That wave count says we've had wave-a up and now we're due a b-wave pullback to be followed by another rally leg in wave-c.
If the July-Aug decline was a larger degree wave-A down then we're in the larger degree wave-B bounce. These b-waves typically take a little longer than the a-wave and the 100% time projection would take us into the middle of September. If this bounce pattern completes as depicted then the typical time projection takes us into opex week. The FOMC decision on rates could very coincide with a high for the bounce (in other words, no rate decrease could start a swift and strong selloff in the stock market).
That's all speculation at this point and the first thing I'm watching for is what kind of pullback we're going to get (assuming it started today). If we get a 3-wave pullback to the 200-dma and uptrend line from July 2006 then it will be time to buy it and see if a new rally leg gets started. If the decline becomes impulsive and blows through 12800 then you'll want to be short for the next strong leg down (pink wave count).
The 60-min chart shows the setup for a short play from here:
DOW chart, 60-min
The bearish ascending wedge pattern since the August 17th high is still intact but won't be if the DOW drops any lower tomorrow. These wedges are typically retraced quickly which means the DOW could drop back down to 13K this week. A drop below 12800, as mentioned above, would also be a break below the 62% retracement of the rally from August 16th. That would be a bearish signal so we'll assess if and when we get there.
The reason it will be important to watch how this next decline progresses (again, assuming we get one) is because of the larger pattern. This monthly chart gives a sense of where we are in the rally from 2002:
DOW chart, Monthly
After reaching, and slightly exceeding, the projection for two equal legs up from October 2002 it would appear the DOW is ready to roll back over. This year's highs were on lower volume and now the oscillators are rolling back over. If the market has peaked (bull market finished) then the next leg down will be Bear Market Phase II. I show a Fib projection for the decline where it will equal 162% of the 1st leg down in 2000-2002 (typical for the kind of Elliott Wave pattern we have here). That projection is at 6655 and would be a break below the October 2002 low.
For those who can't believe that that could possibly happen I've included a chart of the DOW during the 1970s:
DOW chart, Monthly
After making a new high in 1973, when everyone thought the bear market must be over because of the new high, the DOW then proceeded to drop back below the 1970 low in late 1974. I don't know if we'll repeat this pattern but it's possible we're going to face the same economic troubles that we faced 30 years ago and therefore find a market that does the same thing to us. As you can see, the 50% haircut in a little less than 2 years was a swift decline. The Fib projection to 6655 doesn't look so outlandish when you look at this chart.
SPX chart, Daily
The SPX daily chart shows the same Fib retracement and time projection as the DOW chart. The key level is at 1412 which would be a 62% retracement of the rally off the August 16th low. Even if we're going to get a larger 3-wave upward correction, as per the dark red a-b-c bounce, a decline should still get us down to the 1430 area before bouncing (which would then be a very good long play). The time projection shows the 2nd leg up of that larger bounce pattern finishing during opex week. Whether it's opex related or FOMC related, it looks like it could be an important turn week if we rally into it. But if more immediately bearish things are about to happen then the pink wave count is about to unfold which has us declining to new lows from here.
SPX chart, 60-min
The ascending wedge pattern on the 60-min chart, the same as shown for the DOW, shows price broke below the pattern today which created a sell signal. A quick retracement of the wedge, so back to 1430, would be a typical move. If we get a 3-wave decline to that level or above then I'll be looking to buy it to see if we get the next rally leg (dark red wave count) but if the decline looks impulsive and blows through 1412 then the more bearish wave count will begin to look like a better possibility.
Nasdaq-100 (NDX) chart, Daily
NDX has the same pattern as the DOW and SPX and the same comments apply. Note that the rally did almost a perfect tap of the 62% retracement of the July-Aug decline at 1963. This higher level retracement actually increases the odds that the bounce from August 16th is ending and not just part of a larger upward correction.
Nasdaq-100 (NDX) chart, 60-min
(insert http://content.rightside.com/13390/1748_6402ac6240fe50c1_MW_082707_04A.gif here)
Assuming we'll start a larger pullback this week, a retracement greater than 62%, which would be below 1865, would begin to look more bearish. Like the DOW and SPX, the form of the decline will help determine whether we're getting an impulsive (more bearish) or a corrective (intermediate bullish) pullback.
Russell-2000 (RUT) chart, Daily
The RUT continues to show me a price pattern that is more immediately bearish. The bounce off the August 6th low looks like a complete A-B-C correction of the July-Aug decline. With that decline as wave-1 and the A-B-C bounce as wave-2 that means we should be ready for wave-3 down. These are the strong and fast legs of a 5-wave move so getting short for the next leg down is the right thing to try here.
Russell-2000 (RUT) chart, 60-min
If the wave count for the bounce is complete then the 802.57 high on August 23rd should not be violated. The downtrend line from July 19th should hold and in fact should not even be tested again. The bearish wave count on the RUT calls for a swift decline to follow and the weekly chart shows downside potential:
Russell-2000 (RUT) chart, Weekly
Using typical Fib relationships between the waves, the next leg down could drop quickly to the 620 area by October. Some might view this as a crash and when defined by percentage changes I suppose they'd be correct. But the daily selloffs might look more like an orderly bout of panic selling rather than a crash. Panic selling would be relentless and hard selling as opposed to a flat out no-bid situation with trading halts, etc. that you'd see in a market crash.
BIX banking index, Daily chart
After bouncing back up to its broken uptrend line from October 2002 through its October 2005 low, the banking index appears to be rolling back over. The 3-wave bounce off the August 6th low looks very much like the RUT's pattern that I just explained. But in this case the banks look to be setup for a decline in a 3rd of a 3rd wave down. Again it doesn't have to take on the appearance of a crash but strong relentless selling bordering on panic selling is probably something we could expect out of this kind of bearish setup.
Don't forget, the Fed has really done nothing to alleviate the credit crunch. They've made token gestures but the banks are still starving for cash with their inability to sell their debt. It's not just subprime mortgages but now includes all kinds of dubious debt that investors don't want to touch with a 10-foot pole. The plight of the banks is far from over and the bearish wave count that I have for the banking index suggests we're about to see a lot of investors getting the picture of what's happening and they're going to want out fast.
U.S. Home Construction Index chart, DJUSHB, Daily
The home builders just keep working their way lower and the index is currently stalled at the bottom of its parallel down-channel. It should fall out the bottom and then find it to be resistance on its next bounce.
Oil chart, December contract (CL07Z), Daily
Oil broke its uptrend line, bounced back up for a retest and is now bouncing around inside its 100 and 200-day moving averages. The wave pattern here suggests we're about to see a stronger decline in the price of oil right around the corner.
Oil Index chart, Daily
The oil stock index might be able to make it a little higher to retest the top of its parallel up-channel, but it doesn't have to. It has already met the minimum that I would expect to see for this bounce and the next leg down should see some strong selling. Protect or exit long positions is my advice here.
Transportation Index chart, TRAN, Daily
The Trannies are also setting up a very bearish wave pattern with a strong 3rd of a 3rd wave down due next. The selling in the next leg down should be faster and stronger than what has been seen so far.
U.S. Dollar chart, Daily
If the US dollar can find support at its recent low, which is a retest of the bottom of its long term descending wedge, then the next leg up should finally break out of the wedge. That would be bullish and would suggest the US dollar is finding support from those who want to buy it for safety. If the stock market and bond market sell off in the next few weeks then investors flocking to the dollar makes sense.
Gold chart, December contract (GC07Z), Daily
If the US dollar finally finds its way out of its descending wedge and sees a strong rally then it won't be good for precious metals. We've already seen gold suffer even when the stock market sold off hard. It's no longer a safe haven because people will need to sell assets with real value in order to meet margin calls on assets with questionable value. The wave pattern is set up for a very strong decline from here, as long as it doesn't rally back above 688. A rally above 688 would suggest either a much larger sideways/up correction is in progress or could even be bullish. Until that happens, shorting gold is the right trade.
Results of today's economic reports and tomorrow's reports include the following:
Tomorrow's economic reports are only Consumer Confidence and the FOMC minutes. So much has changed since the last FOMC that most people will simply ignore the minutes of the last meeting. So the market will be left to fend for itself tomorrow.
SPX chart, Weekly
I showed the RUT weekly chart earlier so I thought I'd show the same kind of price projection if we're about to see some strong selling in the next two months. Using Fib projections I'm showing a decline to the 1220 area into October, a bounce into the end of the year and then a decline to the 1070 area within the first quarter of 2008. Those levels also coincide with previous price levels which adds credence to their potential importance. That 5-wave move down into next year would then be followed by a strong rally to correct the decline, perhaps back up to the 1300 area by the summer and then a very large decline in a 3rd wave in the last half of 2008 and into 2009.
While I see a lot of fundamental reasons for why the stock market is likely in trouble, I base much of my analysis on the EW (Elliott Wave) pattern. It helps keep me unbiased in my perspective as I try to listen to the wave pattern and not who's on CNBC. The wave pattern is unquestionably bearish right now and the only question in my mind is whether or not we get a larger upward correction into September opex week (and FOMC on the 18th) or start a more serious decline from here.
I will discuss more details in my Wednesday Wrap about some very interesting time studies and previous price patterns that point to a significantly vulnerable period dead ahead. Starting this week and running through the end of October we are exceptionally vulnerable to a significant market dislocation. I don't like to use the word "crash" because it has so many different connotations for different people. A market correction of 10% or more in a certain period of time can be considered a crash. Or perhaps it has to be a move that causes trading to shut down for a period of time. Or anything in between.
So instead of talking about a market crash I'll discuss why we could see very controlled but very strong selling that persists for days on end. Call it panic selling where fear simply grips the market and buyers are extremely scarce. The Fed will do things that may calm fears or it might exacerbate fears. Tonight I've shown some wave counts that are set up for a strong 3rd wave down, or even stronger 3rd of a 3rd wave down. That could certainly fulfill the definition of panic selling.
We've entered a window of vulnerability for the market and I'll get into more details of that on Wednesday. But I wanted to briefly mention it tonight because the window started today. It doesn't mean we can't get a new high in some markets and it doesn't mean we can't get the larger upward correction that runs into the 3rd week of September. What it does mean is to be careful about being long the market. If you have stops on long positions we could wake up some day and the market will have gapped down below your stops. Of all the times that the market has been precariously perched on the edge of a cliff, this is one of the worst times.
There are seasonal reasons (September/October) and time studies that point to this period of time as one you should be particularly cautious so please review your portfolio and positions and make some decisions now, not in a panic situation, about what you want to do and how you want to protect yourself. More details to follow on Wednesday.
Good luck in this slow trading week and I'll see you Wednesday (or tomorrow on
the Market Monitor).