Option Investor
Market Wrap

'Tis the Bearish Season

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After reading Jim's Market Wrap from last night (a must read if you missed it) about the massive options trades that are either hugely bearish or a way for a very large customer to satisfy short term cash needs, one can only conclude that something very bearish could be in the works for the coming month (before September opex). We are entering one of the most bearish seasons for the stock market (September/October) and as it turns out we've entered a decennial pattern within a Kondratieff cycle that is also bearish.

Even if you don't follow or understand EW (Elliott Wave) patterns, I hope I've been able to explain adequately over the past couple of weeks how the wave pattern points to the potential for a significant decline within the next several weeks. So reading Jim's piece on the potentially enormous bearish options bet grabbed my attention big time.

The idea that someone knows about some kind of terrorist plot that is going to tank the market is something I'd rather not consider. Call me Pollyannaish but I'd like to think we can stop that kind of massive terrorist attack. The other option that Jim discussed was someone making the trade as a way to get their hands on a large sum of money for a few weeks. This one actually makes some sense if you think about the possibility that a major bank is in trouble.

Let's say Bear Stearns (BSC) is in serious trouble. Last week the Fed waved the rule that restricts the amount of money a bank can lend to its brokerage business. They upped it from 10% to 30% (which can be raised if needed). First of all that's a very scary proposition and it sounds like the Fed just OK'd the BSCs of the banking world to double down on their bad bets. Now let's assume that a BSC has acknowledged that even that's not enough and they need more cash. The Fed is not an option and no other bank is going to lend to them knowing where the money is going. So that leaves BSC (hypothetically) only one option--get it from the market.

Call it the Hail Mary play. If a BSC knows they're going to lay a big stink bomb on the market (bad earnings, threat of bankruptcy, etc.) and knows that it will tank the market then this could be their last and only hope for generating capital to bail themselves out. And if it doesn't work and they have to take other banks and hedge funds with them, so much the better so as to take the spotlight off only them. This is of course all speculation but I think entirely plausible.

I had mentioned at the end of Monday's Market Wrap that there's some additional information I wanted to share tonight about the confluence of timing studies, historical patterns and the seasonal pattern that point to a particularly vulnerable period between August 27th and October 26th. We've entered that window and therefore it's important that we understand why the stock market is now vulnerable to a significant dislocation.

I hesitate to even talk about stock market vulnerability at this point since my Monday and Jim's Tuesday Market Wraps were already heavy on the bearish sentiment. Nobody likes to talk about negative things and when we talk bearishly we know we lose readers. So the decision for us writers is whether to blow sunshine up your yoohoos or talk reality and let the chips fall where they may.


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I know you know where I stand on that issue. We're all adults and trading our own money. If I don't tell you the good And the bad then I do you a disservice. My hope is that you find information from this newsletter helpful enough to make you money (or sometimes more importantly, to keep you from losing money) such that the subscription cost is recouped multiple times over. Teach a person to fish and feed him for life is something I strive to do. You can then take information we present and make your own trading decisions. Always remember that one trading decision is to remain flat. Many times no trade is far and away the best trade.

Before getting into this I do want to cover today's events first.

Economic reports
There was only one scheduled report today--crude inventories. There was also a report on mortgage applications.

Crude Inventories
Oil price got a boost today on the report that crude inventories dropped more than had been expected, down -3.5M barrels to 333.6M. This is a big reversal off last week's gain of 1.9M barrels but continues the decline over the past two months of more than 20M barrels. Gasoline supplies also declined, down -3.6M barrels to 192.6M. That puts it at -8.2% below the year-ago level. They're down -12.1M barrels in just the last month. Distillates (includes diesel and heating oil) were up +900K barrels to 129.9M.

The drop in refinery capacity from 91.6% to 90.3% in the past week helped explain the continuing drop in gasoline supplies but the continuing build in distillates and a slowdown in driving (after Labor Day) could mean a lower demand soon for refinery capacity and therefore a lower demand for crude. This in turn has many believing crude prices will drop into the fall. The current chart, and its wave pattern, supports that contention.

Mortgage Applications
Applications for mortgages filed last week fell -4.0% from the previous week while average interest rates on ARMs (adjustable rate mortgages) shot higher to 6.51% from 5.84%. Fixed rate mortgages fell slightly. Refinance applications on existing mortgages also dropped -4.2%.

While on the subject of interest rates, here's an update to the 10-year yield that I've been following:

10-year Yield (TNX), Daily chart

I thought TNX would start a bounce from the 45.61 area (where its 5th wave down was equal to its 1st wave down) but it dropped a little lower yesterday and today. But today it bounced back up and may have found a bottom (bullish divergence at today's low). If not then it's not much further down where it will touch the bottom of its parallel down-channel which should provide support near 44.50. I still expect a larger bounce back up into the end of September/early October. The only fly in the ointment is what it will do around FOMC on September 18th. I'll be assessing this all the way into that meeting.

Onto another subject, a reader had asked me how I could tell when a move was "running out of steam". I had explained on the Market Monitor that a move up or down that was losing momentum was essentially running out of steam. The oscillators are momentum indicators and two of my favorites are MACD and RSI. I use divergence between price highs and oscillator highs or price lows and oscillator lows. If a new price high is met with a lower high in MACD or RSI then I know the move is likely losing momentum and to start watching for signals of topping (and reverse for finding a bottom).

Market breadth is another way to identify when a market is losing momentum. Whether it's the number of new highs vs. new lows, up volume vs. down volume or advancing issues vs. declining issues, there are a number of these indicators to tell you when a move is running out of steam. For example, look at the NYSE during its last rally as compared to the number of new 52-week highs that were being made:

NYSE (NYA) vs. New 52-week highs, 60-min chart

What I find interesting, if the numbers are true (I haven't had time to verify them at other web sites although QCharts reports them the same), are the number of new 52-week highs and lows as shown in the table at the beginning of this report. If a strong rally like today can't produce a higher number of new highs than new lows then something is very wrong with today's rally. The numbers in the table above show twice the number of new lows over new highs.

But what I really wanted to show is the lack of strength in the rally as it approached the high on August 24th. Fewer and fewer stocks were participating in making those new price highs in the bounce and that created a negative divergence. The move up was running out of steam.

Now before getting to the rest of the charts which haven't changed a whole lot from Monday's charts, I wanted to finish the discussion on what makes the next two months a particularly vulnerable period (which the EW pattern fully supports).

First is the seasonal pattern. May and September/October are the seasonally weak periods in the stock market. So we're entering a weak period now.

There is a decennial pattern that has been very reliable in showing that the years 6 and 7 of the decade are important years. If a bull market corrects during year 6 it will then tend to run until year 9. But if there is no correction in year 6 (which there wasn't in 2006) then the market peak occurs in year 7. The years 0 through 2 of the decennial pattern are the other weak years and this decade was no exception.

After the stock market peak in 1929 the next high for the market was a lower high 8 years later (a Fibonacci number). Back then the US dollar was tied to the price of gold so the 1937 high was a lower high in both US dollar and gold terms. More recently, in gold terms the market made its high in 1999 and that high has been followed by the next high this year, 2007 (also 8 years), but it was a lower high when measured in real terms, i.e., using the price of gold. In fact when pricing the market by the price of gold the DOW hasn't even retraced 70% of the 2000-2002 decline.

So the market has reached the top of both models--we're at the top seasonally and we're at the top in the decennial pattern. In the past these occurrences have not been kind to the stock market. This only offers us a guide since the window is fairly wide. We could still make a new high in September and experience a significant selloff into October. What this period warns us about is the higher than usual likelihood that the market will be much lower by the end of October than it is now as the probability of panic selling during this time is higher than usual.

An interesting Fibonacci ratio is at play here as well. The window of vulnerability, as I mentioned Monday, started August 27th and runs through October 26th. The end of August is close to a Fibonacci 62% of the way through the year and this week is close to 62% of the way through a 10-year period when that period starts with year 1 instead of year 0.

When we relate this period of vulnerability to what's happening in the credit market, and the fact that nothing has been done to ameliorate the problem (the Fed's reduction in the discount rate does not solve the problem but was instead a token gesture in hopes of calming the market), the credit contraction has only just begun and the market could get a strong whiff of the significance of the problem in the next two months. That's when risk will be avoided at all costs.

Banks are withdrawing credit availability to everyone from hedge funds to home buyers. The swamp has been drained of water so rapidly that all the alligators (leveraged plays) have become fully exposed. The underlying values of the leveraged vehicles, such as houses and their mortgages leveraged into the multitude of mortgage-backed and other collateralized securities, has been dropping. As these underlying values drop we are seeing the leveraged vehicles completely collapse in value. Again, nothing has been done to slow this process down nor will anyone be able to prevent the necessary correction that is coming.

Back to Jim's article last night--if there is a major bank, or two, in serious trouble because of all this, and we're in a significantly more vulnerable period in the market, the combination may be a one-two punch that's going to cause lights out for the market.

I read some interesting information about what the Fed has done and more importantly what it has not done to help this credit situation. As for injecting liquidity, the Fed actually only offered temporary collateralized loans and only against valuable mortgages issued by Fannie Mae, Freddie Mac and Ginnie Mae. It's also accepting "investment quality" commercial paper which is highly liquid IOUs and not junk.

By doing these things the Fed has taken on virtually no risk and the net liquidity push (after the repo agreements close) is zero. The financial system is still saddled with a huge number of bad loans that can't be sold to free up capital. This is forcing banks to sell other assets to raise the necessary cash in order to buy back their mortgage collateral from the Fed. The only thing the Fed accomplished is putting off for a couple of weeks what's going to happen anyway. And they pushed it off into what is the most vulnerable period for the market.

The Federal Reserve is made up of member banks whose shareholders can be anyone. These member banks are not going to want their assets exposed to the subprime slime and they very likely have been on the phone with Bernanke insisting that they don't want that exposure on their books. This is also a reason why I think a major bank could be in trouble and is not getting a helping hand from the other banks. Hence the Hail Mary play (that's being referred to as the Bin Laden trade in various chat rooms).

If the Fed were willing to take on junk as collateral then they risk the strong backing and security enjoyed by investors in Treasury bonds. Risk those and the Fed would seriously risk the entire banking system. While mortgage lenders and a slew of hedge funds might be screaming for relief, the Fed has very little power to help them out. The Fed's policies encouraged the leveraging and credit creation over the past many years but now that it's collapsing they'll be forced to sit on the sidelines with the rest of us and watch the flailing, crying and gnashing of teeth as the excesses are worked out of the system.

Bill Gross, of PIMCO, has been all over the news about his piece written last week in which he implored President Bush to create a task force to save homeowners from defaulting on their loans. In order to do this the government would effectively be guaranteeing the mortgage loans. If they did that they would effectively be converting them to Treasury bonds. And then we'd be back to the same problem mentioned above--the government would risk the security prized by owners of US Treasuries. Risk that and you risk a major selloff in Treasuries. There's no way the government is going to risk that.

During the time that all this credit has been created we have an investor group that had essentially ignored risk. As things start to unwind it will be shocking to most investors how quickly things can change and fear will likely grip the market in ways most of us have never experienced. Unless you were trading prior to 1982, and really in the 1970s, you have only known a bull market. When the reality of what's in front of us starts to be recognized by the masses then we'll see the market move down like there's no tomorrow.

So as I've been warning more lately, now is the time to go into protection mode. Take your profits off the table, go to cash and hunker down until we get through the next two months and then let's see what we've got. If you like playing the short side of the market then always have a short position--a couple of December puts or something like that. I believe the upside gain potential is significantly dwarfed by the downside risk and it's simply not worth it in my book.

Now that you're all depressed, let's take a look at today's charts. The market had a great rally today and pretty much reversed yesterday's hard selloff. What traders hated yesterday they loved today, although I suspect a lot of shorts simply covered as the market proceeded higher.

After a very nice impulsive 5-wave decline from Friday through yesterday's close I had suggested on the Market Monitor to take profits on a short that was entered on Monday afternoon and get ready for a bounce today. We got the bounce and at the end of the day I suggested traders get short again.

DOW chart, Daily

On Monday night I had said I expected a pullback this week. The pullback would then lead to either another leg up into September or a decline that keeps going. The pullback, if it is to be just a correction to the August rally, needs to be a 3-wave decline. The drop from Monday to Tuesday's low was the first leg down, today was the bounce and now we're due the 2nd leg down, to give us the a-b-c pullback from Monday's high.

That's why I'm expecting another leg down tomorrow and if it happens then it should really whack traders around since a big decline to 12900-13000 will give us a much more volatile week than had been expected. There is an unwritten rule that in the last week of August no one does much in the market since it is vacation week for many of the traders. I guess the memo didn't get passed around this year.

DOW chart, 60-min

The decline from Monday was a 5-wave impulsive move and today's bounce was a 3-wave correction of it. If the EW count is correct on those two moves then we'll get another leg down starting tomorrow. A 5-wave move followed by a 3-wave correction will get another 5-wave move in the original direction--down. Two equal legs down would have the DOW dropping to about 12950 which is also a 50% retracement of the August rally.

The market is not in immediate trouble unless the DOW drops below 12800 which would be a break below the 62% retracement level and it would suggest that we could be into a 3rd wave down and not wave-c of B which would lead us to another strong rally into September. Therefore, assuming we'll get a decline started tomorrow, I'll be watching for a 5-wave move to complete. If it does so at or near 12950 then on the Market Monitor I'll be recommending a buy there. If we only have a 3-wave move down and it's blasting through 12950 in the 3rd leg down then I'll be recommending staying short until we see a 5-wave move complete. Then if that move is followed by a sideways/up consolidation it will look like a 4th wave and I'll be recommending a short play again. I'm continuing to play this one leg at a time until the larger pattern becomes clear (either bearish from here or bearish after the rally into September).

SPX chart, Daily

It's the same setup on SPX as on the DOW (and NDX). Today's bounce should lead to another leg down as part of the pullback against the August rally. Notice where the rally stopped today--right at its broken uptrend line from July 2006. If it drops back tomorrow then it's going to look like a bearish kiss goodbye. A drop back below the 200-dma could be three strikes you're out when it comes to the 200-dma. Institutions would likely find 3 attempts and 3 failures to recapture the 200-dma this month to be bearish and would be their sell signal. That interpretation suggests the pink wave count is the correct one. I'll let price lead the way in that regard, as explained for the DOW charts.

SPX chart, 60-min

If the market declines tomorrow, as I think it will, then two equal legs down is just above 1412 which is the 62% retracement level. As explained for the DOW's 60-min chart I'll be looking at the wave count for the decline. If we get a 5-wave decline tomorrow that finishes at or above 1412 (1416.10 would be two equal legs down) then I'll be recommending a buy to see if the next rally leg into September gets started (upside potential to at least 1500 so it would be a very nice long trade). If the decline has not completed 5 waves and is blowing through 1412 then short will be right place to be.

The 30-min chart shows the setup I was using on today's Market Monitor:

SPX chart, 30-min

I had recommended a short play at the end of the day with a stop just above gap closure from Tuesday. That's at 1466.65 (ES 1469.75, which is the e-mini futures contract for the S&P 500). Front month put options work well right now because there's less time premium and the play should only last a couple of days (I'm getting in and out of plays on the individual legs until the larger pattern clears up). You can see how I labeled the decline from Friday's high--nice clean 5-wave move down. That sets the trend (unless it's finishing a larger a-b-c correction) which is why today's 3-wave bounce is a correction of it and why another leg down is needed.

The rally stopped right at the downtrend line from the two highs on Friday and Monday and was a little more than a 62% retracement of that decline. There's a good chance it will gap down tomorrow but if it gives us a quick pop higher to close the Tuesday gap then watch it for a shorting opportunity there. A drop back down to at least 1416 should be in the cards.

If by chance the rally turns into a 5-wave advance then something different is playing out and I'll be on the sidelines until it clears up. Until that happens this is a very good short setup.

Nasdaq-100 (NDX) chart, Daily

NDX got a stronger bounce than the others but so far its bounce is also just a 3-wave move so if it turns back down tomorrow then another leg down below 1900 should be next. If it keeps rallying instead then look for a move up to the 2000 area.

Nasdaq-100 (NDX) chart, 60-min

I'm expecting a 3-wave decline from last Friday's high. Even if we were to get a new high for the current bounce it does not necessarily become immediately bullish. An a-b-c correction (shown in dark red where the current bounce is wave-b) can have the b-wave exceed the previous high in this case. That kind of correction usually means wave-c down will travel 162% of wave-a.

Assuming the next leg down starts tomorrow then two equal legs down will take it close to the 50% retracement level near 1884. A little higher for this bounce followed by a 162% move down would then get it close to 1865, the 62% retracement. Anything below 1865 would have me thinking more immediately bearish this index.

Russell-2000 (RUT) chart, Daily

I've been saying the 3-wave bounce off the August 6th low completed a wave-2 correction of the July-Aug decline (wave-1). Until the RUT can rally back above 800 we should see a strong decline start to kick in.

Russell-2000 (RUT) chart, 60-min

Today's rally tells bears to be cautious. The high today overlapped the low on August 23rd which is labeled as a small degree 1st wave down. That means today's rally can't be the small degree 4th wave (wave-4 can't overlap wave-1 low) which means the pullback from the high on August 23rd is either just a 3-wave move and therefore a correction to the rally off the August 16th low (which means today's rally started a new leg up which will exceed 800) or else today's rally is a smaller degree 2nd wave correction.

This latter count, which is the way I labeled the chart in dark red, is very bearish as it calls for a 3rd of a 3rd wave down (within an even larger degree 3rd wave down from the August 23rd high). That probably sounds like a bunch of gobbledygook if you don't follow EW analysis but simply stated, that bearish wave count calls for a screamer of a selloff next. It would mean the RUT will drop below 730 in roughly a blink of an eye, give or take a twitch. So take any selling tomorrow seriously. On the flip side, a rally above 795 would be bullish.

BIX banking index, Daily chart

The banking index bounced with the broader market but again looks like a correction of the recent decline. Unless the banks can rally back above 380 the wave pattern looks very bullish for the banks. Strong selling is due next.

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

Even with the strong rally in the broader market the best the home builders could do is a doji day with a flat finish. It should continue lower. But the short term picture is starting to show bullish divergences so the move down may be "running out of steam". It could drop lower as depicted but it may be getting close to a larger consolidation to work off its oversold condition before proceeding lower.

Oil chart, December contract (CL07Z), Daily

Oil's rally stopped at its 50-dma (pink) so the correction to its decline might have ended today. The wave count on the chart shows a strong decline is next. But a continuation higher calls for at least a higher correction and back up to its broken uptrend line near 74 would likely be next.

Oil Index chart, Daily

I had thought the oil stocks would tag 750 before dropping back down but yesterday's decline made it look like the bounce had finished. Now it's questionable. If the broader market sells off then the oil stocks will likely follow. But it might push higher and tag its 50% retracement and the top of its parallel channel before turning back down.

Transportation Index chart, TRAN, Daily

The wave count on the Transports is very bearish with yesterday's decline the start of the 3rd of a 3rd wave down. If this wave count is correct then the rest of the week will see strong selling. Otherwise a continuation of its bounce back up to its broken uptrend line near 5100 could be next.

U.S. Dollar chart, Daily

The US dollar is trying to bounce off the bottom of its descending wedge. If it drops a little lower then it will create some doubt as to whether or not it has made a bottom. I think it has but it must bounce from here otherwise that assumption could be wrong.

Gold chart, December contract (GC07Z), Daily

Assuming the US dollar can finally get its rally going that would support the bearish wave count on gold. But if the dollar drops lower then gold will likely break above its downtrend line from July and a rally above 688 would suggest gold is in at least a much larger sideways correction or possibly even bullish. But until then I expect gold to turn south and start to sell off at a high rate of speed.

If the credit crunch becomes more recognized and investors start to realize the Fed really can't do much to help then real assets will get sold to cover huge margin calls from all the bad debts and collapsing leveraged positions. That scenario fully supports the very bearish wave count that I currently have on the chart.

From a fundamental aspect, for those who can't believe gold is not going to be something someone runs to as a safe haven as an inflation hedge, I think it's important to understand why I'm bearish gold (other than what the wave count is telling me and the fact that I think all assets will get sold this time around). As long as the dollar remains the world's reserve currency gold will primarily function only as a hedge against inflation. With banks in trouble, loans going bad and mortgage lending coming to a halt, there's a very good chance that the economy will slow rapidly. The collapse of the mortgage industry will be deflationary and therein lies the problem for gold.

Looking back to the last big credit crunch (1990), which was centered around the savings and loan companies not being able to lend to commercial real estate developers, gold fell from around $400 in 1989 to a low of $327 in early 1993 (about 20%). Gold should fall at least that much during the next 12 to 18 months, potentially much faster, which would put gold at around $550. Looking at a weekly chart of gold I show what we should expect from an EW and Fibonacci perspective:

Gold chart, December contract (GC07Z), Weekly

A correction to the long term bull market in gold would typically see an A-B-C pullback which is how I have it labeled on the chart. Two equal legs down would take gold back down to 515. It's quite possible this correction will be more severe and the 2004 lows near 425 would also be a typical move for the 2nd leg down in times of stress. If and when we get that kind of decline then it will be an ideal time to get long the shiny metal for what should be a very good long term bull market in gold. But not yet.

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

Tomorrow's economic reports are generally benign except for the GDP number. If it shows strong growth then the market will start to doubt its assumption that the Fed will reduce interest rates on September 18th. Right now the market is thinking the Fed will cut the Fed funds rate and if that assumption starts to change then a selloff could follow. That might be the reason we'll get an immediate selloff started tomorrow morning.

SPX chart, Weekly

Obviously there's little change on the weekly chart from what I showed on Monday. If this starts back down and we don't get the larger bounce into September then the next leg down will probably break below 1365 and sell off quickly. Otherwise we'll have to see if it chops its way higher for a little longer into opex week.

Tomorrow should be easy--either get short or stay flat. The setup is there for another leg down but the selloff has to start right away. Therefore it should be a quick decision to short or stay out. If the market does gap down then the entry becomes a little more difficult since the stop would have to be above today's close in order to prevent a whipsaw exit. On the Market Monitor I'll try to identify additional entries and stop levels. But as I said, if the rally continues then there's a good chance we'll see a consolidation followed by a minor new high and then a deeper pullback. In other words it would look like a choppy day and I'd rather see be on the sidelines until I figure out what's next.

Volatility is clearly more than most traders had expected for the week and that may not change. While volume was respectable today it's still relatively light and light volume can make for a whippier market or a relentless move in one direction without willing participants to take the other side of a trade. For this reason a little extra care in your trading is warranted until we get everyone back next week after the holiday.

Good luck tomorrow and for the rest of the week. Have a great long weekend and I'll be back next Wednesday.

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