Option Investor
Market Wrap

Follow the Money

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I've said this before and it will always be true--following the money trail is the way towards finding answers to many questions. The big question on most traders' minds of course is which way this market is going. We had a big drop from the July high and the market has been holding up fairly well since then. The bullish pundits continue to pound the table about the buying opportunity that the latest decline presented to long term "buy-and-holders". This strategy has worked for so long and is therefore perfectly understandable. When it stops working there will probably be some surprised faces on Wall Street. What we of course are attempting to do is identify beforehand whether or not the market may have topped out.

So far those who bought the August low have been nicely rewarded and like the Pavlovian response the bullish traders stay bullish with the expectation that dips are to be bought and those who buy will be rewarded. It's what reinforces the same behavior time and again and keeps those traders expecting the same result. I happen to believe the July high was an important one and that the bounce off the August low is simply a correction to the July-August decline. I don't believe that because I'm fundamentally bearish (although that's certainly part of my analysis) but I believe it because of what the charts are telling me. I believe it because of the time cycle we're in and the combination of the bearish EW (Elliott Wave) pattern along with the seasonal and decennial patterns is what makes the market particularly vulnerable at this time.

I know people don't like to hear bearish things about the market. It's much easier to feel bullish than bearish. When I tell family members to go to cash they think I'm one of those survivalists (just because I have a Montana ranch where we grow all our own food and don't need anyone else...just kidding folks). It's real simple what we do as traders--we try to get on the right side of the market and trade with it. We should be neutral and follow the market. We should make as much money on the down side as the up side. It just so happens it's more difficult to make money in a bearish market (you can make it faster but the moves against you are much stronger and faster as well).

While I base my trades strictly off the charts I also work hard to keep track of what's happening around us so that I have a heads up to what might be coming down the road. If a chart pattern is confusing and it's a choice between a bearish vs. bullish outcome then I like to see what fundamental reasons might swing the vote. My discussions in these Wraps have tended to focus on what could cause problems for the bull market. For this I have been labeled a permabear. So be it. I'm not big on titles. When we're fully established in a bear market I'll be looking for problems for the bear market and I'll probably be labeled Pollyanna. I'll get over it.

I'm going to go on record here and declare that the Fed will drop the Fed funds rate next week but it will only be a .25% rate cut to 5.0%. Linda and I will be switching Market Wraps next week so I won't be back here with you until Thursday. By that time the dust will have settled post-FOMC and we'll get to see how the market reacts to that. I'll explain below with the 10-year yield chart and the SPX chart why I believe the rate cut will only be .25% (I can't even imagine what would happen if the Fed stood firm on the current rate).

As we head into next week, which is opex week by the way (triple witching opex at that), all eyes are on the Fed and what they're going to do with interest rates. The market has priced in virtually a 100% chance for a .25% rate cut and a 74% chance for a .50% rate cut. If the Fed makes the cut (no pun intended) to 4.75% (.50% cut) do you think we could see a sell-the-news reaction? If the Fed only cuts to 5.00% (.25% cut) do you think the market will have a hissy fit? Do you want to be long the market next Tuesday afternoon? Me neither.

The market has rallied bonds strong in the past 2-1/2 months and in so doing it has knocked the 10-year yield down from 5.3% to 4.3% at Monday's low. It has since rallied to 4.4% today. So it has effectively priced in a full percentage point decline. But here's the interesting thing about the 10-year--it looks ready for a strong bounce if not rally. Here's the monthly chart of the 10-year yield:

10-year Yield (TNX) chart, Monthly

The internal wave pattern of the move down from the June high looks like a clean 5-wave move. That means at a minimum it's ready for a correction of that decline and I think we've seen the low for now. So if rates are going to bounce what does that tell us about what the Fed is going to do? To me it says the Fed could disappoint the market and show that it's not willing to aggressively slash rates like the market thinks/wants. So the stock market could be set up for disappointment as well.

For the weekly pattern of TNX I show two possibilities from here, both short term bullish (so bearish for bonds). The bearish wave count (dark red) shows a correction of the June-Sept decline, perhaps back up to near 4.95%, which would be a typical 62% correction of the decline (and suspiciously close to 5.0% which would be a .25% rate cut). From there we'd see renewed buying in the bonds in 2008 which would drive yields to new lows (and the Fed would probably follow).

The bullish price pattern calls the June-Sept decline as the finish to a 3-wave pattern within the ascending wedge (labeled wave-D in green) and this interpretation calls for rates to increase into 2008 to finish the ascending wedge pattern that started from the 2003 low. This scenario suggests inflation will continue to be a problem, even if the economy is slowing down, and rates will be driven back up with that threat (and a Fed that can't reduce rates and may be forced to raise them instead).

Which way yields go after a bounce should become clearer as the bounce progresses but for now understand that this pattern calls for higher rates and that could be telling us something important about the upcoming FOMC decision. I'll review why the pattern in the stock market could be telling us the same thing, particularly with the SPX 60-min chart below.


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Economic reports
Crude inventories report was the only scheduled economic report but the mortgage applications number was also released.

Crude Inventories
Consumers got the "blame" for continuing to consume and not conserve when it comes to oil products and the inventory drawdown took many by surprise. Crude prices for the front-month contract (October) hit an all-time high of $80.18 today, above the previous record high of $78.70. Crude supplies dropped -7.1M barrels to 322.6M which makes for a -14.5M barrel drop since mid August. However, inventory levels are still about +1.4% higher than this time last year.

Gasoline supplies also dropped, down -700K barrels to 190.4M. This is the sixth straight week for a decline in gasoline supplies and they're down -14.3M barrels since late July. The API data disagreed with the Energy Department's data on this as API showed an increase of +3.3M barrels to 200.2M. The Energy Department had distillates up +1.8M barrels to 134M while API had them up +5.7M at 137.6M.

Refinery utilization dropped to 90.5% from 92.1% the previous week and that's a sizeable drop. This attributed to the drawdown in gasoline supplies.

Mortgage Applications
The Mortgage Bankers Association (MBA) reported mortgage applications rose a seasonally adjusted +5.5% last week from the previous week as mortgage rates dropped. But applications were only up +0.1% vs. this time last year. The two components--refinance applications and purchase applications--were up +6% and +5.2%, respectively, from the previous week. The 4-week moving average shows mortgage applications down -0.8%.

DOW chart, Daily

The bounce off the August low is a well defined 3-wave bounce and a 3-wave move is a correction to the previous move. That means we should expect another leg down and that's what's shown with the dark red price depiction.

If you like to follow EW counts and for those who question the 3-wave move down from July I say good eye. The first thought is that a 3-wave pullback against the longer term uptrend should mean we'll see a continuation higher to new all-time highs. In fact many Elliotticians are calling for just such a move. This is where the art of interpretation (as with any technical indicator) comes into play. In corrective wave structures you need to explore many different possibilities.

I believe the longer term wave count from October 2002 is complete at the July high (which says the bull market finished there) and therefore it doesn't call for another leg up here. The 3-wave move down to the August low, as I'm interpreting it here, makes up a larger degree wave-A, and the 3-wave bounce into September 4th makes a larger degree wave-B. That calls for a large wave-C to the downside and that's what I'm showing.

DOW chart, 60-min

The decline from September 4th should have kicked off the large wave-C down as I explained on the daily chart. I'm showing a 1st wave down to the September 10th low, a 2nd wave bounce to today's high and now get ready for a stronger decline in a 3rd wave down. That's the bearish interpretation. It's possible we're still in a larger upward correction which calls for a rally up to the 13800 area. I show it as a possibility even though I think the chances of that happening are very slim. But the DOW needs to break below 13024 in order to negate that more bullish possibility.

SPX chart, Daily

The same daily pattern exists for SPX as I discussed for the DOW. The 3-wave bounce from the August low ended on September 4th and now we should be in the early stages of a strong decline in wave-C on the chart. I show a price and time projection based on typical wave relationships and it's pointing towards the 1250 area by mid-October.

The larger A-B-C move down from July into October (assuming this is how it will play out) will then create an even larger degree wave-(a) and we'll then be due a large 3-wave bounce into the end of the year for wave-(b). Following that bounce would likely be a very strong and protracted selloff into 2008. The price pattern will probably look similar in a lot of ways to the decline in 2000-2002.

SPX chart, 60-min

Also like the DOW's 60-min chart I show the bullish potential for a pullback to be followed by a press higher, potentially getting up above 1510. But I don't think the chances are very good for that move. More likely is a break of the uptrend line from August 16th through the September 10th low, currently near 1452. Then a bounce back up to retest the broken uptrend line before letting go to the downside in a stronger 3rd wave down.

The interesting thing about this price projection is that it shows a market selloff into Friday of this week and we've often seen the market get driven to lows on the Thursday/Friday before opex week. Then they rally the market during opex so they can cash in on all the cheap front-month options purchased (or shorted) during the selloff. So that fits the pattern here. But then a typical retracement of the leg down from today's high would take SPX back up to its broken uptrend line near 1468 by Tuesday September 18th. From there we'd be due a very strong 3rd of a 3rd wave down. These are the screamer waves.

And it falls on FOMC day. If this wave pattern sets up like this on Tuesday you'll want to stuff a few puts in your pocket. It says the market is not going to like the FOMC rate decision and that's the other reason I think the Fed only gives us a .25% rate cut. The 10-year yield and the stock market's charts are both in agreement here so now we'll have to see if I'm right on that call. Could be fun.

Nasdaq-100 (NDX) chart, Daily

NDX has the same chart pattern as the DOW and SPX. The 3-wave bounce off the August low should have ended on September 4th and today should have ended the correction to the first wave down from that high. I show the projection for the next leg down, wave-C, to the 1650 area by mid-October.

Nasdaq-100 (NDX) chart, 60-min

From the September 4th high I'm showing an impulsive decline followed by a corrective bounce (it was a double zigzag a-b-c-x-a-b-c bounce which can be seen more clearly on a 10-min chart). This says we'll see selling for the rest of the week and you should look for bounces to get short. Price needs to drop below 1944 in order to negate the bullish possibility that we'll see a pullback followed by another press higher.

Russell-2000 (RUT) chart, Daily

The RUT's bounce pattern off the August 16th low is similar but weaker than the others. One look at the sideways chop since the early August low is very telling--a sharp drop followed by consolidation means you should be looking for another leg down and that's what I'm showing. The downside projection for this one should be to about 650, potentially lower, by mid-October.

Russell-2000 (RUT) chart, 60-min

The RUT shows a very clean 5-wave move down from September 4th and that's impulsive. Then the overlapping highs and lows in the bounce says it's corrective. Put the two together and it calls for another leg down. It should drop relatively quickly below 760 from here.

In the above indices I show an "orderly" decline from our present position. While the selling will be intense at times, bordering on panic selling similar to what we saw at times in the July-Aug selling, it's not saying we're going to get a crash. Planning for a crash is always a low-odds probability play (since a market crash happens maybe once every 10 or 20 years). But, and this is a big but, if we're going to have a market crash, we're in the window for it now. I had mentioned in past Wraps that we're in a very vulnerable period for the stock market right now. Between the seasonal (Sept/Oct) and decennial (2007) patterns this is the time for a crash if one is due. With that, here's the analog between 1987 and 2007:

DOW in 1987 vs. 2007, Daily

Following analogs (comparisons of chart patterns from different periods) is something that can be very helpful since it's amazing how often patterns repeat. As you can see by the above chart pattern we've been following the 1987 pattern remarkably closely. We're currently peering over the edge looking at 10K directly below. For heaven's sake don't be on margin right now. Once we get through October, assuming we haven't crashed, then the analog comparison will have been broken and we'll be out of the vulnerable window. Until then, just stay on your guard for this possibility.

BIX banking index, Daily chart

The banks are chopping their way lower from the August high and this is either bullish (needing another leg up to at least the 200-dma near 392) or else it's very bearish with multiple 3rd waves to the downside setting up. If the steeper downtrend line, currently near 363, is broken to the upside, and especially if it pushes back above its last bounce high near 371, then the bearish pattern is in jeopardy and I'd start to think a little more short term bullish. And if that happens I would definitely be thinking more short term bullish the broader market. So keep an eye on this index (same with the Trannies as I'll explain with its chart).

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

There just hasn't been that much good news for the home builders to grab onto. The bullish divergences are hinting of a loss in momentum in the selling so a bounce should be around the corner. But the larger pattern suggests this index will work its way down towards the 200 area where it was in 2001.

Oil chart, December contract (CL07Z), Weekly

The front month contract is October and it popped over $80 today and made the headlines (and high oil prices can't be good for both inflation or the economy and therefore not for the stock market either). The weekly chart of the December contract here shows an ascending wedge pattern that has been developing since the January 2007 low. Whether it is wave-(b) as I've labeled it or instead a final 5th wave in its longer term bullish pattern it doesn't make any difference. It's an ending pattern and this says the next major move for oil will be a swift decline below $54 and likely below $40.

The monthly chart shows the bearish divergence at this retest of its prior high:

Oil chart, December contract (CL07Z), Monthly

It's striking how much bearish divergence oil has been showing for such a long time. And now with price about to test its previous high back in June 2006 you can see how divergent the oscillators will be. Once it becomes clearer that the global economy (including China) is slowing down I suspect we'll see that recognition in the price of oil.

Oil Index chart, Daily

The oil stocks are in a similar pattern as the broader market except that the July-Aug decline looks more impulsive. The bounce counts best as with a corrective wave count and therefore the decline should resume once the bounce is finished. Today might have finished the bounce although I see a decent possibility for this index to make it back up to the top of its parallel up-channel near 785.

Transportation Index chart, TRAN, Daily

I had mentioned that it would be a good idea to keep an eye on the banks to see if they break their bearish price pattern. Of all the indices I review the Trannies give me the most bullish impression for an upcoming bounce. The internal price pattern looks like it needs another leg up to perhaps test its broken uptrend line from September 2006, currently near 5090.

And if the Trannies are rallying I don't think we'll be seeing selling in the broader averages. I've seen before where the Trannies gave us a heads up for a rally in the broader averages so this bears close scrutiny. Watch the downtrend line from July, currently near 4840, since that shouldn't be broken if we're into a more bearish wave pattern. We could see the Trannies bounce up to that downtrend line before selling resumes but it shouldn't break it.

U.S. Dollar chart, Daily

Since the November 2005 high in the US dollar rally it's been downhill ever since. The challenge has been trying to determine where the low is going to be and it just keeps making new lows. The bearish sentiment on the dollar is thick enough to cut with a knife (which is bullish from a contrarian standpoint). The wave structure counts out well for a large A-B-C move down and this week the dollar has broken beneath the trend line along the lows since December 2006, which defines the bottom of a potential descending wedge for wave-C, the move down from October 2006. If this is a throw-under to finish the wave count then we should see it turn right back up and get inside the wedge pattern (for a buy signal).

If we're to get equality between waves A and C in the move down from November 2005 then we won't see a bottom in the dollar until 78.25 so about another dollar to go. But the long term bullish divergence continues and this fits the wave pattern so we could see the dollar make a low at any time now.

I received a great question on gold from Peter this week, who asked, "With December Gold closing today at 721.10, above the key 717 level, what's your current thinking/projections for this market?" I answered his question on the Market Monitor with the following:

Gold has surprised me how much it has rallied and it has forced me to change the EW count based on it exceeding 688 never mind 717. But I believe this is the last hurrah for gold as it should join the selling once equities start to sell off hard again. The lack of participation by silver (relatively speaking) is a big bearish statement for the gold rally. It should turn into a bull trap for gold bulls.

This weekly chart shows a new EW count and satisfies the one gnawing question that's been on my mind since the high in February. Price action has been whippy and corrective looking. I should have taken that as more of a clue that price action since February has been part of a larger corrective pattern and that's what I show on the weekly chart:

Gold chart, December contract (GC07Z), Weekly

The triangle consolidation pattern following the 3-wave rally into February 2007 was an indication that there was to be one more leg up to finish a larger A-B-C correction to the 2006 decline. Triangle patterns precede the last leg of the move prior to a reversal and that means the current leg up is finishing the larger correction and Not the start of something more bullish. This is very important to understand. The 3-wave rally into February 2007 already gave us a heads up that it was a correction to the 2006 decline and now the current leg up is finishing the larger correction.

So it's time to identify potential upside targets and gold is getting very close to its first target at 725.67 which is where wave-C = 62% of wave-A (common with commodities). The short term pattern in gold makes it look like it needs at least another small push higher. Tuesday's high was 723.90 so another push higher should tag that Fib level. The shorter term charts are showing bearish divergences at the new highs so the new high is somewhat questionable right now but would make for a good shorting opportunity.

There's another much higher target at 771.40 but I'm thinking it's too far. That's subjective based on my belief gold will sell off with equities and equities are close to selling off. So based on this, get ready to short gold.

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

There are no big economic reports tomorrow so the market is on its own to duke it out between the bulls and the bears.

SPX chart, Weekly

I changed the wave count on the weekly chart to reflect the count I'm carrying on the daily chart above. I'm projecting a swift decline to the 1200-1250 area by October as it should be a "wave of recognition" where market participants realize not all is well with credit availability.

Several reports, mainly out of the London banks and media (who seem to be more honest, or maybe realistic, in their reporting) and the indications are that there's a lot of commercial paper (short term loans that are typically backed by collateralized assets, including mortgages) coming due in the next couple of weeks and if they can't find buyers for it (which so far they're struggling to get) then banks will be forced to buy it themselves. Thats a big reason why the banks have been hoarding the extra cash the central banks have been doling out--they're not lending it out as the central banks had hoped but instead hoarding it in the event they're forced to buy back their commercial paper. This will put a severe dent in the available credit for other purposes and the bell for round two will be rung for the market to get in there and slug it out. It won't be pretty.

One other note I forgot to mention on the 60-min charts for the various indices--check out the H&S patterns that are developing (we're into the right shoulder). The necklines are the September 10th lows so if they break it should usher in some strong selling.

If all this bearish talk depresses you then you're a unidirectional trader and you're denying yourself the ability to be a better trader, one who can comfortably trade both directions. I've been focusing on the bearish trades for quite some time because I think the surprises will be to the downside and I'm hoping to help you position yourself for a juicy short trade. If you haven't played with the short side much, now's a great time to try. Buy just a couple of index puts, risking no more than you would with any other kind of trade, and see how it works.

I don't recommend any credit spreads in this market because of the volatility. If you manage to catch the market right and sell bear call spreads near the top of a big bounce and bull put spreads near the bottom of a big decline then you should do well. But catching those tops and bottoms puts you in the same seat as a directional trader and if you're wrong then the amount of credit is dwarfed by the amount of risk. There will be better times for those plays, like after October. Either sit back and relax for a bit and paper trade something new, or try the short side for the JIC trade (Just in Case).

Good luck over the next week. Beware triple witching opex week with a sprinkle of FOMC thrown in for good measure. The market will be on pins and needles come Tuesday and we could start to see a very whippy market. Trade light and trade carefully, taking profits on winning trades often. I'll be back here next Thursday as Linda will take my Wednesday. See you on the Market Monitor tomorrow.

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