Option Investor
Market Wrap

Opex Pinning

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I checked the OI (open interest) on the SPX option chain this morning and saw the following:

September Option Chain for SPX

I put a box around the 1525 call and put OI and you can see that at 235K and 227K, respectively, those OI levels dwarfed surrounding strikes. This virtually guaranteed that we'd see SPX pinned around the 1525 level today as those options were settled. The market dropped a little this afternoon and SPX closed just below 1519 so it will be interesting to see where SPX settles tomorrow morning (SET.X) at tomorrow morning's open (or at least sometime shortly thereafter).

So today was a pretty boring day to watch the market and actually the past two days have been pretty boring as the market consolidated its recent gains. The first impression from the two-day pullback is that it looks like a bull flag and that would be the higher odds scenario. A bull flag is a downward sloping small channel where price chops up and down as it consolidates the previous rally's gains (think of a flag on a flag pole). A bear flag would be an upward sloping channel against the previous leg down.

Sometimes these flag patterns will fail and in this case that would mean a price drop out the bottom of the flag. Since many traders see these flag patterns and position for a long trade, the failure of the pattern will usually see traders covering their trades quickly and hence a quick thrust lower. In tonight's charts I'm going to show these bull flags and an expectation that we'll get another rally leg started. Just stay aware that we're in a period of potential downside surprises and therefore don't get complacent about trading the long side, no matter how bullish things may feel at the moment.

Economic reports
The three economic reports scheduled for today had very little impact on the market. Even though there were some negative numbers there were no real surprises and therefore the market essentially ignored the reports.

Initial Claims
New jobless claims fell by 9K to a seven-week low of 311K. The 4-week average also fell by 3500 to 320,750, the lowest in four weeks. Continuing claims fell by 53K to 2.54M, also a seven-week low. When comparing the numbers to this time last year the initial claims are up about +1% while continuing claims are up about +4%. Employment numbers are always a lagging indicator of the economy's health.

Leading Indicators
The leading indicators index consists of 10 components and all but one were down with the overall number dropping -0.6% in August. This is a fairly large drop but was only slightly worse than the expected -0.5%. The only component that was up was money supply and that shouldn't be a surprise when we see what the Fed has been doing in an attempt to increase liquidity in the banking system. The nine declining components were led by consumer expectations, initial jobless claims, stock prices and building permits.

The Fed is trying to help stock prices through the injection of capital and they're hoping to get people willing to borrow mortgage money to buy more houses. But a funny thing happens when the Fed lowers the Fed funds rate--mortgages usually barely budge, just as they barely dropped even while the Fed lowered their rate to 1% (to which Greenspan had commented that it was a conundrum for him). Economists recognize that the economy will have difficulty as long as business confidence continues to drop and consumers continue to pull back on their spending. In fact one big reason for the Fed funds rate reduction is an attempt to re-prime the pump called consumer spending.


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One of the problems in getting the consumer to spend more, by lowering interest rates, is that the consumer is already in debt up to his eyeballs (like that commercial with the guy riding his mower and talking about everything he owns but now says he needs help with his debt--the reason it's a funny commercial is because it rings so true). Making it easier for the consumer to add more debt is not exactly the way to longer term financial prosperity or stability. But the Fed is short term oriented here and I'm sure quite nervous about the sudden contraction in liquidity. They'll worry about the added debt levels, inflation, weak dollar (which is harder on the consumer since so much of our stuff now comes from foreign manufacturers) and all the other negative consequences of a rate reduction in hopes they can stimulate the economy again.

But I digress. Back to the economic reports. The drop in the leading indicators is worrisome, especially when it comes to slowing business and consumer spending. With the loss of home equity many (most?) homeowners are starting to batten down the hatches in hopes they can weather their own personal financial storm.

Philadelphia Fed
After a poor showing in August the Philly Fed index jumped back up to 10.9 which surprised to the upside. Anything over zero (the reading in August) is a sign of growth. Both shipments and orders increased to 16.9 and 15.1, respectively. The bad news was the inflationary pressures--the prices-paid index rose to 23.1 from August's 15.4 while the prices-received index dropped to 3.3 from 6.8. If this kind of problem expands and the core PPI continues to rise for the rest of this year (which could easily happen when doing year-over-year comparisons) then the Fed's rate reduction campaign could hit a wall.

We've seen an interesting reaction out of the bond market this week following the Fed's drop in their rate--bonds have sold off which has spiked yields up and in so doing has broken its steep downtrend from the high in June. The following weekly chart shows two potential scenarios that I currently see for the 10-year yield:

10-year Yield (TNX), Weekly chart

The bearish pattern for yields (longer term bullish for the price of bonds) is shown in the dark red wave count. There is a large ascending wedge when viewed on a monthly chart from the 2003 low to the June 2007 high. Recent "price" action on the TNX shows a break below the bottom of the wedge and therefore suggests we'll see a bounce, possibly into the end of the year, followed by a further drop into 2008. This scenario and wave pattern from 2000 suggests the economy is going to slow down drastically from here and we'll be facing a deep recession or worse.

But the choppy price action and failure of TNX to make it up to the top of its wedge pattern in June leaves open the possibility that the spike down into the September low finished a 3-wave move down from the June 2006 high within the ascending wedge. That interpretation calls for another rally to new highs above 5.4%, shown in green, and probably much higher since it would likely do a throw-over above the top of the wedge equal to the throw-under at the September low. This scenario suggests that inflation will be a greater problem for the Fed who will be forced to raise rates and not continue lowering them.

Did anyone catch Greenspan's comment about inflation (when making reference to his recently published memoirs)? Basically he believes Bernanke will have a much more difficult time than he had in lowering rates to stimulate liquidity and credit expansion. Greenspan said he didn't have to worry about inflation like Bernanke will have to. He believes the Fed will be forced to raise rates considerably in order to fight inflation. I'm not a fan of Greenspan but from what I've read I'd have to say I concur with his thinking. It's why the core PPI readings, and the expected rise, are going to be a real problem for the Fed.

If we have a slowing economy while this happens then we run the risk of stagflation and I've been warning for quite some time now that I think we've entered a period that's going to be very similar to the 1970s. It would be helpful for everyone to review how the stock market did during that time. In one word it sucked (hey if the housing market for 2007 can be described by one of the home builder's CEOs with that term then I can use it too). It was a period that did not work for buy-and-holders. As difficult as it is to time the market, those who did well knew when to be invested and when to be out (or short).

So back to the TNX chart above, price has now bounced back up to the broken uptrend line from 2003 which is the bottom of the wedge. It would be natural for yields to pull back now (and if buying in the bonds resumes we could see rotation out of stocks). It might even start another leg down to new lows although that's the lower-odds scenario in my opinion. The correction of the steep drop from June will likely become larger in both time and price, so a down-up sequence as shown in dark red would be typical.

If at any time the rise in yields becomes sharp and gets above 5.0% then the odds of new highs in the 10-year increase substantially. By that time the bond market would have already sniffed out the inflation problem and be predicting the Fed will have to reverse course and get back to raising rates. Needless to say the stock market would not be pleased about that. This is why I'm so interested in watching what the bond market does over the next few months and I'll continue to keep you updated on what I'm seeing.

Now that we're through the FOMC rate reduction, which was what many had hoped for and what few had expected (myself included since I went on record saying we'd get a .25 reduction and a stock market selloff--oops, I obviously need to go back to forecasting school), we need to see what effect it could have. We know the Fed felt the need to cut the rate in an effort to relieve the liquidity crisis as the credit market freezes up. Asset-backed securities are receiving no bids, the commercial paper market is locking up (no one is interested in buying what is coming due and the banks are being forced to buy them), the subprime problem has in fact spread (weak home buyers weren't the only ones getting loans they should never have received in the first place), the jobs market is weak and mass layoff announcements have been on the rise.

Foreclosures are soaring and the huge increase in mortgage resets won't even kick into gear until we get into the first six months of 2008. Bloomberg recently reported that as many as half of the 450,000 subprime borrowers will have their mortgages reset within the next three months. Many, if not most, of these people will probably lose their homes especially if they've already missed at least one payment which makes them ineligible for help from the U.S. government under last month's Bush proposal for FHA assistance. The average reset for these mortgage holders is about 26% or +$400/month. For someone who could only afford the mortgage at the teaser rate you can imagine how difficult it would be to absorb that kind of payment increase.

The number of mortgage resets this coming quarter will likely be the 2nd highest on record and as I said the number increases dramatically starting the 1st quarter of 2008. The Fed funds rate reduction is a smoke screen. Mortgage rates don't tend to move much even after the Fed starts on a rate reduction campaign. That's because the market doesn't always agree with what the central bankers are doing. The other problem with these adjustable-rate mortgages is that the index commonly used to establish the mortgage rate is the LIBOR index. Linda covered this very well in last night's Wrap and the BOE (Bank of England) will likely be forced to raise the LIBOR rate to reflect the actual rate that is being used between banks.

Banks are hoarding cash for fear that they'll need it to buy back the commercial paper that is coming due (and there's a lot of it). So when they do lend their money to another bank they want better compensation. So if the LIBOR rate is forced higher then the adjustable mortgages will also be forced higher, regardless of what the Fed does with their rates.

And herein lies the problem for the Fed--the market dictates what the interest rates need to be, not the omnipotent (or so they think) Fed. This is why the Fed funds rate follows the market rates and not the other way around. And if the bond market sniffs out inflation and sells off that will raise rates. The Fed will be forced to follow, just as the BOE is being forced to raise the LIBOR rate to reflect true market rates. The central bankers think they're in control when in fact they're merely marionette puppets whose strings are controlled by the market.

And now to the charts to see what's setting up.

DOW chart, Daily

It's certainly been painful trying to stop those rising knives with bare hands. The blast higher following the Fed funds rate cut looks like it's going to drive the DOW up to the top of a parallel up-channel for price action since the August low. By the looks of it here that could mean a retest of the July high or perhaps even a minor new high. Too bad the push to this high has been marked with weaker market breadth than the push to the July high (which was weaker than the push to the lower high in May). The EW count that I show (A-B-C bounce off the August low) calls for a resumption of the decline that was started in July. This time it should sell off faster and drop well below 12K.

The leg up from September 10th is the c-wave by my current wave count (it has been changing as the bounce has progressed) needs another push up to finish a 5-wave count, as shown on the 60-min chart:

DOW chart, 60-min

Because of the larger bounce pattern from the August low, this wave count may not be correct which means the high for the bounce might already be in (and not get the next push higher as I show). That's why I had mentioned at the beginning of the report that the bull flags that have formed over the past two days may not be bull flags but instead could be a slow start to the next decline. A sharp drop below the bottom of the flags would be bearish.

But if instead we do see another leg higher, as depicted on the chart, then watch for potential resistance at the 14016 Fib projection (where wave-(v) = 62% of wave-(i)). Interesting that that falls right on top of the July high. But if the 5th wave is to achieve equality with the 1st wave then that would take the DOW up to 14186. Those projections would drop slightly if the current pullback drops a little further, say to the uptrend line from September 10th, currently near 13625. The other Fib projection shown on the chart is at 13892 which is where the move up from August 16th would have two equal legs (wave-C = wave-A).

SPX chart, Daily

SPX, as well as many of the other charts, has the exact same pattern as the DOW so all comments for the SPX are the same. The top of its parallel up-channel (think of these up-channels as bear flags since that's what they are here) is near 1560 which would also essentially be a retest of the July high even if it goes marginally higher.

SPX chart, 60-min

The 2nd leg up for the bounce off the August 16th low, wave-C, needs to be a 5-wave move and that's why I'm showing an expectation for another leg up. But as I said before, any sharp breakdown from here would mean the top is probably already in. It takes a break below the key level of 1471 to confirm the bears are back in control.

Nasdaq-100 (NDX) chart, Daily

I've got a slightly different EW count on the NDX because I wanted to show how it would look if today marked the high for the market--an a-b-c-d-e count for wave-B (after wave-A down from July to August). The overlapping wave structure in the bounce off the August low is very corrective looking and it's why I continue to call for another strong decline to follow. This is not how a new bull market rally leg would look.

Not to get you bogged down in EW details but the other wave count would be for an ascending wedge (ending diagonal) 5th wave after a 4th wave pullback to the August low. The end result is exactly the same--we should be looking for a high to get short for a big ride back down.

Nasdaq-100 (NDX) chart, 60-min

Keeping with the EW count shown on the daily chart, the last leg up within the ascending wedge (the move up from September 10th) should be a 3-wave move and that's what we have as of the high on Wednesday. This wave count calls for an immediate selloff on Friday (or at least a bounce that doesn't make it to a new high). If the market does rally instead then the wave count for NDX would be the same as shown for the DOW and SPX.

Russell-2000 (RUT) chart, Daily

Back to the same wave count as I've got on the DOW and SPX--it calls for one more push higher to complete the leg up from September 10th which would complete the a-b-c bounce off the August 16th low. The top of its parallel up-channel (another bear flag) is currently near 832.

Russell-2000 (RUT) chart, 60-min

The closer view of the leg up from September 10th shows the expected 5-wave move up to complete the bounce. Not shown on the chart but a projection for where that 5th wave would equal the 1st wave is just under 833 which coincides with the top of its channel. So if we get that move then watch for potential resistance to hold and an opportunity to short it.

BIX banking index, Daily chart

The banks got a big rally post-FOMC but the index smacked its head against the 200-ema and the broken uptrend line from October 2002 (again). It sold off hard today following that test and dropped back below the broken downtrend line from June. I don't see how this can be interpreted as anything but bearish price action. If the broader market does get one more push harder perhaps the banks will also but the October 2002 trend line and then the 200-dma just above it would likely be very tough resistance, especially with the daily chart in overbought territory. This is a bearish price pattern since August, pure and simple. I think the credit contraction has only just begun and the banks are going to pay dearly for it.

For a larger perspective of the banking index, and why that broken uptrend line from October 2002 is significant, take a look at the weekly chart:

BIX banking index, Weekly chart

After the 2000 low the banking index had a choppy rise in an ascending wedge pattern, which is bearish. Price broke sharply down out of it to the August low and have since bounced back up to retest the bottom of the wedge. This is a pound-the-table short play setup. It may not work but it's one of those trades you have to try. It should drop back to or below 210, and do it a lot quicker than it took to rally to 410.

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

The home builder's index got a bounce back up to the top of its down-channel and promptly sold off. Wednesday's candlestick is a bearish shooting star and today's big red candle confirms the bearish reversal. I suspect this index is not far from a longer lasting bottom but the correction to follow will likely be a very choppy sideways/up correction before tipping back over before the end of the year. This is an oversold index so it probably won't see the same kind of hard selling that I expect to see in the broader market.

Oil chart, December contract (CL07Z), Weekly

The bounce pattern in oil looks very similar to the pattern in the stock market and that's not surprising. Commodities and stocks have been trading in synch and the fact that I see an end to its bounce soon ties in well with what I'm seeing in stocks. A little higher is a Fib projection at 82.66 and the top of its parallel up-channel. It's a sharp climb off the August 22nd low so any break of its uptrend line would be a sell signal for oil.

No surprise, the oil stock index looks like oil and the broader stock market. It really is amazing how they're all in synch the way they are.

Oil Index chart, Daily

The only difference in the oil stocks index is that price has already achieved both the Fib projection at 812.48 and hit the top of its parallel up-channel. But the short term pattern supports the idea that we could see a minor push higher, just as I showed for the indices.

Transportation Index chart, TRAN, Daily

The Transport index bounced up to the 200-dma and got promptly slapped down. While it too could get another minor push higher I don't think it will. I think we've already seen the high for its bounce. The lowering of the outlook by FedEx this morning is a strong indication of further slowing in our economy.

U.S. Dollar chart, Weekly

The US dollar is probably the most unloved currency out there. Well maybe the Zimbabwean currency is a little lower. Bearish sentiment on the US dollar (which is now at parity with the Canadian dollar as of today) and bullish sentiment on gold are at extremes. From strictly a contrarian standpoint they both are set up for strong reversals. The US dollar is with pennies of a Fib projection to 78.28 which is where the decline from November 2005 has two equal legs down. The bullish divergence continues at the new lows. One of these is going to stick and the coming rally is going to catch a lot of dollar bears by surprise.

Gold chart, December contract (GC07Z), Daily

Another sharp rise, more bloody hands trying to catch rising knives. I underestimated the reaction in the US dollar to the Fed rate decrease and the strong rally in commodities, including oil and gold. Probably the first time I've been wrong this year (wink). The top of the parallel up-channel for gold is near 753 and while the Fib projection for two equal legs up from the October 2006 low is at 771.40 I don't think it will make it that high.

It's important, from an EW perspective, to understand why I'm bearish gold (and bullish the US dollar). After a 3-wave rally from October 2006 to February 2007 (an indication that the rally is just a correction and will eventually turn back down), price consolidated in a triangle pattern (wave-B which is a common b-wave pattern) and this points to the need for one more and only one more leg up to complete a larger 3-wave bounce off the October 2006 low.

This wave pattern now can't be any clearer and it's very bearish. The only question now is where the end of the leg up from the August low will end. My hands are bandaged and I'm getting ready to grab for those rising knives again.

Results of today's economic reports include the following:

I've already discussed today's reports and there are none scheduled for tomorrow.

SPX chart, Weekly

The weekly chart shows wave-A down from the July high, wave-B bounce in progress and then wave-C down is due next. Equality between waves A and C is at 1311 and is the minimum downside projection for the next decline. If we're entering a much more bearish time then the 162% projection at 1196 may be the more accurate one. That should become clearer after the decline gets started. But this should give you an idea of what to expect over the next few months.

I've shown the analog between 1987 and 2007 before and a decline below the August low would also be a break of the uptrend line from the October 2002 low. That would obviously be a significant break and you can imagine how quickly the selling could take hold. That's why the analog with 1987 where the crash leg that started shortly after breaking below its recent low (equivalent to the August low here) could play out again here. You don't want to be long the stock market if the August low is taken out.

Tomorrow will hopefully provide some clues as to what's next. We shouldn't drop much further, if at all, if we've got another leg up to finish off the rally. It could be good for a long trade if you're able to watch the market carefully but a better setup for the short side. Just keep an eye on the target levels I provided.

But if the market sells off hard tomorrow (not expected if only because it's opex Friday) then the top would appear to be in. In that case wait for the next bounce as an opportunity to get short for what could be a long ride back down (dare I say a position trade on the short side?).

Good luck and I'll be back next Wednesday when we should have an answer to this question. See you on the Market Monitor tomorrow for what will hopefully provide a better trading environment that the past two days.

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