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Market Wrap

Accumulation or Distribution

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The market for the past week has been a little choppier than usual and when that happens at the high of a move it always prompts the question about whether price action is showing accumulation or distribution. Guess right, and trade that way, and you will probably make some good money. Guess wrong and you had better be using stops.

Oftentimes at market tops and bottoms you'll see the market churning a lot. Rounded bottoms are bullish and rounded tops are bearish as inventory is accumulated by large funds at bottoms and distributed at tops. So when we see the kind of chop we've seen lately, including the whole bounce from the August low, we're left wondering if this is indicative of some larger accumulation plan (buying the dips) or distribution plan (selling the rallies). Unfortunately this is better recognized in hindsight and I've yet to perfect that trading technique.

One way to help figure it out is to look at market breadth. When the market is making new highs you'd like to see broad participation with strong advance-decline numbers, new 52-week highs vs. lows, volume, etc. When we see bullish divergences at lows or bearish divergences at highs then we know we should be preparing for a reversal. As traders we look for reversals and therefore their advance signals. Many trade momentum but unless you've got a real solid trend in progress we've seen lately that momentum is fleeting at best. Spread traders do well when there isn't momentum and the last couple of years have favored spread trading (that could change and last month was hard on a lot of them).

This year's highs have been marked by a lot of bearish divergences--new price highs have tended to be accompanied by weaker market breadth. This hasn't always helped pinpoint tops but it does give us a heads up for a potential reversal. That was true at the February and July highs this year. Now as the market approaches or in some indices passes the July highs we are again checking the pulse of the market and listening to the heart beats to see if it's strong and healthy. I'd have to say I hear a bit of a heart murmur in there and has me thinking the patient may be sicker than it looks on the outside.

I'll discuss that a little more below but first the economic reports:

Economic reports
It was a quiet day today with only the Durable Goods report having the power to move the market. Even though it was not a good report the market wanted to rally anyway. The Crude Inventories report helped drop crude prices a little.

Crude Inventories
There was an unexpected rise in oil inventories and that was credited for the drop in the price of oil today. The Energy Dept reported crude supplies rose for the first time since mid-August, up +1.8M barrels to 320.6M. Analysts had expected a drop of -2.15M barrels so that was a swing of almost 3M barrels to the plus side from expectations. However that increase is only a small reversal of the 18.3M barrel drop over the previous four weeks.

Gasoline demand has weakened and supplies climbed +600K barrels to 191.4M. API's data showed a larger increase of +1.0M to 199.1M. Refiners are now demanding less crude to be converted to gasoline and other distillates so that has helped increase the crude supplies. Distillate stocks also rose, up +1.6M barrels to 137.1M (but API showed a drop of -1.9M). Refinery capacity dropped sharply from 89.6% to 86.9%.

Some interesting data from gasoline vs. distillate demand verifies that the economy is slowing even if the consumer has not (yet). Gasoline demand is up about +0.4% year-over-year but distillates (which include diesel fuel) dropped -1.2%. Jet fuel demand is down -1.9%. So the lower demand for distillate fuels indicates less demand for shipping (truck and air) which supports the other indicators that we're getting of an economic slowing. A weaker economy will likely mean lower commodity prices in the near future, including oil.

Durable Orders
The durable goods number dropped sharply by -4.9% in August after a +6.1% gain in July. The orders component for new aircraft is swinging the total number more than usual. Excluding the -11.2% drop in transportation goods orders for July and August shows a drop in new orders from a gain of +3.4% in July to a drop of -1.6% in August. Shipments for durable goods also dropped, down -1.6% in August which as the largest drop in eleven months. Businesses also reduced their orders for capital equipment, a sign of economic weakening, by -0.7%.

The stock market rallied on the news. Go figure. We of course can guess what market participants are thinking--a weak economy must be good for the stock market because it means the Fed can get more aggressive about lowering interest rates. This is such hogwash and belies the truth about what's happening, and will happen to the market, but don't argue with it when it goes against fundamentals (it's why I insist you can't trade the market from a fundamental perspective, except for perhaps very long term swings). Instead understand the obtuse logic it sometimes uses for doing what it does. Only later will the facts prove how stupid the market really is (personal comment not shared by many).

The longer term view of the market in a slowing economy should be very clear--it's bearish. A slowing economy means slowing businesses means layoffs means lower consumer spending means fewer products/services purchased means lower corporate earnings means lower stock prices. Show me the illogic in this argument and I'll gladly buy you a cup of coffee (the limit of my betting). A slowing economy will always have the Fed lowering interest rates in an attempt to re-prime the economic pump by making credit cheaper and more available (whether people do anything with easier credit is the real issue).

So when the Fed starts to drop interest rates it is mind boggling to me that the market thinks this is bullish. It's usually good for short term bursts higher (why, I have no clue) but it's always bearish longer term. Charts like this one bear this out:

SPX weekly chart, 2000-2007

I showed this chart about a month ago which has been updated through today's price. After the market peaked in 2000 and the economy headed south the Fed stepped in and started aggressively lowering interest rates. Greenspan was trying to flood the market with liquidity, which he did and those who get hurt in the collapse of the housing bubble can thank him for that. But those 12 rate cuts between January 2001 and June 2003, so over 2-1/2 years, did not give us a stock market rally. Bursts higher following rate cuts were followed shortly thereafter by stronger selloffs.

Just the opposite happened after 2003. As the market strengthened the Fed started removing their "accommodation" but the market kept rallying because the economy was getting stronger. And therein lies the message--follow the economy and not the Fed (since the Fed also follows the economy). Understand we'll see short term bursts higher, like we're seeing after the last FOMC meeting and the rate reduction, but don't get sucked in thinking the brief period of euphoria is going to last. It is a gift presented to you to get out of your long positions. Bow and say thank you (like your mother taught you) and exit your long positions. You will have another opportunity to put that money to work later (but first use a little of it on the short side).

With the Fed and other country's central bankers flooding the monetary system with liquidity there's been a lot of speculation as to how bullish that will be in several areas. I've mentioned the stock market--many believe the added liquidity will inflate most assets and that's generally the reason that many traders position themselves for the coming rally. It's when the rally fails that these new buyers suddenly jump ship and cause the big selloffs.

Re-inflating the economy is the goal of the central bankers (which is like giving a junky more crack so he feels better, but usually only crashes harder later) and the result is traders think the result will be either inflation of assets and/or higher economic activity. After all, that's what the extra money is being pumped into the economy for--banks lend it out and the credit expansion continues. So traders rush to buy those assets they feel will do better with inflation (stocks, commodities) and dump that which will not do well with inflation (the US dollar).

But a funny thing happens in a period of credit contraction--the central banks aren't in charge, the market is. So when they try to pump extra liquidity into the system the bankers are afraid to lend it out and the credit contraction continues. It's why I've been saying when it comes time for the Fed to try to re-inflate the economy they will be pushing on a string.

I came across an interesting chart in an article by GaveKal in one of John Mauldin's recent newsletters. They talked about the velocity of money (meaning velocity of money growth) and showed this chart:

GaveKal Velocity Indicator,

As GaveKal pointed out in their newsletter, buyers of gold and oil (and sellers of the US dollar) have been focused on the idea that the extra liquidity push by central bankers is going to inflate the money supply (in other countries as well, not just the U.S.) and that it will be good for commodities (bad for the US dollar). But they're failing to realize that the Fed and other central bankers don't control the money supply. The market does. If credit is not created through the aggressive lending practices that led us to where we are today then the central bankers couldn't possibly create enough new money to compensate (not without creating hyperinflationary problems).

And the chart above shows the velocity of money growth is now in negative territory and has been trending down since 2006, just as it did from 1999 to 2002. The central bankers know this and have been attempting to plug the dike by dumping helicopter loads of cash into the market. The stock market followed the money in 2000-2002 and it's very likely it will do the same thing again this time. And the sharp spike up in commodities (such as gold and oil) will very likely get reversed quickly once traders realize what's happening (the EW count I've shown on gold the past couple of weeks supports the idea that the gold rally will likely fail hard).


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Banks have recently been forced to buy back many of the loans they were hoping to farm back out to investors. Having these loans back on their balance sheets has taken a lot of cash out of the market place. This will force banks to severely curtail further lending as they will literally have run out of money to lend. The credit collapse is likely in the very early stages.

The problem has become one of fear instead of greed. Investors are now fearful of taking on debt instruments that they don't know or understand. They don't want to see their investment turned to dust. Therefore much of the commercial paper (short term collateralized loans between banks and corporations) that is coming due will end back on the banks' balance sheets.

Today started the Congressional inquiry into the ratings agencies (Moody's, Standard & Poor's and Fitch) and how "they let this happen." First they will be accused of rating everything AAA or AA when it was in fact at best BBB, and then they will be accused of the credit collapse when they started downgrading these investment-grade assets to something less than. They're in a can't-win situation and out of this will come more onerous legislation and fearful bankers and ratings agencies. To think that lending will suddenly become easier out of this mess is to not recognize reality. Like I said, I hope the string that the Fed is pushing on is a stiff one.

Let's see where we are on the chart:

DOW chart, Daily

The rally pattern for the DOW would look better with another push higher. The past week's consolidation looks bullish for another rally and the parallel up-channel for price action since the August 16th low supports another high above 14K. Price even found support at the mid line of the up-channel on Tuesday's pullback. The very short term pattern of the rally off Tuesday's low shows a small 5-wave move and therefore leaves open the possibility that Wednesday's high completed the rally. Therefore any break back below Tuesday's low would be a heads up that something more bearish may have begun. It takes a break below 13400 to put the bears back in the driver's seat and I suspect we'd see the DOW struggling to hold onto the 13K level for October opex.

But as long as Tuesday's 13696 low holds then I'd continue to buy the dips (scalp trade only) for a run up to a target zone of 14K to 14200. Then it would be time to get short for a large decline from there.

DOW chart, 60-min

The corrective wave structure the past week leaves open several possibilities and without trying to make it too complicated that's what I'm trying to show on the 60-min chart. The more immediately bullish possibility (in green) is that Tuesday's low finished the pullback and now we're seeing the next (and should be last) rally leg that will take the DOW above 14K. It's possible we're seeing a larger sideways consolidation that is forming an expanding triangle (shown in pink) which calls for another leg down inside the pattern to finish it. It should stay above 13600 in that case and from there we'd get a strong rally leg to potentially the 14200 area. This scenario would likely have the DOW finishing October opex in the 13500-14000 area.

The more immediately bearish scenario (dark red) calls Wednesday's high as the end of the 5-wave run up from Sept 10th. The rally from Tuesday's low counts well as a small 5-wave move for the 5th wave (wave-(v) on the chart). The bulls do not want to see the DOW back below 13780 in any pullback from here otherwise it would likely mean we're either on the pink or dark red price path. As noted by the negative divergence shown on RSI, this is either bearish with the 5th wave bearishly divergent against the 3rd wave (as it should be) or else the oscillators have been resetting themselves with time instead of price (which would be bullish). That's why a break below 13780 would be potentially bearish.

SPX chart, Daily

Some Fib projections based on the wave relationships in the move up from the August low point to 1548-1567 as a target zone for the rally by early next week. From there it should be a steep selloff through October. A drop below Tuesday's 1507 low would be more immediately bearish and a break below 1489 would have the bears in control.

SPX chart, 60-min

It's possible SPX finished its last leg up with a truncated finish (lower price high) but that's usually best identified in hindsight. At least the DOW has made a new price high. But that's why a drop below Tuesday's low would be bearish. Until that happens I see the possibility for a retest of the July high before this is ready to turn back down.

Nasdaq-100 (NDX) chart, Daily

NDX looks like it could be forming a bearish ascending wedge for its bounce off the August low. That's speculation at this point since we don't yet have a tested trend line across the highs but today's doji star finish has the potential to form an evening star if it closes down on Thursday so we have a heads up for a potential reversal at today's close. NDX is also up very close to the top of its parallel up-channel from July 2006 which is where price was rejected in July. There is the possibility we'll see a choppy pullback and then one more push higher into early October (pink) which gets slightly above 2100. That would be an excellent short play setup if it happens. In the meantime the bulls don't want to see NDX below 2032 and a break below 2050 would be a bearish heads up (down).

Nasdaq-100 (NDX) chart, 60-min

The dark red wave count calls Wednesday's high as the end of the rally. If we do get a pullback on Thursday then it will be important what form it takes. If it's a choppy pullback with overlapping highs and lows then it would be pointing to a pullback that will lead to another push higher (pink). A stronger impulsive decline that breaks the uptrend line from August 16th, currently near 2030, would be a strong signal that we've seen the high.

Relative Strength chart of NDX vs.COMPX, Daily

The NDX has been outperforming the COMP ever since the July 2006 low and that's been a good thing in some respects. You want to see the generals out there leading the troops. But if and when the generals tuck tail and run then we will probably see the COMP fall right in behind. So it'll be important to now start watching the NDX vs. the COMP relative strength chart.

Remember, the RS chart simply shows who's outperforming who. Both could be heading down but if the COMP is selling off faster than the NDX then this chart would continue to show a higher move for the RS line. The current move up has poked above the trend line along the highs since July 2006 but notice the bearish divergence against the current high.

This tells us the generals are getting tired and the next likely move will be down. In my opinion that will be a bearish signal even if the market heads slightly higher first. At that point I would become more confident in finding a market top based on the EW count, but not yet.

Russell-2000 (RUT) chart, Daily

Like the DOW and SPX it looks like the RUT could give us another poke higher before finding stronger resistance in the 825-830 area. If it rallies up to that level then I'll be watching closely for failure as an opportunity to short this index. If the RUT breaks down below 796 it would be a heads up that something more immediately bearish is happening but it takes a break below 775 to confirm it for the bears.

Russell-2000 (RUT) chart, 60-min

Wednesday's dip held the uptrend line from last week's low so any break of that uptrend line would be the first sign of bearishness. Otherwise I'm looking for another (and potentially last) leg up to the 830 area.

NYSE (NYA) vs. Advancing-Declining Volume chart, Daily

The Advancing Volume - Declining Volume for the NYSE continues to be a good example of the lack of market breadth for the rally off the August low. As price has pressed higher the market is getting weaker. The rally is being confined more and more to fewer select stocks and it's often a very good heads up that the rally won't last. It's certainly not indicative of a new bull market leg but instead the sign of either a correction or the last leg of a bull market.

BIX banking index, Daily chart

The very choppy pattern since the early August low is either an extremely bullish pattern with price about to explode to the upside or else it is a correction of the previous decline. Considering the difficulties the banks are facing with the credit crunch, lack of funds and lack of revenue generation, I have a real hard time believing the first possibility. That leaves it more likely as a correction. The correction is either over, having completed it at the September high or it has one more leg up (pink) to finish it. A break below 350 would confirm the next leg down is already underway (dark red).

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

As I had projected last week the home builders continued their descent after testing the top of the parallel down-channel on the September spike up (just like in August--bear market rallies typically look just like those two spikes). But the index could be nearing the end of their strong selloff and could consolidate for a longer period of time before heading lower again. In other words the selling may be temporarily exhausted soon. Support might be found near 340 to be followed by a larger sideways/up correction over the next month or so.

The monthly chart though shows more downside before potentially finding support:

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

The bottom of the longer term parallel down-channel is closer to 250 (also the 2002 low) so another 100 points lower (another 30% haircut). From there it could get the slightly larger sideways/up consolidation into the end of the year before finding a final low early next year just below 200 (the 2001 low). The wave pattern would then call the pullback complete and the selling in the home builders would likely be finished.

I don't think that will be the bottom in the housing market but all the bad news for the builders will have been flushed out by then. It'll probably be a long period of recovery for the builders and not necessarily a good investment (dead money for a while) but nor will it be a good short. By then we should have better shorting candidates to choose from.

Oil chart, December contract (CL07Z), Daily

The December contract never made it as high as the October contract but it did manage to tag the top of its parallel up-channel and has since broken its steep uptrend line from the August low. I maintain my stance that commodities and stocks will sell off together. If oil has topped and is starting back down, which this chart says is a very good possibility, then stocks should not be far behind. The wave pattern of the oil rally from January 2007 is a correction to the decline from the 2006 high and as such should mean we'll see oil decline below 55, potentially much lower (lower demand from a slowing global economy).

Oil Index chart, Daily

Oil stocks have not broken their steep uptrend line from the August low, as oil has done, and it didn't leave any bearish divergences at its last high. This points to the possibility that we'll see those stocks push to a new high before topping out. It takes a break below 787 to say a top is in and down with oil it will go.

Transportation Index chart, TRAN, Daily

The transportation sector has been flashing all kinds of signs about the economy slowing down and the lack of participation in the bounce off the August low tells us this sector is probably in trouble. The choppy pattern off the August low says "correction" all over it. Whether it gets one more push back up (pink) or drops from here (dark red), the next major move should be to new lows.

U.S. Dollar chart, Daily

People all over the world are ready to dump and spit on the US dollar. Even Greenspan dissed our dollar. When you're that unloved you know you've hit bottom. It's time for rehab for the US dollar and it should work (as opposed to Britney Spears and Lindsay Lohan). By tagging the downside Fib projection at 78.28 (two equal legs down from November 2005 for wave-(b) on the chart). But the dollar bulls need to step in now (and dollar bears be willing to take some profits) and drive the dollar back up above 79.50 to give it a buy signal (from the throw-under below its descending wedge pattern.) The weekly chart continues to show bullish divergence at the new low.

Assuming the dollar starts to rally it will be a sign of recognition by many that the Fed is not being successful in re-liquidating the monetary system which is what I continue to expect will happen. That would also get many gold bulls to dump their long positions that they scrambled into in the last month with the expectation that the Fed will reignite inflation.

Gold chart, December contract (GC07Z), Daily

The rally pattern in gold would look best with another push higher, especially if it can manage to tag the top of its parallel up-channel from September 2006, currently near 756. Two equal legs up from September 2006 would have gold tagging 771.40 but I'm not so sure that will happen. I don't even know if it'll make another run higher but that's the upside potential. The A-B-C move up from September 2006 (for wave-(b) on the chart) should be the completion of the correction to the 2006 decline and set up a strong decline as the next big move.

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

Thursday will be busier than Wednesday as far as economic reports go but there's not a lot there that will be market moving.

SPX chart, Weekly

The weekly MACD looks bullish here having turned firmly back up and that certainly supports a continuation higher from here. But MACD is a lagging indicator and at this point is merely reflecting what price is doing. RSI continues to show some negative divergence as price presses back up near the July high. I continue to post this chart to show the downside projection for the next leg down (near 1239 currently) but so far there's nothing bearish about this chart--nice solid up-channel with no indication that the rally is ready to end.

The shorter term charts warn of that possibility but recognize the fact that we're still in a strong up trend and trying to short this market is trying to catch rising knives. That strong spike down into August and now strong spike back up has done some real damage to both sides as traders get whipped around and stopped out. It's been a very difficult trading environment so continue to trade cautiously--smaller positions, slightly wider stops in an attempt to avoid some of the whiplash moves, and don't let the market move too much against you. Stay disciplined.

I've provided some key levels for the various indices to keep an eye on to let us know whether the rally will continue, where the bears may be taking over and where to look for the next shorting opportunities. We are in the middle of a very vulnerable period for the market and downside surprises are very much a real possibility. For that reason alone I'm reluctant to recommend any long plays and only for those able to watch the market all day. Carrying a long overnight is an unnecessary risk in my opinion. There will be better and safer times for that.

Market participants have positioned themselves for what they think is going to be a bullish market based on misperceptions about what the Fed is doing for the market. When they discover that the Fed can't do and isn't doing what they thought then they'll bail from their positions in a heartbeat. I have no idea what will trigger the selling and obviously don't know for sure that it will. But the odds, and history, suggests the current rally will not last much longer. And the next leg down, from an EW perspective, could be a doozy. I'd like to at least have a small short position to take advantage of the move. The tough part has been finding an entry that'll stick. Just need to keep trying while keeping the bleeding under control. Be careful out there...

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