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Market Wrap

Keep Your Eyes on the Moving Tops

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I feel like I'm watching the guy who does slight-of-hand tricks where he asks you to pick the cup with the item in it after he moves the cups all around. Which one contains the top? Pick right and you're the winner. Pick wrong and everyone laughs. But it's all in good fun. But it's no fun losing money if you're trying to find a top to this market and attempting to trade the short side. The bulls of course are having a grand old time and just enjoying the new highs day after day. Their only danger now is complacency, oh, and the small matter of waning momentum as shown with the oscillators (which I'll show later).

This is a very familiar pattern we've seen at this year's highs. Each high has been very difficult to find because it just keeps chopping its way higher, with negative divergence in market breadth, as it forms ascending wedges that forecast a breakdown but the market just keeps pushing marginally higher. Do you remember the joke it was becoming earlier this year when the media kept reporting new all-time highs in the DOW because it would push up a point or 10 points but nothing more. It's deja vu all over again.

I know I annoy a lot of people with my bearish attitude about this market but if I do nothing else than have you watch your long positions carefully and make you at least a tad bit nervous then I will have done my job. I only hope you don't completely ignore the signals I'm showing you otherwise you could be placed in the complacency group. That's a dangerous place to be no matter which side you're on.

A rallying stock market, particularly in the latter stages of it (and let's face it, this bull is getting gray around the snoot), will often mask some things under the hood that you need to pay attention to. Our job as traders is to at least play contrarian and look for the things that can go wrong with our trade. As soon as you place a trade you should be looking for evidence of where the trade is not the correct one. If things start to look wrong you might want to bail on it or you might want to monitor it much more closely and pull your stop closer. The point is to never get complacent and assume your analysis is correct.

If you've been hunting for a top, as I have, and making slashing attacks at it, you're dealing with two things--one, you haven't participated in the rallies; two, you've either made small gains (by taking profits quickly which I've been recommending on the Market Monitor) or you've been taking small losses. The important point of course is to keep your losses small so that the gains, when they come, will easily wipe out small losses. When the market's move is tiring, or becoming more vulnerable to a reversal, and the signs are there that this rally is tiring, then it can often be safer to miss the last part of the move rather than squeeze every nickel that you can out of the move. Sometimes that nickel gain turns into a dollar loss in a heartbeat.

My style of trading is more contrarian. I look for the turns vs. jumping in on momentum plays. If you're not that kind of trader then you don't want to take my recommendations for trade setups. But the information can still be very helpful as a heads up that we Might be ready for a reversal. As I said before, this market has mastered the technique of signaling that a market top is coming and then frustrate the heck out of the bears by chopping it higher for what seems like an eternity. By the time most bears have given up is when the buying completely dries up and down she goes (usually quickly).

What I've attempted to do on my charts is show where potential tops might occur (for those of us who like to probe tops, and bottoms). But more importantly I've shown key levels where the EW (Elliott Wave) counts are either confirmed or negated. Lately this has meant key downside levels since we're in a bull market until we're not. Until those downside levels are achieved we have to assume the pullbacks are going to be bought and new highs will come next.

But one of those pullbacks is going to turn into a red flushie and that's why I like to probe for the top. I can easily control my risk by keeping stops tight at new highs when I attempt to short a rollover. And then peel some money off the table when support levels are hit just in case the market gets bought and heads back up for a new high. Rinse and repeat. When a bounce fails and the market then heads for a new low then it's time to perhaps add to a winning short position (be very careful about pyramiding though as it can get you into trouble in a correction).

Except for scalp longs I do not like the long side. There are way too many indications that the rally is about to end and I consider the risk:reward ratio not nearly enough in my favor on the long side. But the downside potential is large and with tight stops I have a very favorable risk:reward ratio (shoot for at least 1:3 if not 1:4).

Many talk about too many bears (shorts) in the market as a reason why we keep rallying. That was probably true in the beginning of the bounce off the August low, but they're all pretty much gone now. I tend not to follow sentiment indicators because frankly I've had trouble using them as a timing tool. Some are good for at least a heads up for the general mood of the market and from a contrarian standpoint (which is easy to say you are but much harder to actually be) these indicators can be helpful. The put/call ratio and short interest are two examples of sentiment.

Schaeffersresearch.com is a good site for many sentiment indicators and the latest Investors Intelligence sentiment report is not bullish. In fact it's downright bearish:

Investors Intelligence chart, Weekly, courtesy schaeffersresearch.com

The top line, green, is the bullish percentage of investors and as you can see it is now higher than it was at the earlier year highs. The bearish percentage is nearing a yearly low. When the sentiment readings get this far out of whack then you know we've got too many people leaning over one side of the boat. This says the majority of traders are bullish and very likely already positioned for a bullish move in the market. That raises the question about where the buying power is going to come from. The Fed? Maybe, but not all by their lonesome.

When you combine this sentiment indicator to the weakening rally you have to at least pause and ask yourself (if you're bullish) what is going to drive this market higher. Could it be a case of the retail crowd having crowded onto the bullish bus while smart money is quietly exiting the rear? I've shown some market breadth charts of the NYSE during this year's rallies as a heads up as we approached the February and July highs and now the same thing is happening again. Here's the chart of the NYSE vs. the a-d volume:

NYSE vs. Advancing-Declining Volume chart, Daily

The weak market breadth during the rally from the August low is a real problem for the bulls. Strong price action has been a result of buying in a very few select stocks to get the indices higher but it's all smoke and mirrors. Don't get sucked into this rally without your eyes wide open and ready to bail at a moment's notice because that's all you might get.

Bond holders are still wary of an inflation problem and have been selling their holdings, pushing yields back up to the September high:

10-year Yield (TNX) chart, Daily

The 10-year yield is at an interesting point--it is once again challenging the broken uptrend line from June 2003 and if it can get back above it (which I'm expecting based on the corrective pullback from the September high) then we should see TNX head for the Fib projection at 4.9% and the downtrend line from January 2000 and probably get there before the end of this month (to meet the Fib time projection for 62% of the time it took for the June-September decline).

If TNX instead drops back down and heads for new lows then the bond market will be telling us the economy is definitely slowing down faster than originally thought and that the Fed will be right behind them slashing interest rates. Right now the bond market is telegraphing a Fed that is on hold and has an inflation problem to lick. The Fed's one-and-done (so far) rate reduction has actually hurt homeowners who now face higher rates when it comes time for their mortgages to reset.


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Economic reports
Today's lonely economic report was wholesale inventories.

Wholesale Inventories
Inventories remained at very low levels in relation to the sales pace in August. While sales increased +0.4% the inventories only increased by +0.1%, making for a record low 1.11 inventory-to-sales ratio. This is good news for a few reasons. One, just-in-time manufacturing appears to be working well which enables companies to reduce their "just-in-case" inventory which obviously flows right to the bottom line. Two, companies can weather a downturn in business without being saddled with a lot of excess inventory that must be either sold off in a fire sale or written off later as they toss it. The challenge would come from an unexpected demand for product in which case it could be difficult to get it through the manufacturing process (or from China) fast enough. Better inventory control also enables a company to better manage its manpower requirements and not go through big boom/bust cycles and the hiring/firing disruptions.

Let's take a look at the charts to see if that elusive top might be near.

DOW chart, Daily

It's hard to tell on the daily chart but today's price action is threatening to break down from its ascending wedge. If the market can immediately rally Thursday then today's break will have been just a head fake and the next upside target from a Fib projection standpoint is at 14217. If the bulls can get a little more excited here and throw everything they've got at it then the top of the parallel up-channel from 2006 is near 14400. A break below the Monday/Tuesday's lows would signal a breakdown in progress.

DOW chart, 60-min

I drew an uptrend line from the low on September 25th because I think that's the final leg up for its rally so that line is the "controlling" line. Breaking that should indicate that the leg up is finished. Then it will become a matter of figuring out whether we're in just a larger pullback or at the start of a larger decline. Today the DOW broke that uptrend line, got back above it and then closed below it. This is why the bulls have to rally the market immediately tomorrow otherwise the DOW will likely head for 13800 next. It takes a break below 13950 to confirm we're in at least a larger pullback and it has to break below 13696 to confirm we've seen the high for the rally. Obviously I'm trying to identify the potential end of the rally before it gets that low.

SPX chart, Daily

SPX is also showing a potential ending pattern in an ascending wedge over the past month. Last week I showed on the weekly chart why 1563 could be a very important level to watch for a top. On the daily chart I showed the 1565 Fib projection and therefore speculated that we could see a market high in the 1563-1565 area. Tuesday's high was 1564.98 and Wednesday's high was 1565.42. Both of those highs showed negative divergence and its previous high. Was today a double top? I'll just say the pieces are in place for that to be a distinct possibility. This is another reason the bulls need to rally the market right away on Thursday--get the DOW back above its uptrend line and get the SPX to new highs and bust this 1565 level.

There's another reason 1565 is potentially important and that's shown on the 60-min chart:

SPX chart, 60-min

Because the move up from August 16th appears to have formed an ascending wedge, each of the 5 waves in the move up will be a 3-wave move (as is true in all triangle patterns). A more complex version of this 3-wave move is called a double zigzag and is essentially two a-b-c's with an x-wave in between. So it would be counted as a-b-c-x-a-b-c and the move up from September 25th has that labeling. The 2nd a-b-c move would achieve equality between the legs up at 1574.57 and therefore gives us the next higher projection if the rally continues (shown in pink). But there's a 62% Fib projection for the 2nd c-wave at 1564.8 and this is a common Fib relationship between a-waves and c-waves.

The fact that SPX has stalled at this level with negative divergences has been reason enough for me to recommend short plays on the Market Monitor and is a recommendation tonight. Keep your stop relatively close since this must work right away otherwise step aside and wait for more evidence of topping. A more conservative method to short this is to wait for a break down. With a series of higher lows in this rally, the first lower low will be a sell signal.

If the market does rally back up tomorrow but only manages to make a marginal new high, accompanied by lots of negative divergences then it will be an excellent short play setup. The choppy rise this past week is indicative of an ending pattern and the initial decline could be very swift. I'd rather sell into (weakening) strength than try to catch a drop and find myself whipsawed out of my trade on a reactionary spike back up. But that's me and that's why I like to try to catch tops.

Nasdaq-100 (NDX) chart, Daily

NDX naturally looks more bullish--it has had a nice strong rally with nary a pullback. While I feel bearish about SPX and the DOW, I feel bullish about this one. That tells me to be cautious either way. Whenever we see the techs outperform the blue chips like this it tends not to end well for the bulls. That's because the speculative climate reaches a fever pitch as everyone piles into the sexy techs and has been a good indication of a blow-off top. What happened in 2000 was of course a classic example of that.

I show the potential for a pullback (pink) to give us a 4th and 5th wave to complete a larger rally from the August low. I won't have a better feel for that possibility until the pullback is underway (it would need to be a choppy sideways/down kind of correction). The absence of negative divergences at new highs tells us there's nothing bearish about this rally. This one is the biggest reason to exercise caution if you're trying the short side.

Nasdaq-100 (NDX) chart, 60-min

NDX could push a little higher to get to the top of its parallel up-channel for price action since early September (the lower half of its larger up-channel shown on the daily chart). Again, there's absolutely nothing bearish about this chart and in fact is quite bullish. The only thing that's starting to show up is a recent negative divergence at this week's highs. This tells us we should now be close to a pullback. What that pullback turns into will be the next question.

The big negative for the techs is that the rally has been too strong. That sounds strange but it's looking like a rally that has gone too far too fast and often the corrections to these moves can be painful if you don't protect profits. The next chart shows how stretched it has become:

NDX Disparity Index chart, Weekly, courtesy Elliott Wave International

This chart simply shows how far the NDX has moved away from its 200-week moving average. This is the most it has been stretched since the 2004 low and this kind of move is often seen in blow-off tops.

Another sign of trouble is the relationship between the NDX (Nasdaq 100) and the rest of the Nasdaq stocks:

Relative Strength chart of NDX vs. COMPX, Daily

This is a relative strength chart of the NDX vs. the COMP and shows waning momentum. The fact that the chart has been climbing shows the NDX has been outperforming the rest of the tech stocks. The NDX has been rallying on the backs of fewer and fewer stocks. Lately there have been more NDX stocks in the red than green and yet the NDX finishes in the green. Thanks to GOOG, RIMM, AAPL, AMZN and a few other high flyers the NDX has kept rallying to new highs. Once the generals tuck tail and run, the rest of the troops will follow and that's what this relative strength chart is warning us about.

Russell-2000 (RUT) chart, Daily

The RUT is also showing some strength here and not showing us much in the way of negative divergences at the new highs. It could tolerate a little deeper pullback without setting off any sell alarms. This could continue to rally a little higher, maybe after a pullback but not necessarily, and a retest of its July high could happen. Its pattern has become less clear to me and I'm watching the others instead for the moment.

Russell-2000 (RUT) chart, 60-min

If the RUT breaks this week's lows then it will probably head down to its uptrend line from early September, currently near 825. If it chops its way higher to only about 850-852 then I could see it putting in its final higher sooner rather than later, if it hasn't already done so.

BIX banking index, Daily chart

Chop chop. All that choppy price action since the August low is a consolidation pattern. There's nothing bullish about it. It's as though the banks are marking time while the big indices do their thing and impress mom and pop public. As soon as they're finished showing off, the banks will pick this up again and show us the way down. The wave count that I'm currently showing in dark red calls for the selling to pick up to a much faster pace over the next several week. If it instead manages to hold on a little longer then a rally up to its broken uptrend line from 2002 (again) and its 200-dma at 388 could be in the works here. This is now a good setup for a short on the banks but if they reverse back up to that 388 level then it would be an outstanding setup to short the banks.

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

Again, sorry for the confusing trend lines but I'm trying to show what looks to be controlling price action. I still think we could be in the early stages of a larger sideway/up correction to its decline (for wave-4 in dark red). I'm speculating that it will eventually make it up/over to the top of a parallel down-channel from May. But first it needs to break that downtrend line (bold dark blue) from May. It might first come back down for a retest of its recent low. This is Not a good opportunity to buy the home builders as it will likely be a choppy boring move. I'd wait to reinitiate a short at the completion of the bounce.

Oil chart, Oil Fund (USO), Daily

I had trouble today getting some chart on QCharts today and the oil chart was one of them. So here's the oil fund chart in its place. Unlike oil, which stopped at the top of its parallel up-channel from January, USO rallied slightly above its channel but still stopped near the Fib projection for equality in the A-B-C move up from May. If oil manages to rally a little higher I've got a Fib projection at 66.22 that I would watch. If a choppy consolidation continues for another week or more then the upside target becomes a greater likelihood.

Oil Index chart, Daily

Oil is holding on, the stock market is rallying and so the oil stocks themselves have held on as well. The short term pattern has now become fuzzy because the pullback from the September high now looks like a corrective 3-wave move. That says look for more rally (in pink). A break above 815 would improve the odds of that happening. Otherwise a failure here and drop back below 781 would say we've seen the high for the oil stocks.

Transportation Index chart, TRAN, Daily

I showed a chart last week with the glaring non-confirmation of the DOW's rally and the Transport's holding back. Nothing has changed. The Tranny index is threatening to roll over after briefly spiking above the top of its triangle pattern (a typical throw-over finish) and is currently on a sell signal because of that spike above and drop back inside the pattern. The confirming sell signal comes with a drop below its uptrend line and especially below 4734.

U.S. Dollar chart, Daily

I am unable to pull up a chart of the US dollar on QCharts today so I modified last week's chart to show what I'm expecting for the dollar after the little pullback we've seen so far this week. There's still a chance the dollar might pull back for another test of the recent low, if not undercut it a little but with the continuing bullish divergences I would expect it to be a good buying opportunity for dollar traders.

Looking at the chart of the euro shows a mirror image of the US dollar and looks ready for a decline if the US dollar can start a rally. The dollar is hated and the euro is loved. It's all over the press and the bearish sentiment on the dollar is huge. The latest COT report (Commitment of Traders) for the euro shows a large difference between the net short position of the commercial traders (137K contracts short, 24K long) vs. the net long position of the non-commercial traders (132K long, 38K short), and the difference is growing on a weekly basis. Commercials added big to their euro net short position last week and non-commercials added big to their net long positions. Care to guess who will win this battle? Watch for a short covering rally in the US dollar at a theater near you.

Gold chart, Streettracks Gold (GLD), Daily

I was not able to pull up my gold contract chart today so I'm showing the Streettracks gold fund in its place. Looks similar to oil doesn't it? Actually many of the commodities look very similar. After hitting the top of its parallel up-channel for price action since October 2006 GLD pulled back sharply. But it has since rallied back up and could close its October 2nd gap down. That would essentially be a retest of the October 1st high. If it doesn't stop there then the Fib projection at 73.35 would be in play (that's where the A-B-C rally off the October 2006 low would have equality. That's the upside potential but it's equally possible that GLD will continue to find the top of its channel to be resistance.

Be aware also that the COT report shows commercials have been increasing their net short position over the past month while non-commercials have been increasing their net long position. The last time the commercials were this short was in May 2006, just before the peak in gold price.

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

It's a busier day on Thursday for economic reports but nothing market-moving. Friday will be more important, especially with the retail sales and PPI numbers. With the fear that we could be heading for a consumer-led recession, the Michigan Sentiment number could spook the market if it comes in worse than expected.

SPX chart, Weekly

The rally up to the 1563-1565 area is potentially significant. It's hard to see on the squished chart but the negative divergence is apparent on weekly chart as well. It's a good setup for a top. Now we wait to see if the market thinks so too.

There's a lot of information that I won't be able to get too that supports my contention that the stock market is closer to a top than the start of something bigger but I've run out of time. The SOX index is not supporting the NDX rally and now the Gartner Group is forecasting a slowdown in chip-equipment makers due to slowdown in demand for chips.

Mortgage credit problems have not gotten better and in fact continues to worsen. Mortgage resets is going to make the housing problem a lot worse before it gets better. If you think the credit contraction problem is all better, well, I've got a couple of Florida condos I'd like to sell you. Credit Suisse Group Chief Executive Officer Brady Dougan, the former derivatives trader who took over in May, predicts the market for mortgage credit will be "problematic" for as long as 18 months. He said, "U.S. mortgage credit will remain problematic through this year and perhaps through 2008." Dougan doesn't see a return to stability "any time soon" following the seize-up in credit markets in the third quarter.

Credit card defaults are on the rise because credit card debt has spiked higher. The housing market ATM has been shut down. Credit cards have become the consumer loans of last resort. And those are expensive loans. Even if they can keep up with payments, those payments will curtail spending on additional items (eventually)..

We're still in the vulnerable window for the stock market that runs through the end of this month. Here's a quote worth considering: "The average decline between October 4th and November 8th in years ending in 7 since 1897 is -14.29% on a closing basis"--Peter Eliades. A lot of people like to follow the statistics you can find in Trader's Almanac. That's a statistic worth paying attention to.

There will never be complete agreement in the signs we get from the market and the signs of a top (or bottom) is never clear. If it was we'd all be fabulously wealthy. As of Wednesday's finish I would say there are enough signals to interest me in shorting the market here and now. A brief rally to a minor new high on Thursday would make for another opportunity to test the short side. Conservative traders should wait for a break below the key levels I have on the charts..

If the market continues to chop its way higher then I would anticipate this market not finishing its rally until perhaps the end of opex week so don't bet big and keep your stops tight. It's much better to stop out often rather than let the market move big against you. Keep your losses small and your wins will more than take care of you. One big loss can finish you. Stay disciplined and good luck. I'll be back next Wednesday on the Market Monitor each day.

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