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Market Wrap

Volatility Returns

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Did volatility ever really die down? Actually it did when you look at the VIX over the past six weeks. After spiking above 37 at the August low the VIX returned to its 200-dma and uptrend line from last February's low:

Volatility index (VIX) chart, Daily

I had mentioned last week that I liked the setup for a bearish play in equities if VIX came down and tagged its 200-dma/uptrend line in the 15-16 area with SPX tagging its 1563-1565 resistance level. That short trade has worked pretty well from there. The VIX bottomed on October 11th, coinciding with the market high on that day, did a perfect tap of its 200-dma and then shot higher in the past week. Now it's a question whether the VIX will drop lower (and the market rally higher) or if instead we've seen the market high. As always I'll show both scenarios in the charts.

The market is still trying to figure out whether or not the problems that caused the summer swoon have been fixed or just swept under the rug for now. The credit contraction has in many respects not been fixed but it's certainly been alleviated. Everyone's looking around for evidence the credit monster is going to come back out of the woods for another surprise attack.

The Treasury Department made news over the weekend by announcing the formation of a group of large banks (Citigroup, JP Morgan and Bank of America) that will figure out how to support the credit market in the event of another credit crisis. They are going to create a conduit for the purchase of assets from structured investment vehicles (SIV) that can't find a ready market. The entity that they will create to do this will have the name "M-LEC" for Master Liquidity Enhancement Conduit. Great name. Maybe a better one would be MOD for Master of Disguise. Appropriate for Halloween. Think of it as financial engineering squared for the derivatives squared (the SIVs). I will cover this development in more detail this weekend since I'll be filling in for Jim. It's really a fascinating development.


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One of the arguments being tossed around about all of this is whether or not the government should even be getting involved in bailing out those who took on too much risk without appropriate protection. The name given for this is Moral Hazard. If we protect those who took too great risk and penalize those who invested properly (such as penalizing bank shareholders if the banks are forced to buy bad loans that they then have to write off) then one could argue the morality of that.

But if the government doesn't get involved in supporting the financial system then the consequences of a credit collapse could be monumental. It's not an easy problem to solve now and certainly would have been a lot easier to put controls in place instead of calling the creation of this mess a great example of financial engineering as Greenspan did back in 2004-2005. Now he says he didn't see this coming. I have a relatively low opinion of Greenspan but I don't think he's that ignorant of the risks. But maybe I'm wrong.

Back to the moral hazard question, cartoon comics have an amazing way of nailing an issue on the head with just one picture. I saw this one today:

Moral Hazard cartoon, courtesy The Miami Herald

The message is obvious--if I make bad bets then I should be the one who suffers and pay the consequences. We teach our children this very important lesson early on (its called punishment). The cry babies on Wall Street (or wherever they trade these days) are spoiled children and quite frankly need to be punished, Jim Cramer included. But I understand the larger issue of stability in our financial system and it's not an easy problem to solve. I happen to believe the market will solve and it will either be solved quickly or dragged out a lot longer than it should (Japan is a prime example of dragging it out a lot longer due to government involvement and poor decision making).

As for today's activities, we had a relatively busy morning with economic reports and a very bullish opening was quickly turned around and the market sold off for the rest of the day. A late-day rally (surprised by that?) pulled the market back up to essentially even.

Economic reports
The Consumer Price Index (CPI) and Core CPI along with the number of Housing Starts and Permits were released before the bell. Equity futures had already been rallying well before the news and there was barely a reaction. Then at 10:30 we got the Crude Inventories data and at 2:00 the Fed's Beige Book.

CPI and Core CPI
Consumer prices increased +0.3% in September on higher energy and food prices. But since we don't eat or use energy we only need to worry about core CPI which came in at +0.2%. That makes for annualized rates of +3.6% and 2.4%, resp. Both are still higher than the Fed's target rate but at least the core rate is close. It's the 4th month in a row for core CPI to be up this rate and for the last year it's +2.1%. Bonds rallied (yields declined) on the news with the Fed funds futures pricing in a greater likelihood for further rate reductions from the Fed this year. As long as inflation stays tame it gives the Fed room to wiggle on lowering rates further.

Housing Starts and Permits
New construction of U.S. houses dropped for the fourth straight month in September, down -10.2% to a seasonally adjusted 1.19M units. This is the lowest level of starts in 14-1/2 years--since March 1993. New home construction dropped -1.7% to 963K while large apartment units fell -34.3% to 228K. Building permits also fell -7.3% to a seasonally adjusted rate of 1.23M making for the lowest level since July 1993. Of course the drop in permits does not bode well for future construction projects.

Crude Inventories
Crude supplies rose by +1.8M barrels to 321.9M, in line with expectations. API had crude inventories up by +4.4M to 320.5M. They said gasoline supplies fell -3.0M barrels to 198.3M, close to the Energy Dept's numbers. There's still a lot of concern about the Turkey/Iraq situation and many are calling for $100 oil. I'm not so sure about that.

Fed's Beige Book
The Beige Book (which got its name by the color of the report cover) showed economic activity has slowed over the last six weeks. The report showed an expansion of activity but a slowing of the growth. There's mixed opinion about how the Fed will react to the latest data in deciding what to do with rates when they meet again at the end of the month.

The market has been bouncing around quite a bit the past two weeks and the DOW is back to where it was in mid September. We don't have any clear signals yet on where the market is going next but let's see what the setups look like and where the key levels are.

DOW chart, Daily

The DOW dropped down to just above the mid line of its parallel up-channel from 2006 and then closed just below its uptrend line from August 16th. I'm showing the parallel up-channel for price action since August so the bulls are still alive here. It's entirely possible the bulls will drive this back up towards the top of its longer term channel. If it does so by the end of the month we could see 14500. That would be another 4% rally from here. No matter how bearish you feel about this market, or why it shouldn't be able to do that, keep reminding yourself that the market is not logical, it just is.

A rally back above 14011, this morning's early high, would be bullish. It would violate the bearish EW (Elliott Wave) count on the chart and it would be a confirmed break of its downtrend line from last week's high.

DOW chart, 60-min

The downtrend line from last week is the top of a descending wedge as depicted on the chart. Today's low did a throw-under below the bottom of it and then rallied back up into the pattern. That's buy signal #1. A rally out the top of the pattern, so above 13950, would be buy signal #2. And then a pullback to the broken downtrend line for a successful retest (the pullback only occurs about 50% of the time) would be buy signal #3. That's the bullish setup.

What I'd like to see, but don't, is bullish divergence at the new lows. A bullish descending wedge should show clear bullish divergence. So that's a heads up that we might not have a descending wedge pattern here--we saw lots of failures of rising wedges in the past year as the market rallied out the top of them. Be careful of the possibility for the opposite to happen on the downside.

I'm expecting a pullback early in the morning since it looked like the bounce off today's low completed a 5-wave move. Therefore we should see a correction of that move and then another leg up. Once that larger 3-wave bounce is completed, especially if it's at the downtrend line, then we'll have a potential bearish setup. It would be an especially good setup if price fails at its broken uptrend line from August 16th where it crosses the downtrend line near 13930 (depicted in pink). That's the bearish setup.

So now we let price lead the way and trade accordingly. I don't think price will immediately fail from here and drop to a new low first thing tomorrow but I wouldn't be surprised by anything this market does, especially during opex week.

SPX chart, Daily

I attached a line to the September 10th low that is parallel to the one along the highs of the rally since August. This creates a potential parallel up-channel for the rally and a logical place for a 4th wave correction to find support (green wave-4 on the chart). As long as today's low continues to hold then there is the possibility for another rally leg up to a new high. The Fib projection at 1606.58 crosses the mid line of the parallel up-channel at the end of the month.

For the bears, last week's high could have been it. With SPX struggling at the 1563-1565 Fib area (it rallied above it on Thursday but was not able to close above it) it was a good setup and on Thursday I called for a short play on the Market Monitor. Bears want to see SPX stay below 1550 and continue lower. A break below 1507 is needed to confirm the likelihood that a market high is in.

SPX chart, 60-min

Like the DOW I'm showing a potential bullish descending wedge. You can see the throw-under today and then recovery back inside the pattern. So we have a buy signal on SPX as well as the DOW. We should get a pullback followed by another leg up and that will be an important test for the bulls. It will need to get back above 1550 to negate the bearish wave count on the chart and then the next resistance level would be a retest of its broken uptrend line from August, currently up near 1560.

Also like the DOW, for a bullish interpretation of this pattern I would like to have seen clearer evidence of bullish divergence to confirm this pattern. Without I remain somewhat suspect. Without getting into the details of EW first waves, sometimes they form wedges like the one we see on this chart. Therefore, if today's low was the completion of a first wave down then a failed retest of its broken uptrend line (as an example of where the bounce could get to) could be a good short setup for the third wave down. It's what I'll be watching for on the Market Monitor (the earliest it would probably set up would be Friday or Monday).

Nasdaq-100 (NDX) chart, Daily

The NDX remains the most bullish looking index. It has held onto its uptrend line from August, the only one to do so, and the consolidation pattern since last week's high looks constructive for another rally out of it. I'm leaning bullish on this one and it will be interesting to see if it stalls just above 2200 at the top of its parallel up-channel from 2002. If it leaves a bearish divergence at the new high and is not accompanied by any of the other indexes (making for a bearish non-confirmation between indices) then it will be bearish. But it would require a new high followed by a drop back below 2150 to issue a sell signal.

Nasdaq-100 (NDX) chart, 60-min

The sideways triangle pattern since last week's high looks like a 4th wave continuation pattern and says we should see a rally out of it (depicted in green). Today's low was very possibly the throw-under finish to the pattern (typical). A pullback early tomorrow should set up a buy signal for those who would like to scalp a long. I hesitate to recommend a long on this since the 2200 level may be all we're going to see. Watch it closely if long.

Relative Strength of NDX vs. the Nasdaq, Daily

I showed this chart last week and I'll continue to show it so that we can watch to see if it will be effective in calling an approaching high. As long as the generals are in the lead then that's a good thing. As soon as they start underperforming the rest of the tech stocks we'll know the generals are hanging back and letting the troops out front to get shot. So far so good for the bulls.

Russell-2000 (RUT) chart, Daily

I've been showing the rising wedge for the RUT and calling it bearish. Like the current descending wedges I've shown for the DOW and SPX, what I don't like about the rising wedge is the lack of bearish divergence at the new highs. Therefore the bullish possibility, like the others, is that we'll see another push higher for a likely retest of the July high. The Fib projections for green wave-5 are at 856 and then 881. Otherwise a break below 802 and its uptrend line from August 16th through September 10th would be bearish.

I'm currently reading a technical analysis book and came across the following chart in the book:

Rising Wedge pattern, "Technical Analysis" by Charles Kirkpatrick and Julie Dahlquist

Notice the similarity of the pattern depicted in the book and the one I have drawn on the RUT's daily chart above. After what could be the climax peak in price in July we have what looks like a risking wedge up to a retest of that prior peak. Price has now broken below the wedge and one has to wonder if all we'll get is a pullback to the broken uptrend line and then a continuation lower. In the book the authors make reference to data that shows a pullback to a broken trend line like this happens only a little less than 50% of the time. Therefore a bounce from today's low followed by a new low would be a bearish signal.

Russell-2000 (RUT) chart, 60-min

The RUT looks like the DOW and SPX with the potential descending wedge from last week's high. We've got wedges all over the place and may be yet another indication of a topping process. Tops in markets tend to be a process (e.g., a rolling top) versus an event at bottoms (e.g., a v-bottom). The broken uptrend line from September 10th is currently near 836 so if it manages to rally back up to this trend line keep a close eye on it for failure as an opportunity to short the small caps.

As depicted in dark red, it's possible we'll see the market immediately head lower once the current bounce is finished. As long as the RUT stays below 832 and then drops to a new low the bearish wave count calls for a very strong selloff so don't get caught long if a new low is made from here. In the meantime, hints of bullish divergence suggest we could in fact get another rally leg to a new high so don't be caught short if it rallies above 832 (until you give it a chance to see how it does against its broken uptrend line).

BIX banking index, Daily chart

The banks are ugly. While it's possible we'll see the banks get another rally leg back up within its consolidation (continuation) pattern, I can't put anymore lipstick on this and call it pretty. The current decline from the high on October 5th fits well as a 3rd wave (which should exhibit strong selling (or buying in a rally). Therefore the most I'm expecting out of the banks is a small 4th wave consolidation and then a continuation lower. The banking index is a very loud warning to bulls not to get complacent about their positions. If the banks were going to benefit from anything the government, or anyone else, does for them, they're not showing it. The message from the banks is very clear--be afraid, be very afraid.

The brokers aren't looking any better:

Brokers index (XBD), Daily chart

Another rising wedge, another break down. Again, there wasn't the usual bearish divergence at the last high to it's possible we'll see the broker index push to another high but right now it's looking bearish. A failed retest of the broken uptrend line would be a good short play setup.

And then there's Mother Merrill (MER). It's always a good idea to ask Mother what to do next.

Merrill Lynch (MER), Daily chart

The sideways triangle is a very reliable continuation pattern. In this case price dropped down into it and it's a high-odds play that price will drop out of it. Many of the big investment banks made gobs of money during the heyday of leveraged investments. They used leverage well in excess (and still are leveraged) of what got Long Term Management Capital in trouble in 1998. Is it any wonder the Treasury Dept. is pulling out the stops to get involved here?

These big investment houses are in trouble and this chart is a screaming short. Whether it bounces back up for another test of the top of its pattern or drops from here is the question. Mother says come inside so as not to get caught out in the rain. The dark rain clouds and lightning bolts are getting closer.

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

I thought the housing index was going to do it this time--I thought it would break its downtrend line from May. But last week I suggested we could see a pullback to retest its low and I think that's still a possibility here. Then a bounce should break its downtrend line. I shows the potential for a sideways triangle consolidation over to the top of its parallel down-channel. It could bounce up to it instead or it might even drop lower before consolidating. It's not finished going down but it does need to correct its decline from May.

To keep things in perspective, here's the weekly chart of the housing index:

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

Price should work its way down into the end of the year and likely find firmer support around the 2001 or 2002 lows. There's a Fib projection at 215 and for now I think that makes for a good downside target.

Oil chart, December contract (CL07Z), Daily

The November contract (the front month) made a high around $89 today but the December contract hasn't tagged $88 yet. Sounds like traders don't believe the high prices will stick around. The Fib projection for the December contract at 88.15 (where wave-(v) = wave-(i) in the rally from May) makes for a good upside target. It's possible we saw the high today as it came close and today's candlestick is a shooting start. A red candle tomorrow would be a confirmation of the reversal signal. It takes a break below $82 to confirm the high is probably in otherwise we could see oil pull back and then rally to a higher Fib target at $92.

Oil Index chart, Daily

The oil stock index broke its uptrend line from August and has since been pressing up underneath it. While it's bullish that it's making new highs, it's bearish that it's doing so underneath that broken uptrend line. The bearish divergences suggest we're going to see it break down soon.

Transportation Index chart, TRAN, Daily

The Transports is the other index (along with banks, and semiconductor index not confirming the tech rally) not confirming the broader market rally. As you can tell this is not a timing tool but it does suggest caution vs. complacency about being long the market. The Trannies did a throw-over above its consolidation pattern, dropped back inside and has now broken below the pattern. Today's bounce has it back up for a potential retest of its broken uptrend line. If it fails this test and drops back below yesterday's low then we will have had the third sell signal out of this continuation pattern.

U.S. Dollar chart, Weekly

This is the weekly chart to keep the bigger move in perspective. It's possible the US dollar has found a bottom (around its downside Fib projection at 78.28) or else it will drop a little lower to the bottom of a parallel down-channel for price action since September 2006, currently near 77.

Gold chart, December contract (GC07Z), Daily

I called a short on gold yesterday on the Market Monitor when it tagged its Fib target at 771.40 (hit 772 in overnight trading). The throw-over above its rising wedge, accompanied with bearish divergence, tagging its Fib target and then dropping back inside the pattern was a very good setup. I of course have no idea if we've seen the final high but I'll take this kind of setup, on any symbol, every time. You take, you set your stop and you let 'er rip (I had my stop set at 766 tonight which got tagged as I write so I'm watching overnight trade to get back in if it fails at or below its downtrend line from Monday's high, currently at 767.50). Now all I need is a rally in the US dollar to help the play.

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

Tomorrow's economic reports should not move the market. If the Leading Indicators comes in much worse (or better) than expected then it could move the market but not likely. The Philly Fed index at noon could also move it but right now most of the opex positions have probably been squared and it could be just a consolidation day.

SPX chart, Weekly

There's been no change on the weekly chart as we're still waiting for an answer as to whether last week's high was THE high or if we've got one more up to the 1600 area by the end of the month. Hopefully next week we'll know which it is.

Today showed the typical volatility seen during opex week and I suspect tomorrow will be quieter. I think the higher odds scenario is for an early pullback that stays above today's low and then another leg up that creates a larger 3-wave bounce off today's low. Whether that turns into something more bullish, including breaking downtrend lines from last week and getting back above broken uptrend lines, or then rolls back over is the big question for me tonight.

A strong rally back up from here would have a good chance of seeing some new yearly highs for at least one of the indexes (NDX) and then it'll be a matter of watching the others to see if they'll join in. But a 3-wave bounce that stays below the key levels I identified (such as DOW 14011 and SPX 1550) that then rolls over and heads for a new low below today's would be a bearish statement. It could even be accompanied by very strong selling (bordering on panic selling since the bearish wave count would support a very strong decline) so use that as your guide for how you want to be positioned in the market.

We still have the longer term up trends intact and therefore respect the possibility that the bulls have some more work to do. But with the plethora of warnings we're getting for some of the other sectors/indices it would be sensible to stay close to the market right now if you're long. It would be better not to get trapped by a downside surprise that jumps right over your stops so you may want to stay available to exit quickly if the need arises. Let's get through October (we're still in the vulnerable period) and then reassess what we've got then.

But as I showed on the charts, it's possible we put in a low for the pullback and now will start the next rally leg to new highs. I showed some Fib projections and trend lines that intersect at the end of the month. Wouldn't it be interesting if we see the market rally to new highs by October 30th when the Fed meets again for the next rate decision. Now That would be an interesting setup.

Good luck with your trading and I'll be back here for the weekend Wrap.

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