Option Investor
Market Wrap

Easy Come Easy Go

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I (Keene Little) will be filling in for Linda for this evening's Market Wrap. What the market giveth the market taketh away. One of the strongest one-day rallies this year, on Tuesday, has been pretty much been given back after yesterday's and today's selling. Interestingly the big cap techs (Nasdaq-100) have given back less than the others (but only marginally) while the small caps completely erased Tuesday's gain and did a retest of Monday's low right at the end of the day (and got a predictable bounce off that low). The big cap techs got washed out pretty good coming into this week so it's not surprising to see a little less selling in the NDX.

One look at the table above says it all--ugly day today and in fact uglier than the indices might otherwise say. Yes they were down but with the DOW down -121 on the day I'd say that's in the noise area with its increased volatility lately. The S&P 500 was down a greater percentage and gave up almost 20 points on the day. But the market internals were strongly negative with new 52-week lows hammering new highs better than 5:1. Decliners beat out advancers almost 3:1 and down volume swamped up volume 4:1. Those numbers reflect some strong selling that was not necessarily reflected in the big indices.

Today, November 15th, was the last day for withdrawal requests for hedge funds. Jim had mentioned this in his weekend wrap and suggested we could see some strong selling this week from that. So today's selling might have finished if that was a big reason. Considering the steep decline in the market the past month, after it had done a retest of the July high, there were probably many traders who waited until the last minute to withdraw funds as they hoped the market would bounce and get them out at a better price. After yesterday's selloff and inability to add to Tuesday's rally I'm sure many decided to just pull the plug and get some of their money into safety. It would be interesting to see if money market funds increased this week. I suspect they have.

As I had mentioned yesterday, opex can exacerbate these kinds of moves because traders are forced to make hedges to their positions. If they were shorting stock again today to protect short put positions (such as sold puts on SPX which settle tomorrow morning) then that selling pressure just added to the normal selling. And if they no longer need, or want, those short positions tomorrow morning we could see a reversal again back to the upside. Traders got a workout this week.


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As I'll show in the charts I'm thinking we will see a reversal back to the upside on Friday. Opex Friday's are typically pretty boring days so we could get an initial flurry of buying followed by a drop off in volume as the market flattens out. But as long as Thursday's lows hold then I think we could be due another rally leg above Wednesday's early-morning high.

Before getting to the charts we'll review today's economic reports:

Economic reports
This morning we had the CPI (Consumer Price Index) numbers, jobless claims, NY Empire State index, Crude Inventories and the Philly Fed index.

CPI and Core CPI
The consumer price index increased +0.3% in October, driven higher by a +1.4% gain in energy prices (the fastest increase since May). Food prices were up the same +0.3%. Therefore, knowing we don't need to eat or use oil products, the core rate was "only" +0.2%. These numbers were the same as September so both rates are a little higher than the Fed wants to see.

As I had reported yesterday for the PPI numbers, the year-over-year comparisons are now starting to show an increase in inflation due to the drop off of the September and October 2006 declines. So for this October the y-o-y CPI was +3.5% (and +3.6% for all of 2007 so far) and core CPI is +2.2% y-o-y (and +2.3% annualized for the year so far). Neither number is Fed friendly in their inflation battle.

One thing boosting the core rate was a +0.5% gain in rent costs. This could be a little more worrisome for the Fed as housing costs are something they watch a little more closely. The increase in rents may be due to more people renting now that it's harder to get into a home (or more sadly, for those who may have lost their home). Any further pressure on rents could put more pressure on the Fed.

CPI, 1991-2007, courtesy briefing.com

The chart shows CPI heading higher this year but core CPI (blue line) has been trending lower. The Fed watches PCE (Personal Consumption Expeditures) more closely but obviously they would not be happy if the core rate starts following the CPI higher.

Unemployment Claims
Initial claims for last week rose by +20K to a seasonally adjusted 339K, the highest in the past month and higher than most economists were expecting to see. Continuing claims dropped -7K to 2.568M. The 4-week average for initial claims is 330K (the highest since April) and for continuing claims it's only 20K below its 20-month high from late August.

Unemployment Claims, 1991-2007, courtesy briefing.com

The chart shows unemployment claims remain at the low end of their range over the past 17 years which is a good sign for the economy. Unfortunately it's a lagging indicator so any uptick in claims will probably already be felt in other areas of the economy.

NY Empire State Index
Conditions for NY manufacturers improved in November with the index at 27.4 coming in only slightly lower than October's 28.8. The new orders index (24.5) and shipments index (32.2) were also near last month's. The prices paid index (42.9) rose sharply to its highest level in more than a year while the prices received index (11.9) declined slightly and that puts more pressure on the bottom lines for the companies.

The outlook for the companies was not as good as it was in October. The index fell 20 points to 30.5. The future new orders and shipments indexes also fell sharply. The capital expenditures index fell several points to 19.1 and most companies expect to have higher cash levels over the next year (not good for technology and other capital expenditures).

Crude Inventories
Crude supplies rose unexpectedly by 2.8M barrels and helped drive the price of oil lower today (along with a rally in the US dollar). Gasoline supplies rose by 700K barrels and distillate stocks rose by 2M barrels.

Philadelphia Fed Index
The November Philly Fed index rose +1.4 points to 8.2, matching the results seen in NY. Shipments rose to a positive level and the new orders index rose as well. Going against the NY index, the prices paid index dropped slightly while prices received rose. But the report showed weak pricing power in the manufacturing sector.

The worrisome number is the 6-month outlook as shown in the table of recent numbers for this index:

Philly Fed Index, July-November 2007, courtesy briefing.com

I highlighted the November outlook and you can see it's significantly lower than previous months. This is of course worrisome as business leaders who lack optimism about the future will tend to pull in spending and this matches what the NY index showed. The lack of capital expenditures could add to a slowdown in consumer spending and it's not a good sign for our economy in the future.

Getting to the market, other than more of a pullback from yesterday there's really not a lot to add to yesterday's charts but let's see what they look like:

DOW chart, Daily

The wave count that I'm considering here, more clearly seen on the 60-min chart, is an a-b-c upward correct off Monday's low. Tuesdays strong rally would be wave-a and the pullback since that rally would be wave-b. That means we need wave-c to the upside and it should rally back above Tuesday's high (shown in dark red on the chart). A 38% retracement of the October-November decline (13442) or 50% (13587) is what I would expect to see from here. If the DOW were to rally higher than 62% (13731) it would be a break of its downtrend line from October and I think would be telling us some bullish things (shown in green).

On the flip side, a break of Monday's low at 12975 would look bearish. There's one caution about that though--if we are getting a b-wave pullback it can undercut the previous low and not negate the possibility for a wave-c up to follow. It could end up being a head fake break which would mean a bear trap in this case. If you see a new low but it's not confirmed with some of the market internals (you'd see some bullish divergences) then beware the bear trap.

DOW chart, 60-min

Today's pullback undercut the bottom of the parallel down-channel from the October high but essentially closed on it. These channels can be amazing how much they capture price movements which is why I keep them on the charts until it's much older than this one. Shown in pink, a slightly larger bounce now followed by new lows would be a bearish breakdown and I'd be looking to short it. But if a rally starts on Friday then I'd be looking to buy the dips since the upside potential is at least the 13450 area.

SPX chart, Daily

SPX held above the new uptrend line from August and I believe finished its decline at today's low (I show why on the 10-min chart below). I show the potential (in dark red) to rally up to its downtrend line from October, near 1525, but that could be a stretch. But a rally back up to 1500-1510 would be a typical move from here if a move up in wave-c is the next move.

SPX chart, 60-min

Assuming we see a rally on Friday, the downtrend line from October 31st, currently near 1477, will be an important hurdle for the bulls. As shown in pink, any bounce followed by a new low would be immediately bearish. But a rally above it could take it as high as the 1525 area. If it dribbles lower on Friday look for bullish divergences since a minor break of Monday's low would not necessarily be bearish.

I posted this SPX 10-min chart on the Market Monitor this afternoon before the final low in order to show why I thought 1443-1444 was a target zone to look for support:

SPX chart, 10-min

A little EW (Elliott Wave) teaching here (so skip if not interested)--as shown on the daily and 60-min charts, and discussed with the DOW charts, I'm thinking we're going to get an a-b-c bounce off Monday's low and the pullback from Wednesday morning's high is wave-b. I've been watching the decline for evidence to either negate that count or support it. First of all the sideways triangle consolidation on Wednesday fits best as a small degree b-wave since these triangles are present in 4th waves and b-wave. Since it's not a 4th wave it must be a b-wave. That set up the decline as corrective which fits the larger degree b-wave (labeled wave-(b) at today's low). From there I've got the move down labeled as a double zigzag which means two a-b-c's separated by an x-wave.

The Fib projections shown on the chart are based on Fib relationships between these wave patterns and towards the end of the day, after 1451 was violated, I said watch for support in the 1443-1444 area since there's good Fib correlation there for the end of the wave count. Today's low was right in the middle at 1443.49. That low must hold now otherwise it opens up a bunch of possibilities and potentially much lower prices. Therefore long against today's low is the recommended play here.

A break above 1466 is needed by the bulls to confirm a bottom is in. Then move to the 60-min chart and watch that downtrend line at 1477 since a failure there that then heads back down to a new low would be bearish, no ifs ands or buts.

Nasdaq-100 (NDX) chart, Daily

It's the same deal with NDX--today's pullback should lead to another push higher to complete an a-b-c bounce off Monday's low. That should complete a wave-2 correction to wave-1 down from October 31st. Once it completes the next wave down, wave-3, should see the strongest selling we've seen this year.

Nasdaq-100 (NDX) chart, 60-min

I added a Fib projection to this chart that I showed last night. Two equal legs up (for wave-a = wave-c) would be at 2120, assuming today's low holds. That would place the bounce between a 50% and 62% retracement of the decline which is pretty typical for a 2nd wave correction. If we get that kind of rally leg expect to hear Jim Cramer pounding the table on what a wonderful buying opportunity it is for a year-end rally. Believe him at your own risk as I believe it will be a bull trap (which is what makes 3rd waves so strong as those who were trapped start bailing en masse).

I haven't shown the semiconductor holders in a while so I thought an update is in order:

Semiconductor Holder (SMH), Daily chart

After breaking its down-sloping neckline in October and then retesting it on October 31st, it's been downhill for the semis since then. It broke it longer term uptrend line from October 2002 yesterday and was unable to get back above it today. It could flip-flop around this level, or bounce back up for another retest of its broken neckline as part of a sideways consolidation pattern (some bullish divergences are starting to appear), but from a pattern perspective I do not see a reason to be thinking long the semis. This could continue to be an albatross around the neck of the techs if it continues to sink lower.

Russell-2000 (RUT) chart, Daily

Different index same pattern--looking for another leg up in an a-b-c bounce off Monday's low. Assuming it can get up off today's retest of Monday's low, it could rally back up to its downtrend line from October, currently near 807. If it can get up into the area then the 50-dma and 100-dma could block any further progress. If price plays out as I've depicted in dark red you can also visualize a H&S pattern with the right shoulder need here and the neckline near 760. This would be a larger H&S pattern than the one that completed off the September-October H&S formation (for which the downside objective has not yet been achieved).

Russell-2000 (RUT) chart, 60-min

We've got some bullish divergences against the lows since November 8th so that supports a rally leg from here and that would be wave-C up to at least the 800 area if not to the downtrend line from October. As with the others, any appreciable bounce from here, to say the 780 area (shown in pink) that is then followed by a move to new lows would be immediately bearish. That kind of move would very likely break down below the bottom of its parallel down-channel.

The banks got hit hard today, down -4.4% on news that more banks are reporting more troubles with bad loans, mortgage portfolios, derivatives, etc. Barclays UK joined the un-distinguished list and reported this morning that they're writing down 1.3B pounds ($2.7B) for the 3rd quarter and October, citing downgrades from rating agencies on a broad range of CDOs (collateralized debt obligations). It says it has exposure to 7.3B pounds of unsold underwriting positions in leveraged finance (such as for LBOs which will go onto their books if they can't sell them) and another 19B pounds of exposure to its own on-balance-sheet conduits.

This continues to be an unfolding story and will likely play out for some time to come. The reason more write-downs keep occurring is because the ratings agencies are literally downgrading something new every day as the market prices these assets. One look at the ABX closing prices for last week on AAA-rated investments (these are investment grade holdings that investors like pension funds are being forced to sell because of the downgrades) shows the pain many are feeling:

ABX Closing Prices, effective November 8, 2007, courtesy markit.com

These asset-backed securities are divided up into which half year they were sold. The chart above shows the ABX index for AAA-rated securities sold in the 2nd half of 2007. Anything sold after 2005 has taken a bigger hit in value because that's when the garbage was being packaged as AAA and sold to unsuspecting investors. As the chart shows, the value sank to 90 cents on the dollar in August when the market panicked over all of this coming to light and today it's worth 70 cents on the dollar. The ones that have been downgraded are obviously faring even worse, with A-rated currently trading for 30 cents and BBB is at 20 cents.

Many holders of this garbage still haven't accounted for the actual mark-to-market value but instead carry them at their mark-to-model values (100 cents on the dollar). When a ratings agency downgrades one of these securities and someone then sells it, that can trigger a write-down for the banks and others who hold the same package. This process will take a while to undo. One thing that the market may not have been happy about today, especially for the banks, is the FASB decision to not allow a deferral of Statement 157, Fair Value Measurements.

FASB 157 requires companies to implement this new standard for financial assets and liabilities. This ruling requires companies to value their assets at fair value which means market value. It will require companies to go to the mark-to-market model and there are many who are not happy about this. In order to have their financial statements signed off by an auditor they will have to demonstrate that they've fairly valued all of their assets. This is going to be painful for those who are carrying a lot of these asset-backed securities at inflated values when compared to how the market is currently pricing them.

Financial Executives International (FEI), which is a trade group for heads of finance, treasurers and corporate comptrollers, had asked the FASB to delay implementing the 157 standard by a year but today's decision shot that request down (except for non-financial assets). There are many who have simply swept this problem under the rug in hopes the market will improve before they have to sell. Now it won't make a difference--they're going to have to value them as if they were sold today.

There's going to be more pain ahead. This problem has been compounded in the banks because of their record-low rates of reserves that they had set aside for bad loans. I reported before the summer that banks were going to take big hits to their bottom lines just to fund their reserve accounts once loans start going bad (and it didn't take a rocket scientist to know it would happen when Fido was given a loan but no way to pay it back). So the banks found some more sellers today.

BIX banking index, Daily chart

Even though banks got hit hard today I still think they're due a bigger bounce, the same as for the broader market indices that I've been showing. Obviously that's not a given and it could turn real ugly if the banks continue lower right from here but I continue to lean towards another leg up before the hard selling resumes.

However, the brokers could be pointing to a very bearish setup:

Brokers index (XBD), Daily chart

The one big bearish thing I do see setting up is what I see for the brokers. I show (in pink) the possibility for a rally up to, or above, the downtrend line from October (which would match the others) but right now there is the possibility for a very strong 3rd of a 3rd wave down to unfold (dark red arrow). If the brokers drop to a new low from here then the selling could accelerate and border on panic selling. I'll be watching this one carefully.

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

It's possible the correction for the home builders is over and we'll see the next leg down begin from here. The 50-dma has been a brick wall for this index. A break below 300 would be an indication that we'll see this index head down to its 215 target next.

Oil chart, December contract (CL07Z), Daily

Another kiss of its broken uptrend line and a pullback from it. The US dollar is rallying and that could hurt all commodities if it continues. A drop below 90 would likely mean a quick drop down to 85 on its way to 80.

Oil Index chart, Daily

I think the oil stocks are also due another leg up in its bounce before it resumes its path to lower lows. After bouncing off its 100-dma it should then head for its 200-dma, at 731 currently.

Transportation Index chart, TRAN, Daily

If the broader market manages to rally I'm sure the Trannies will be doing the same. Watch for resistance at either its downtrend line from October, near 4850, or higher if it's able to get through that.

U.S. Dollar chart, Daily

The US dollar just might do it here. It just might be able to continue rallying and finally break its downtrend. It's got a little ways to go, above 76.50, to prove it but see that little poke above the RSI downtrend line. Like a little snake sticking its head above water to see if it's safe to come ashore. If it's able to break that downtrend line then it should be a heads up that the dollar will be able to break its downtrend line next.

Gold chart, December contract (GC07Z), Daily

The US dollar rallied and gold got spanked, down almost -$27 today. But it's still holding its uptrend line so the gold bulls have a chance here of saving this. Unfortunately for them the break of the RSI uptrend line says gold will likely follow with a break below 780. I show one possibility, in pink, for gold to rally back up for a test of its high while RSI bounces back up for a retest of its broken uptrend line. This is not that uncommon and in fact would be an excellent short play setup.

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

Friday's economic reports will not likely be market moving. The capacity utilization report is used by the Fed in their inflation assessment so a big jump in utilization would spark inflation concerns but that's not expected.

Rather than show the SPX weekly chart again, since so little changed, I thought I'd show a chart of copper:

Copper chart, December contract, Weekly

Copper is a very good metal to follow as it provides a good signal for how the economy is doing. It's an industrial metal and obviously used a lot in homes so the reduction in home building has caused a reduction in requirements for the metal. But the price recovered significantly off the January low and was a result of global demand. That was a good sign for growing economies. But now we have an expanding bullhorn pattern and at highs this is a bearish pattern. It's setting up a reversal. Also notice the bearish divergences at the highs as compared to the 2006 high and even the 2007 highs. We may have seen the last high for copper and a break below 2.90/lb. would be a signal the top is in and a slowing in the global economy. That would obviously be a bearish sign for the stock market as well.

So I'm looking for a rally on Friday but I wonder how much it will be able to rally since opex Fridays aren't known for big moves. But it occasionally happens. If the market just trades sideways and consolidates most of the day it will look bearish and I would expect lower prices from there. The short term bullish scenario requires a strong rally and to start from the open. Anything less would have me on the sidelines watching to see what's happening. I don't recommend a short play here only because I'd be worried about a bear trap with a minor new low for the week and then a reversal. You'd need to be able to watch the market intraday in case that happened. We all know what v-bottoms can do to short positions.

If your trading horizon is longer than a trade that lasts for only a day or two then the long play setup is not for you. We have to see some resistance overhead broken before I'd be comfortable recommending a long play. But if we get the bounce back up to the DOW 13500-13600 area then I'd look for a short entry or two since you'll be able to keep your stop relatively tight.

I'll be back on Wednesday to see how this sets up. Good luck in your trading.

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