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Market Wrap

Rate Cut Hopes Stay Alive

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This morning started with a large gap up due to a strong overnight rally and then boosted higher by the morning economic reports. With the stronger productivity numbers and lower wage growth it opened up the door for the Fed to lower rates without fear of stoking inflation. Or at least the wage inflation part of it. We don't need to worry our little selves with the higher costs of food and energy because that's not what the Fed looks at. So the market gapped up big and rallied into the lunch hour. Only in the afternoon did it come back down and tested the early morning price levels and when it found support there it took off to the upside again, closing near the highs for the day.

These on again, off again rate guessing games by the market is driving traders to drink. Each time one side or the other thinks they might have a swing trade along comes another piece of data that has the market second guessing its previous assumptions (usually associated with what the Fed will and will not do) and reverses course. The good news for the bulls is that last week's strong rally was followed by one of those relatively flat (except for techs) corrections that has led to another big up day. This is reminiscent of the previous rallies where corrections are small and both bulls and those wanting out of shorts are forced to chase the market higher in order to do some buying/covering.

The market internals were strong today and supported the bullish day. This supports the idea that we'll see at least another couple of days of buying ahead of us so it's looking more and more like we could have a rally into next week which of course has the FOMC meeting on Tuesday, December 11th. The only reason a rally into FOMC might not be such a good idea for the bulls is because it could set up a sell-the-news event. The market is pricing in a 50 basis point cut and based on the troubles in the credit market I think there's a good chance that's what we'll see. Certainly the Treasury market is forecasting at least that if not more.

If the Fed only cuts 25 basis points, ouch, and if they do the 50 basis points cut then the market could react with a whiny "that's all?" and sell off. I'll provide some upside targets to watch if we get a continuation of today's rally. There are some significant resistance levels dead ahead so another rally leg is not a given, or at least it might not make it very far.

There are many reasons to be a trader today rather than an investor. By investor I of course mean a longer term buy and hold kind of person. We don't normally think of investing in a short position although Goldman Sachs seems to have perfected that very well. The market has become more volatile in the past several months and that's usually indicative of a topping process. It comes as no surprise to most of you that I am bearish the market on a longer term basis (next 1 to 3 years). So this topping process is quite natural and "fills the bill".

There are many things on the charts that tell me we've probably topped (or we'll get a very choppy ride over the next few months to new highs) and now we're getting a plethora of signals from the economy that are saying "danger ahead". Most market pundits on CNBC don't mention any of this because it's a bullish program (keeps more viewers interested and that sells more advertising). You need to do your own digging and research to get the facts. Major media outlets simply don't want to upset and lose their readership. We writers for this publication feel the same pressure to not be bearish.

A downturn in the housing market, when it's been in more than one isolated geographic area, has consistently forecast a recession. A downturn in consumer confidence has consistently led to a slowdown in consumer spending. With consumer spending 2/3 of our GDP it doesn't take a rocket scientist to figure out that a slowing in consumer spending will likely cause a recession. This is why the upcoming holiday shopping season is being watched so carefully (and preliminary data says the consumer is in fact slowing).

Investor mood, which mirrors consumer confidence, is not heading in the right direction for the stock market. Consumer Confidence numbers have consistently proven to be good indicators for the stock market because it is investor (consumer) sentiment more than anything else which dictates whether they will continue to buy stock or instead start selling (or just not buy). With a consumer that looks to be pulling in its spending because of unease (or no more money/credit) it probably won't bode well for the economy.

Consumer confidence has taken a nosedive in the past few months, especially the future expectations component, and as this chart shows:

Consumer Confidence, courtesy briefing.com

It's a little hard to see but the blue line is the expectations component and it has dropped below the level it's been at for the past few years. When the consumer loses confidence in the future you can bet they're not in as much of a buying mood (for goods or stocks).

A measure of consumer spending can be seen in all kinds of places. We of course know about the slowdown in the housing market. This has spilled over into anything related to housing. The items collecting dust in warehouses are furniture, light fixtures, appliances and other goods related to home sales.

Another place you'll see consumer spending slow down first is in discretionary goods as opposed to consumer staples like food and basic home supplies. In a recession a defensive stock is one which sells products that you can eat, drink or smoke. Discretionary items are purchased when people are feeling good and have money in their pockets. Big plasma TVs, new cars, vacations (including motor homes) and recreational products are examples of discretionary items. The AMEX:XLY is the Consumer Discretionary Select Sector SPDR Fund and gives us a sense of what's happening to the consumer. This fund includes the following stocks:

Discretionary Select Sector SPDR Fund, AMEX:XLY, component stocks

Even though you eat what McDonalds sells, eating out is considered a luxury and when money gets tight people tend to eat at home more. Perusing this list of stocks would have most of you agreeing they sell products you would probably be cutting from your buying list if you suddenly felt poorer for whatever reason.

Looking at a chart of this fund shows some bearish things happening:

Discretionary Select Sector SPDR Fund, AMEX:XLY, Daily chart

The sector broke the August low and recently bounced back up to the top of a parallel down-channel for price action since the September high. The sector is clearly in a down trend and the breaking of the August low is a bearish signal. This sector is an advance warning for the rest of the market as it's saying we're headed for a recession. I suspect the broader market will follow suit sooner rather than later.

This is a big reason I have continued to harp on the point about why the Fed will be ineffective in stopping the decline. The credit contraction will be a result of a loss of confidence in the system. Investors aren't even sure what they're buying in many of the asset-backed bonds and therefore they aren't. The Fed can drop rates all they want and make more money available for lending but if people are no longer interested in buying the risk associated with that credit, or don't want to take out loans to buy the new motor home, then the credit market will continue to collapse. It's just part of the cycle and after the credit bubble we are unfortunately due a severe credit contraction.

And it's not really the Fed's fault although they could certainly have done more to thwart the creation of so much credit through "financial engineering" as Greenspan so many times marveled about, but in reality it was due to the excess bullishness in all participants up and down the chain--from the homeowner who couldn't afford the home or business which couldn't afford the loan to the investor buying up investment vehicles that they had no idea what it contained (just that it had a slightly higher yield). Years of greater than normal stability leads to greater instability and we're at the very beginning stages of this process.

Speaking of businesses taking on loans they can't afford, that's the next area to get a lot of attention. There are construction firms that now have higher debt balances than equity. With the significant downturn in the home-building business, soon to be any building business, it will become the next area where we hear about more loan defaults. The default rate for construction companies is already increasing rapidly but it's not even making page 10 in the Wall Street Journal yet. Risky homeowners who could fog a mirror were not the only ones who were blessed with easy access to money. Loan defaults are starting to spread across the spectrum and this will continue to erode the confidence of investors and is another reason it's becoming next to impossible to sell the "financially engineered" debt vehicles.

These are more of the fundamental reasons why any bounce in the stock market should be viewed as an opportunity to lighten up on your stock holdings. We've entered a period where the return of capital is far more important than the return on capital. Could you miss another 10% rise in the market? Absolutely. But I believe we're in a period of negative surprises. The chances of a sudden 10% drop is far more likely than a 10% rally.

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This is a game of probabilities and when you hear and read about the massive corrections that need to take place in the banking system, that the housing market probably won't see a bottom until 2009 (mortgage resets will accelerate for the next six months from now, causing a lot more defaults), that the consumer is clearly losing hope and slowing down the spending and that more businesses (not just homeowners who the government is now trying to bail out of their bad money management decisions) are getting behind and defaulting on their loans, you've got to wonder why the market is rallying at all. Bullish hope dies hard and it's why the volatility has increased--the battle rages on but to me the outcome is clear. It's a matter of when not if the market will suffer a severe decline.

So let's see what got the bulls all excited about this morning:

Economic reports
There were four scheduled economic reports this morning--Productivity (Rev), Factory Orders, ISM Services and Crude Inventories. While not an economic report per se, ADP also reported their employment numbers and say that private payrolls grew by 189K in November following a revised gain of 119K in October. This bodes well for Friday's jobs number and if it comes in stronger than expected the market will cheer even more since the it gives the Fed more leeway to reduce rates.

Productivity
Productivity in the nonfarm business increased +6.3% annualized which was revised up from the previously reported +4.9%. Unit labor costs (which the Fed watches carefully for signs of inflation) declined -2% annualized which was more than the -0.2% drop reported a month ago. Higher productivity with lower wage growth is exactly what the Fed wants to see and this helped ignite the booster rockets under equity futures before the market opened this morning. This data is volatile and not exactly reliable month-to-month and considering the slowdown in GDP there are a lot of expectations for further revisions and reversals in those numbers. But that can be worried about later.

Factory Orders
Factory orders were up +0.5% while shipments rose +1.0% and inventories rose only +0.1%. Most of the gains were in non-durable goods, up +1.3%, while durable goods orders actually dropped -0.2%. A sign of concern from businesses is the continued decline in core capital goods--down over the last 6 and 12 months.

ISM Services
The November non-manufacturing ISM (Institute of Supply Management) dropped 1.7 points from October to 54.1, making it the lowest reading since March and following the 14-month high in June. The new orders component fell to 51.1 and employment dropped to 50.8. Prices paid jumped to 76.5 which is inflationary. It's hard to get a sense about this index month to month but the longer term chart shows it's been in a steady decline since the high in 2004:

ISM Indices

This chart shows both the manufacturing and non-manufacturing indices both tracking together fairly well. The downtrend from 2004 has brought both of them near the 50 level. Below that level is a sign of contraction.

Crude Inventories
API reported inventories of crude fell by 8M barrels to 304.6M (EIA has inventory at 305.2M barrels). Distillate stocks rose by 744K barrels to 135.3M (EIA had a 1.4M increase) and gasoline supplies rose 3.6M barrels to 201.6M (EIA had 4.0M increase). The price of oil and gasoline were down slightly on the day.

And with that let's get to a review of today's charts.

DOW chart, Daily

Follow the bouncing lines! The first thought is that the DOW is going to have a tough time getting above the 13500 area--its downtrend line from October and 200-dma (and then the 50-dma just above those) stand in the way of progress for the bulls. The pink wave count shows the potential for the rally to fail in that area and then a turn back down. I show a pullback and then rally higher for the bounce but that's just one thought. If it turns back down and drops much below 13K (the reason for the dark red "target" symbol at that level) I think the bounce will be over (not shown otherwise it gets way too busy on the chart).

The dark red count is based on a bounce off the November low that achieves two equal legs up and the potential for resistance at the 78.6% retracement of the October-November decline. This gives us a resistance zone of 13800-14000 to watch for if the DOW can rally above 12635 (62% retracement). And if it can manage to break back above 14K then new market highs (green) should be on their way.

DOW chart, 60-min

Assuming the market continues to rally higher from here, two equal legs would take it up to just shy of 14K. I'm showing the possibility for the rally to take us into a high on December 11th (FOMC). If the price pattern plays out as I've depicted (5-wave move up from Tuesday's low) then it would make for an ideal setup to get short. The pink wave count simply shows more detail from the daily chart for a potential pullback (from maybe a slightly higher high first) before rallying again (or not).

SPX chart, Daily

Similar to the DOW, if the bounce off the November low achieves two equal legs up at 1545 then the resistance zone could be 1540 to 1545. But also like the DOW it has a multitude of resistance levels to get through just to get above 1512--multiple moving averages, all just above it, the "wall" at 1490, the downtrend line from October (near 1510) and then 62% retracement just below 1512. This market is going to need to be high on something to do it but I've learned long ago not to try to stare down a mad cow.

The pink wave count shows how we could see a deeper pullback from resistance before another rally attempt but any drop below the 1440 area would be a heads up that something more bearish could be happening. The uptrend line from March 2003 is the line in the sand--The August low and November low both found support at this trend line. It's very important now for the bulls to hold that line. Break that you might as well order a red flushie to go.

SPX chart, 60-min

The thin red line at 1490 is the "wall". This level has been key support and resistance for a good part of this year. The bulls need to tear down that wall and then tackle the downtrend line from the October high, currently near a potential Fib projection for the 2nd leg up for the rally--62% of the 1st leg up (I don't show the potential scenario from there but watch for resistance at that level for an end to the rally). A drop from here, or a little higher first, below Tuesday's low near 1462 would be more immediately bearish but I'll be watching to see if the pullback is corrective (overlapping highs and lows) or more impulsive for clues as to whether to expect 1540 to give way, and then the all-important uptrend line from March 2003. Watch the highs in RSI and MACD here--the bulls want to see the rally continue so as to avoid a negative divergence here since a test of the high, or a little higher, with bearish divergence would not be a healthy sign for the rally.

Nasdaq-100 (NDX) chart, Daily

The price pattern for the techs has been on a different path for a while now. If the bounce creates a rising wedge, as depicted on the chart, it will be clearly bearish. The wave count on a smaller time frame supports the idea that the November 30 high will hold and you want to be short against that high (pink wave count). Otherwise I would expect the techs to work their way higher if the broader market can do it. I highlighted the MACD because it has rebounded to the zero line, thereby relieving its oversold condition at the November lows. If it turns back down now it's one of the best sell signals you'll get from MACD (and just the opposite if it comes back down to the zero line from overbought). Bulls want to see the histogram portion of this stay above zero (the fast blue line stay above the slower red line).

Nasdaq-100 (NDX) chart, 60-min

The dark red count depicts a bullish impulsive wave count playing out into next week (for an FOMC high?). Two equal legs up from November 26th is just under 2182 which is close to a 78.6% retracement of the November decline. If today's high holds and NDX drops back down below 2048 then the selling could kick into gear otherwise I would expect this one to work its way higher first.

Russell-2000 (RUT) chart, Daily

The RUT remains stuck in its down-channel from October. If you're trading this to the long side then understand you're trading counter trend at the moment. Resistance by this chart is very close to today's high. The RUT needs to get above 780 to confirm a break of its downtrend. If it can do that then a bounce with two equal legs up from November 26th could have it rallying to 795 before finishing its bounce and then turning back down. Above 802 would be a more bullish sign (green). It takes a break below the November low to declare the downtrend is in full effect, but a break below Tuesday's low near 749 would be a heads up.

Russell-2000 (RUT) chart, 60-min

Like the NDX I'm showing an impulsive 5-wave count for a move up from Tuesday so as to give us an A-B-C rally off the November 26 low for two equal legs up to 795 (potentially finishing next Tuesday for FOMC). If today's high holds and the RUT breaks back below 749 then the bears could take over a lot sooner.

Before looking at the banking index, there is a lot of debate as to whether the banks have found a bottom. There's always a debate about this, especially after a hard selloff as the banks have seen this year. One of the reasons for the hard selling in bank stocks is because of the worries about how much of a loss the banks will incur because of all the bad loans, mortgage foreclosures, investments risks, etc. Much of the profits of the banks over the past few years have been a result of the massive increase in credit growth, especially in just the last four years. More money to lend, lending fees, repackaged loans sold and derivatives of derivatives gave the banks huge increases in profits. Unfortunately they didn't reserve much on their books for bad debts.

The combination of bad loans and having to take off-balance sheet loans back onto their books (and then write them down) has created a nightmare for these banks. Just increasing their loan-loss reserves is taking a huge bite out of their earnings. The write-down of much of the financially engineered credit has caused huge losses in their capital base (hence the reason you're reading of the huge ongoing effort to sell stock and borrow money in order to increase their capital base so as to meet their regulatory requirements for assets to liabilities ratios. Level 3 assets (the junky credit derivatives) are larger than their assets for many of the big investment banks (Goldman Sachs and Citigroup included) and as they've been forced to write down this stuff their asset base keeps dwindling. This process is a long ways from a bottom. When you look at the amount of credit that was created, especially since 2004 you can see what has to be "unwound":

Outstanding Credit Derivatives

From only a couple hundred billion in 1998 we've seen credit derivatives (money created from nothing more than leveraging it off other assets including derivatives of those assets) increase to $45T (that's $45,000B on the chart). It has exploded by about 10 times in less than 5 years. A parabolic increase in money creation will be followed by a swift and painful credit destruction. It's only a matter of how much the Fed and other government efforts will be able to stretch out the pain (like what happened in Japan).

And that brings us to chart of the banks:

BIX banking index, Daily chart

The pattern of the decline has changed a little so I've updated the wave count for what I think is a better count (basically a zigzag count for the move down from the February 2007 high). The current bounce could make it a little higher (similar pattern to what I've shown for the broader averages) but at any time we will probably continue to see downside surprises in this sector.

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

The home builders index has gotten a little bounce in the past week, bringing price back up to the trend line along the lows from September. At the same time RSI has made it back up to its downtrend line in place since May. I show a continuation lower to finish the 5th wave down (to either 215 or 153) which means it should turn back down from here. But if it manages to work its way higher, especially if the broader market is rallying, then I'd say there's a good chance for at least a rally to the top of its down-channel, currently just under 400.

Oil chart, January contract (CL08F), Daily

Oil dropped to its uptrend line from August and October, consolidated for a bit and then closed below the trend line, and its 50-dma, today. This could be part of a slightly larger bounce pattern (dark red) but from here it's possible we'll see continued selling tomorrow.

Oil Index chart, Daily

The oil index has been rallying with the broader market and has the same upside potential I see for the broader averages. I expect this index to turn back down and a break below 770 should usher in some strong selling.

Transportation Index chart, TRAN, Daily

The Transports are almost back up to the top of its down-channel after bouncing off the mid line at the November low. With the 50-dma located at the same potential resistance level near 4750 I think it will find resistance at or below that level. Then whether it pulls back for another run higher or just drops straight down (wave-3) will be the question. With the slowing economy I'm definitely in the camp that says you should be looking for shorting opportunities in this index. There's a plethora of data that shows a slowing in the transportation business. There are few containers coming into the ports, truckers are reporting less business, the air carriers the same, and all this while the economy is only threatening a slowdown and the consumer is just starting to slow down. There's probably a lot more pain to be felt in this sector.

U.S. Dollar chart, Daily

We have liftoff! It could blow up at any moment but so far the launch looks good. Gisele Bundchen, some rapper and even Greenspan have effectively called the bottom. At least it looks like it could be a bottom. The wave count looks good for a completed count as price hit the bottom of its parallel down-channel. It has now broken its downtrend line from August, came back for a retest and rallied some more today. At a minimum the US dollar should make it back up to the top of its channel, currently near 80. Based on the larger wave count I suspect the dollar will bust out of this down-channel as it rallies well into next year. The US dollar should be sought out as a safe(r) haven next year as the global economy experiences a significant slowing.

Gold chart, December contract (GC07Z), Daily

A stronger US dollar will likely be bearish for gold. Right now it has bounced off its 50-dma and holding (so far) above its uptrend line from August through the November low. I see the possibility for a bounce up to its downtrend line from the November high, currently near 830 but that could be a stretch and would be potentially more bullish if it did that (shown in green after finishing a sideways triangle correction). A drop at any time back below 785 would likely usher in some very strong selling. There are a lot of gold bugs out there absolutely convinced of the long term bull market that gold is about to embark on (we have a very high bullish sentiment in gold) and any quick selling could find some weak holders who just want to protect profits. Gold should be headed for well below $660 into next year, potentially down to $500, before the bull market in gold resumes.

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

It'll be a very quiet day for economic reports on Thursday so it will left to fend for itself on whatever overnight news develops.

SPX chart, Weekly

The weekly chart shows price has rallied to the 20-week moving average (blue) at last week's high and you can see this has been effective support/resistance in the past. It closed on it today and therefore today's high and last week's high are the critical levels for now. A rally above it and then turn it into support would be good for the bulls but since the July high we've seen price cycle above and below it. The daily and 60-min charts obviously give us a little more detail to watch for where resistance and support could be found over the next week.

Stay aware of the daily battle raging in the market right now about what the Fed will or won't do. It's senseless to think that a Fed rate cut is bullish for the market (it's not) but that's what so many have been conditioned to believe from many many years ago. Investor sentiment has clearly shifted and it's getting more bearish. That's what the Fed won't be able to help with a rate cut. But don't get in the way of the movers of the market and we're certainly not one of them.

The EW patterns help me define potential support and resistance and I'll continue to call out trade setups as I see them on the Market Monitor. This is a very challenging market to trade right now because of the lack of follow through. Continue to take quick trades and pull out smaller profits and be happy with those. If you grab a big move pat yourself on the back and don't give it back. Longer term traders (even swing trader) are probably getting a little seasick. Welcome to a topping process. Trade light and continued good luck. See you next week.
 

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