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Market Wrap

Fear and Greed

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Those are probably the two strongest emotions that drive our lives, and certainly drives the stock market. There may be quant(itative) computer models, P/E ratios and beaucoup fundamental assessments that tell traders when to buy and sell but those are all attempts to explain why the market does what it does. It behaves the way it does because of peoples' emotions--fear and greed. Fear of losing money in a selloff causes panic selling. Fear of losing out on a rally causes panic buying (or fear of losing money if you're short). Greed causes people to hang on too long in a rally--hoping to get that last cent in the rally. Greed also drives people into buying into a momentum run higher (seen any parabolic rallies in the past year?).

Greed is what got us into so much trouble with the credit situation. People who couldn't afford a home were enticed into one anyway. The mortgage brokers saw huge fees and got stars in their eyes (and a lot of money in their pockets). Even though they knew the crap they were handing off to resellers would likely fail, they didn't care. Greed got in the way. Wall Street and big banks got greedy and sliced and diced and AAA rated anything that could be sold off, just so they could get their fat fees. Investors bought the CDOs and derivatives of CDOs, never really understanding what they were buying, so that they could get an extra percent of yield. They were greedy to the point that they're getting killed now that their "investments" are paying 30 cents on the dollar if they're lucky.

So we've got some recognition underway and fear is replacing greed. It hasn't replaced it (that's a process, not a switchover). Many are already calling for a bottom. Nearly every analyst on the Cheerleading Network is recommending this as a buying opportunity. Greed is alive and well. It will take a long time before no one is recommending buying the bottom. There will be crying and gnashing of teeth that there is no bottom in sight. Fear will have completely replaced greed. That's when you'll know we're at a bottom.

Based on the wave pattern of the decline from October I believe we're in a bear market. The question is how the bear market decline will play out. I want to take a little extra time going over some longer term charts tonight to show you what the potential downside risks are for the next two years. I'm hearing almost 100% agreement on regular news shows about what people should do with their retirement funds. See if this sounds familiar--"Don't panic and don't do anything. It has been proven over and over again that market timers don't do as well as buy and holders. By continuing to invest in the stock market on the way down you lower your cost average." Etc, etc.

For those who held onto their stocks from 1966 to 1982 how well do you think that worked for them?

DOW chart, Weekly, 1961-1988

After the DOW made a high in 1966 it was tested in late 1968, early 1973, 1976 and 1981. In between those times the market made new lows below the previous low and made no headway until early 1983. Basically it was 17 years where a buy-and-holder made no progress. I drew in two trend lines to show that the price consolidation formed an expanding triangle. This is less common than a contracting triangle but they both mean the same thing--it's a continuation pattern and the market continued rallying once the consolidation completed.

That flat period for the market was a period of low growth and high inflation. There's been much talk recently about the potential for the US to enter another stagflationary period. This is when inflation will not abate even while the economy slows. Paul Volcker finally cracked the inflation problem by raising rates through the roof (I remember buying a home and being happy to get an ARM somewhere around 13% in 1982--I've tried to forget about that one).

If we were to follow a similar pattern as the 1970s then another drop below the October 2002 low would not be out of the question. The question in my mind is not whether we've entered into another bear market leg down but more about how it will look. It's possible we've entered a similar period as 1966-1983 where we'll see just as long a period of consolidation before the stock market resumes its long term bull market. It's also possible that instead of a consolidation over many years (absorbing the excesses of the past bull market in time rather than price) we'll retrace deeper in price to correct those excesses. I'll show both possibilities in charts below.


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I want to spend time in tonight's newsletter going over some what-if scenarios. I'm hoping the exercise will help you make some longer term decisions about your own investments.

Elliott Wave (EW) analysis provides one of the best predictive tools available for studying the stock market. I've mentioned before that it evaluates repeating patterns that are based on swings in human emotions and mass psychology. The stock market happens to be one of the best reflectors of these cyclical and repeating patterns. Studying the past definitely helps predict the future when it comes to the stock market. It's one of the reasons publications like the Stock Traders Almanac have such a large following.

I'm going to first look at the SPX from 30,000 feet and then we'll drop lower and lower to see how the price pattern could play out. I'll start off saying that I'm assuming we've been in a secular bear market since the secular bull market from 1982 finished in 2000 (arguably in 1998). These secular cycles typically run about 18 years. Within a secular move there will be cyclical counter-trend moves. The 2002-2007 bull market was a cyclical bull market within a secular bear market. So I now want to make some projections for where the next leg down within this bear market might take us.

So let's start with a quarterly view of the S&P 500 index to show price since 1990 (that's as far back as QCharts will go):

SPX chart, Quarterly

The 2000 high has been labeled as wave 3 and I've plotted two scenarios for the bear market since that high. The pink wave count assumes we'll be in a relatively flat period (with some obviously large swings between the highs and lows, like the 1970s with the market giving up 50% and then doubling, and repeating that a couple of times). I've drawn in a contracting triangle rather than an expanding triangle but obviously that's just a guess at this time. It calls for a decline to near, but staying above, the October 2002 low and then another rally back up to test the 2007 high, and then back down again before finally being ready to start the next secular bull market, perhaps in 2017.

The dark red wave count says wave C, of the A-B-C correction of the last bull market, will drop sharply to a new low in 2010-2011 that's well below the October 2002 low. Back to the lows in 1994, from an EW perspective, would be a typical retracement (basically retracing the parabolic climb off those lows). There's no way to know from here which will play out. It will hopefully become more certain as the decline progresses (impulsively or correctively).

Dropping down to 20,000 feet gives us a monthly view of the next leg down in the bear market. It looks a little messy with the different projections so hopefully it's clear enough:

SPX chart, Monthly

The breakdown from the parallel up-channel for the 2002-2007 rally is one of the signals that the cyclical bull market is finished. It strongly suggests we've now entered the next bear market leg down. Following the pink wave count first, I show an A-B-C move down to just above the October 2002 low by the end of 2009. From there it would be another 3-wave move up to test the 2007 high, probably in 2012-2013.

The dark red count calls for a steep drop in wave C (which will be an impulsive 5-wave move) that breaks well below the October 2002 low. In reality, for our trading purposes, it doesn't matter which count we're in. Both will drop us back down towards the October 2002 low so the question you need to ask yourself is whether you want to stomach that kind of drop again. Cash looks pretty good when you look at this chart.

Now we drop down further to 10,000 feet to look at the daily chart:

SPX chart, Daily

Here's where the two wave counts would start to differentiate themselves a little. If we're to get an A-B-C move down then it's possible we've seen the low for now and will start a correction of the October-January decline. As depicted with the pink wave count, we could see a rally back up to the 1450 area by early March and tag the downtrend line from October and December. That would be wave B (pink). It would then drop faster in wave C to a low around 1125 in April (labeled as pink wave A on the monthly chart) and set up another larger upward correction of the October-April decline (pink wave B on the monthly chart).

The dark red count calls for a continuation of the current decline in a stair-step fashion. It will work its way lower to about 1180 by the end of February, followed by a slightly larger bounce and then a final low in April at the same 1125 area. That would complete a larger degree wave 1 (dark red wave 1 on the monthly chart). This would be followed by a sharper rally (wave 2 on the monthly) into the summer, potentially right back up to where we closed today.

Now dropping to 1000 feet we look at the 60-min chart for some short term clues as to what's next:

SPX chart, 60-min

The steep drop from January 10th makes it a bit of a challenge to count the squiggles that make up the EW count so the error rate climbs on the shorter term charts. But today's rally has the potential to continue higher in support of the pink wave count on the daily chart. If we see a pullback tomorrow that finds support at or above 1300 and then makes another high then that would be proof enough that a low is in for now. Remember the pink wave count calls for a rally into March (very likely a choppy one with lots of whipsaw price action).

The dark red count calls for a continuation of the decline when today's rally leg finishes. It could go slightly higher and if it just rallies strong from here then it will take a break above 1375 to declare the bottom is in. But as of this evening I think the dark red wave count is the correct one and therefore, as mentioned on the Market Monitor towards the end of the day, I'm looking for today's rally to fail and continue lower again.

Down into the weeds now, the 30-min chart shows why I'm looking lower tomorrow (after a little higher first):

SPX chart, 30-min

EW analysis on the shorter term charts is fraught with errors (from manipulation and other short term disruptions that are not necessarily indicative of mass behavior of traders) so I always caution traders about making trading decisions solely on the EW pattern. Always look to back up EW counts with other technical indicators. Having said that, the pullback from yesterday's high looks corrective (a 3-wave move). If it was to be the bottom of the decline it needed to finish with a 5-wave move.

Since the pullback looks like a 3-wave move then I'm assuming for now that it was part of a larger A-B-C upward correction from Tuesday morning's low. That means the sharp rally this afternoon was wave C which will set up the next leg down. Since c-waves are 5-wave moves I'm looking for a small pullback tomorrow morning and then another relatively minor high. That new high should have negative divergence against this afternoon's high (or wherever that high will be if it pushes a little higher first tomorrow morning). That would help confirm the signal that it's time to be looking for a short entry for the next decline.

Doing the same analysis on the DOW shows the same potential move down. On the monthly chart I'm showing just one scenario--the 5-wave move down for the c-wave that could end the bear market in early 2010:

DOW chart, Monthly

So far the parallel up-channel from October 2002 has not been broken so by this measure we could say that the current pullback is merely a correction within the longer term bull market. It's certainly the mantra heard from many analysts. But the DOW has been stronger than the other indices and I believe it will follow the others lower. If it follows a path similar to that shown for the SPX, then we should see a continuation lower (even if it's after a bounce into March/April). The interesting thing about the Fib projection on the DOW is that a c-wave that achieves 162% of the a-wave (the 2000-2002 decline) would have the DOW finding support just below the October 2002 low.

DOW chart, Daily

The daily chart of the DOW looks like that for SPX. Notice that today's bounce took the DOW right up to the mid line of its down-channel from October. The mid lines of these parallel channels work amazingly well as support and resistance so watch to see if the bulls can power the market higher tomorrow.

If the bulls can keep today's rally alive (more than a minor new high) then the pink wave count shows the potential to see what will likely be a choppy rally into March up to its downtrend line from the October-December highs, probably just above 13K, before rolling back over. Otherwise the dark red count calls for a continuation of the decline to below 11K in early March before a little larger correction and then finally down to about 10200-10400 in April. From there it should be ready for a rally into the summer (similar pattern as shown for SPX).

DOW chart, 60-min

Drawing in a parallel down-channel for price action since the December high shows a little more upside potential to the top of the channel near 12400. That's another 140 points above today's close so there's some pretty good potential for a short term move higher and that's where I'd watch for a short play to set up (if it gets there). Any higher than 12400 would have me thinking a longer term upward move but stay cautious about some whipsaw moves inside the rally.

When we look at an even broader market, the NYSE, its chart confirms the likelihood that we've entered a bear market. The one thing I've noticed about the NYSE is that it trades very well technically. It follows trend channels and hits its Fibs closer than the other indices (possibly because of more manipulation in the other indices or perhaps undue influence from sector vs. another). You can see on it monthly chart that it fell out of bed when it broke down from its up-channel in place since the March 2003 low:

NYSE (NYA.X) chart, Monthly

The decline on January 15th is when the channel was broken and it never even got retested (proving the point that you won't always see a retest, at least not right away). I don't show any price projections on this chart but it's not unreasonable to think that we could see a retest in the next month or so if the market gets a good bounce. To say that would be a sweet short play setup would be an understatement of the year.

The daily NYSE chart shows the down-channel in place since the October high:

NYSE (NYA.X) chart, Daily

Yesterday and today the NYSE bounced off the bottom of its down-channel and that's potentially at least short term bullish. I haven't drawn in the alternate pink wave count but that would become a higher probability in my mind if the NYSE rallies above 9200. In the meantime I see the same possibility for a stair-step move lower into April and finding firmer support in the 7200-7500 area.

Nasdaq (COMP) chart, Daily

I've got the COMP on a slightly different wave count, which has been true since it topped out a little later than the DOW and SPX. It's possible today's low finished its 3rd wave down in its decline from late October (it could also be the end of wave C since the move down from October is so far only a 3-wave move). It found support where the 3rd wave down achieved 162% of the 1st wave down (2214). That's also the location of the uptrend line from the August 2004 low through the July 2006 low.

As shown on the 60-min chart below, we could see one more new low (especially if the others drop back down) but if the rally continues then a bounce up to its broken uptrend line from October 2002 could be the upside target (likely to be choppy). The broken uptrend line intersects the top of its current down-channel near 2390 in early February. Any higher than about 2400 would have me thinking the pink wave count is in play, which is looking for a rally into early April and possibly back up to its broken uptrend line from July 2006, up near 2600.

Nasdaq (COMP) chart, 60-min

Today's rally was a marginal break of its downtrend line from January 14th so if it can make it higher tomorrow then the downtrend line from December 26th, near 2360, could be the next upside target. If it instead sells off again then watch for support near 2200.

Russell-2000 (RUT) chart, Daily

Like the COMP I see the possibility for yesterday's low being the end of the leg down from December. I've labeled this chart a little more bearishly (in dark red) than the chart of the COMP in that the move down to yesterday's low from December could be the 1st wave down of wave (3). This would mean the next bounce would be the 2nd wave correction (to perhaps the 725 area) and set up a strong decline in the 3rd of a 3rd wave down. This is somewhat speculative at the moment but it would be one of the best short plays of the year if it sets up this way. Otherwise a slightly larger bounce (pink count) could see a move back up to its downtrend line near 750 by the end of February.

Russell-2000 (RUT) chart, 60-min

The move down from December looks like a descending wedge and the poke below it yesterday followed by a recovery back inside the pattern was a buy signal. It tried twice more today to poke below it but each time it recovered. This afternoon it broke out the top of the pattern and that's the second buy signal out of this pattern. A successful retest of its broken downtrend line, as depicted, would be the third buy signal. So if you're feeling bullish about at least the short term prospects for the market, look to buy the next pullback (and keep your stop relatively tight).

BIX banking index, Daily chart

The Fed is here to save the day. At least that's what traders in banks (and home builders) must be thinking. The banks got a very strong bounce off yesterday's low and carried through to today. The rally broke the downtrend line from October but watch the 50-dma near 276 just above. If the BIX successfully retests its broken downtrend line then we should see a continuation higher to at least the top of its down-channel, currently near 295. The pink wave count calls for another leg down after the current rally finishes (which would finish an A-B-C correction from the January 9th low. If the banks drop to one more new low, as depicted in pink, I think that would be a good opportunity to test the long side in the banks for what should be a multi-month correction before tipping back over.

To provide a little wider view of the home builders I want to look at its weekly chart this week:

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

Like the banks, traders in home builders believe that the Fed's rate cuts will make a difference. They won't but that's why they call buying bottoms and holding on in declining markets the slippery slope of hope. It's when traders become disgusted with the idea of buying a bottom that we'll know a bottom is in. However, that doesn't preclude big bounces along the way. The credit crunch will likely not be relieved by the Fed's actions and that's what the last two days of buying is based on.

Price stopped at the top of its parallel down-channel for the 2007 decline. So the first thing the bulls need to do is keep the buying in the home builders going. If they pull back some and then charge higher again it will be a good sign that the bottom is for now. I've been saying a tradeable bottom for the home builders is close so whether it's already here or after one more new low, as depicted, I think it's unwise to be short the home builders any more. You squeezed about as much juice as you can from that orange. After the next big rally it could be time to short the weakest home builders again, but not now.

Oil chart, Oil Fund (USO), Daily

USO came close to negating the bullish wave count possibility, which it will do if it drops below 68.30. Today's low was 68.63. For the March contract on crude it needs to break below 85.37 and yesterday's low was 85.42. Assuming it will continue to decline, I see a downside target of 64 (81 for oil) before setting up a larger bounce.

Oil Index chart, Daily

The drop in both oil and stocks hammered the oil stocks. It has sliced through several layers of support like they weren't even there, including the 200-dma most recently. I think this index will drop down to its uptrend line from March 2003, currently near 730, before getting a bigger correction of the decline.

Transportation Index chart, TRAN, Daily

Looking at the Trannies you'd think oil dropped to $60 and business suddenly did a major turnaround. That's a monster white candle on the charts. If it breaks above 4513 it would support the idea that we'll see at least a run up to its downtrend line from July, currently near 4750. This index has one of the choppiest patterns I've seen. Deciphering its longer term pattern continues to be difficult. But based on the wave count possibilities I see either a bounce up to its downtrend line setting up a very bearish scenario (3rd waves start unwinding to the downside) or else we'll see it continue to chop its way lower inside the down-channel.

U.S. Dollar chart, Daily

Yesterday's rate cut pummeled the US dollar as money fled the greenback and ran for higher returns overseas. The pullback may not be finished but it still holds the potential to rally some more. It takes a break below its last low at 75.20 to suggest new lows are coming.

Gold chart, Gold Fund (GLD), Daily

Gold's short term pattern leaves it open for interpretation where it will head next. The longer term pattern looks good for a top of significance. Gold bugs were left scratching their heads in wonderment why it was selling off Monday with news that stock markets around the world were crashing. Isn't gold supposed to be a safe haven where everyone runs to when the stock market crashes? In normal times yes. But these are not normal times. I've often said that the credit explosion over the past several years provided more liquidity than has ever been created in our history. This floated all boats and all asset classes rose.

We're in the first inning of the credit implosion and it will sink all boats. All asset classes will sell off. Strong assets will be sold to cover the costs of losses in weak assets (especially those hit by margin calls). Therefore I would not assume that you're safe by parking your money in gold. It's not clear today whether or not we're going to see another push higher in gold (watch the US dollar and that 75.20 level) but regardless, we should be close to a major correction in the price of gold. Back down to the apex of its previous 4th wave triangle, near 78, would be the first downside objective.

There were no economic reports today and tomorrow's reports include the following:

Tomorrow's economic reports include jobless claims, existing home sales (that could deflate the two-day rally in home builders if it's a nasty number) and crude inventories.

We've had a very volatile couple of days. Volume has been high and it's been a real battle between the bulls and the bears. I've learned to tread carefully when the Big Boyz are in the ring. Today's 630-point run up in the DOW off today's low was pretty awesome. Bear market rallies are like that. There's nothing like a short covering rally. But I also saw evidence of accumulation today--spurt higher followed by s small pullback, spurt higher, small pullback, repeat.

So today's rally clearly has the potential to build up a head of steam and continue. But that's what all bear market rallies look like. Then they suddenly stop, tuck tail and turn. We saw several hundred point runs in the DOW that simply kept us in an intraday trading range. Normally that kind of trading range would be over a week or more but these were intraday. That kind of price volatility may not be over so trade carefully.

Keep an eye on the key levels I identified on the charts for some signals for the short term pattern. Until proven otherwise we're in a short-the-bounces environment so look to do that. But those bounces can get pretty big so you clearly want to honor your stops. One big move against you could wipe you out in a hurry. Live to trade another day. And if the spike in volatility makes you uncomfortable taking a trade because of the need to open up your stop (which you need to do now) then simply wait for things to calm down a little. You do not need to trade every day and just keep reminding yourself that flat is a position.

Based on the short term pattern of the rally from yesterday's low I think we could see marginally higher tomorrow (preferably after a pullback) that finishes the correction of the decline and then head lower again. Stair stepping lower could be in our future for a little while, punctuated by strong rallies to flush out the weaker shorts. In other words the volatility could be with us for several more weeks at a minimum (probably much longer).

Therefore be careful chasing a move higher tomorrow if we get a pullback. It could be good for 100-200 points on the DOW but it might get reversed quickly. If you're day-trading this market, get in and out quickly. If you're looking for longer term trades, we need to let the dust settle before picking a direction. Until proven otherwise with a break of some key upside levels, I'd prefer to be flat or short the market.

I'll be back next Wednesday and each day on the Market Monitor. See you then and good luck riding this pony.

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