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Market Wrap

Rubber Bullets

HAVING TROUBLE PRINTING?
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Maybe a Taser Gun would work better against the bears. They're selling them to women now for personal protection so I'm thinking the Fed should buy a couple and use them on the bears which won't go away. The Fed is down to rubber bullets now and they're not very effective.

Unless you were sleeping under a rock today, or just someone who completely ignores the news (I don't blame you), you know that the Fed lowered the Fed funds rate another .50 to 3.0% now (and lowered the discount rate by the same .50). This should help mortgage holders, or those wishing to get a mortgage since the move will lower interest rates, right?

Well, maybe not. The LIBOR rate (London Interbank Offered Rate, the overnight rate banks charge each other for borrowed money) has come down a little since the central banks have cooperated in pumping massive amounts of liquidity into the monetary system (in an effort to re-inflate, the same way they got us into this mess to begin with). But the LIBOR, which is used by many ARMs (adjustable rate mortgages) for their resets, has remained stubbornly high--the 1-month rate was around 5.3% last summer and today it is 4.6%.

The 10-year yield (TNX), also used by many banks to set mortgage rates, has come down significantly since last year, dropping from over 5% to a low of 3.3% this month. But last week's low on January 23rd, the day of the historical Fed cut of 0.75%, has since reversed hard as bonds got sold last week and continued to get sold this week. The current rate is a little over 3.7%, up about 0.5% from last week's low.

Before continuing, I wanted to show an updated chart of the 10-year yield:

10-year Yield (TNX.X), Daily

The bounce off last week's low should have more to go. A 38% retracement of the decline from last June would have TNX at 4.0% while a 50% retracement would be 4.3%. That higher level is also the bounce high in December and would be a typical retracement level from an EW perspective. As depicted, this could play out into March before rates are ready to head south again.

So while the Fed has aggressively cut 1.25% in the last week to 3.0%, the 10-year yield has bounced 0.5% to 3.73%. Therefore if the Fed is aggressively cutting rates to help the mortgage market, it's backfiring on them. The bond market is saying loud and clear that they're concerned about the inflationary effect of the Fed's aggressive cuts. The US dollar and gold market are saying the same thing. Sooner or later the Fed will be forced to turn around and face the music (the inflation monster that they're going to create).

But what the Fed is most worried about is a meltdown in the financial markets. Home buyers/owners? The Fed's response: "Sorry, if you're in trouble, we wish you well. We've got more important people to worry about, like our banking buddies." That's a little harsh I know, but the Fed is clearly panicked by what they see happening and the late-day selloff in the stock market (after a manufactured post-FOMC rally, thank you PPT) shows that stock market participants are getting a whiff of that fear.

As discussed by Jim in the past week, the bond insurers are in serious trouble. As they get downgraded, which will happen more quickly from here, the bonds they've insured will get downgraded as well. I've said many times in the last year that the subprime problem is the tip of the iceberg and that the collapse of the credit bubble will completely wipe out the gains created by that bubble. We're witnessing it starting to unravel now.

The billions of dollars written off so far by the major banks is just the start and many will soon have serious problems finding willing partners, Sovereign Foreign Funds or not, who will belly up to the bar with them and invest hundreds of billions more in the bank. The banks will be writing off probably at least quadruple what they've written off so far. I'm sure we'll see some high-profile bank failures and buyouts. The Federal government could be forced to prop up a big bank or two (like they did with Chrysler but on a much bigger scale) before all is said and done. Or they might assist in the joining of two banks to pool assets. That's obviously speculation on my part but I think the problem will turn very serious for the banking industry within the next year, potentially much faster than that. Do you know where your money is?

And that brings us back to the Fed. I'm not the only one who sees these bond downgrades and massive write-offs coming. The banks are going to be hugely under-capitalized by the time they take further write-downs and sock more money away into their reserve accounts for losses. I mentioned last year that banks were carrying record low amounts in reserve accounts for potential losses.

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The banking executives and regulators were so confident that the good times would continue, even though the banks were taking extraordinary risks (like never before in the history of the banking industry), that they pulled their reserve accounts down to record low levels so that they could count every penny earned and jack up their share price. And for this, and the hundreds of billions of dollars flushed down the toilet, the fired CEOs left with hundreds of millions in severance while a "rogue trader" gets thrown in jail. But I digress.

The Fed knows the banks are in big trouble. They have to give them every way possible to make money and reducing their cost of borrowing is about all they have. But the Fed is rapidly running out of even the rubber bullets and they're panicking. Expect the stock market to be right behind the Fed.

As for the central banks having the ability to flood the market with money, especially in the US where we have the ability to create all the money we want (at the risk of deflating the dollar further and creating more inflation), it won't work. Whether the Fed lowers interest rates or floods the market with more money to help the banks lend more (and make more), we still need someone on the other end who wants the money. The perfect analogy is the one where you can lead a horse to water but you can't make him drink.

The Fed can make more money available at a cheaper price but if I'm worried about my job or already maxed out in loans and credit cards, you can lower rates to zero and I still can't afford another payment. Japan proved this. But the stock market has been in another world, thinking that it's different this time and that it will work for us. The mood has shifted and we're entering a bear market cycle (within a larger secular bear market cycle) and that's just the way cycles run. The poor Fed thinks they have the power to thwart cycles but alas they're just along for the ride, flailing and gnashing their teeth and tilting at windmills. Don't fight the Fed? How about don't fight the social mood swings (which are reflected in the stock market).

Economic reports
GDP, the ADP employment numbers, crude inventories and the FOMC announcement were scheduled reports today.

GDP and Chain Deflator
For the 4th quarter the U.S. economy slowed more than the expected 1.1%, growing at only a 0.6% annual rate. This is the weakest growth since 2002 and the end of the last recession. This was down from 4.9% in the 3rd quarter. Residential investments fell at the fastest rate in 26 years (1981). We were coming out of a long bear market back then.

Real personal spending grew at a 2.0% rate, down from the 3% average rate last year. Thanks to government spending of +2.6%, even with a decline in defense spending, the GDP number was helped.

Speaking of personal spending, the following chart shows it's been slowing for quite a while now:

Personal Consumption, 1990-2008, courtesy briefing.com

The line of interest is the red one which shows consumer spending has been in a steady decline since 2004. I fully expect to see it drop well below the lows seen back in 2002, and quite possibly below the low in 1991. The amount of credit being carried by people is absolutely staggering and the credit implosion will be seen here as well.

ADP Employment
ADP shows the U.S. private sector added 130K jobs in January. Adding about 25K government jobs makes the total about 155K which is a decent number. Whether the government's numbers will anywhere close is unknown (Friday's payrolls number is expected to be around 80K). The service sector added 141K jobs while we lost another 11K jobs in the manufacturing sector. Guess which one pays more.

Crude Inventories
Crude supplies rose more than expected to 293M barrels, up +3.6M. Gasoline supplies were also up +3.6M barrels but distillate products dropped by -1.5M barrels.

FOMC Policy Statement
As already mentioned, the Fed dropped the Fed funds rate another 0.50% for a total of 1.25% in the past week, now at 3.0%. "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets. The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully."

The statement that had everyone initially excited was "The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."

This was an effort by the Fed to let the market know that they're not done and will continue lowering rates for as long as they feel the need is there. But as with every rate cut so far (the market is well below where the Fed first started cutting last September, which are now 2.25% below the starting point of 5.25%), the market seems to be shrugging off each rate cut announcement faster and faster now. Fear is replacing greed and rallies are looked at as opportunities to unload. Will that continue? Onto the chart:

DOW chart, Daily

Price action has left several possibilities on the charts (from an EW--Elliott Wave--perspective). I'm only showing two on the DOW chart but I'll show a couple of others on the other indices, including a more immediately bearish one on the RUT's chart.

The dark red wave count shows a triangle consolidation pattern playing out in the month of February. We'd see lots of chop and whipsaws if this happens so trade carefully and be reluctant to hold onto trades--take profits often if in a winning trade. Then price would continue lower out of the triangle and head for new lows in March.

The pink wave count is looking for a little higher, maybe, and then a pullback before heading higher again in February. If the DOW makes it above 12724, the wave (1) low in November, then the dark red wave count gets negated, hence the key level (pink target symbol) there.

DOW chart, 60-min

This afternoon's reversal left a bearish candlestick pattern on the 60-min chart and I expect to see follow through to the downside on Thursday. A drop below 12115 would negate the pink wave count so that's the key level to the downside right now. Otherwise we could see a pullback before continuing higher again to the 12800 area.

SPX chart, Daily

The SPX daily chart is messier looking because I tried to add one other scenario that's not on the DOW chart--a break from here to below last week's low near 1274 (in grey). I show a stair-step move lower in February but a more bearish possibility is that we could be set up for a 3rd of a 3rd wave down. The wave count is not important for those who don't follow the counts but understand that that setup is for a very hard selloff next month. If last week's lows in the market break, the risk is for a strong selloff that will make the December-January selloff look mild. In light of the news coming out about downgrades in the bond insurers and what impact that will have on the major banks, I do not for one minute underestimate this possibility.

But like the DOW we could see price chop up and down for a month (dark red), or bounce a little higher (pink), before the next leg down.

SPX chart, 60-min

Again, it looks like a key reversal this afternoon and strongly suggests lower prices tomorrow. Futures are down pretty hard tonight but I have no idea what it will look like in the morning. I wouldn't be surprised if the PPT steps in in the early morning hours and tries to lift the futures. The key level to the downside is 1323 which would negate the pink wave count whereas a rally back above today's high would suggest we'll see at least a rally up the 1400 area.

Nasdaq (COMP) chart, Daily

I'm showing the same possibilities for the COMP as for the DOW and SPX--either a sideways triangle will play out next month or we could get a whippy bounce that makes it a little higher into the end of February before turning back down. If price breaks below last week's low near 2200 then the risk is for a hard decline as explained for SPX.

Nasdaq (COMP) chart, 60-min

If the bulls (or PPT) can pull a rabbit out of the hat tomorrow and flame the shorts, a rally back above today's high would likely mean a rally above last Friday's high near 2407 and it would be off to the races to the upside, targeting around 2500. But continued selling tomorrow and a drop below Monday's low near 2307 would likely target the 2230 area for support and a bounce back up (if the sideways triangle pattern is going to play out, shown on the daily chart). Much below 2230 and I think the market will be in trouble.

Russell-2000 (RUT) chart, Daily

Instead of showing the possibility for a sideways triangle consolidation into February I'm showing the possibility that we have an even more immediately bearish setup (dark red). After the high in December, labeled as wave (2), the decline from there would be the start of wave (3). The third wave is typically the strongest and largest wave and therefore the decline to the January low looks too short to be all of wave (3). This is one of the subjective factors in EW analysis--it has to pass the "smell" test. Wave (3) will consist of a 5-wave move and therefore if the decline into January was only the 1st wave of (3), then the bounce to today's high was wave 2 of (3) and we could be ready to start wave 3 of (3). This is potentially significant because a 3rd of a 3rd wave is usually a powerful move. You don't want to get in the way of these (think tsunami and you're standing on the beach). It would be a drop much larger and faster than the drop from late December to the January low. You get my drift.

So that's the very bearish possibility. Take a break of last week's lows very seriously. In the meantime we could still see a strong pullback but have it be only part of a larger sideways triangle or a pullback before heading higher (pink). Unfortunately, with the wide price swings of late, we don't have too many close-by levels to tell us which could be playing out. Keep taking profits when offered and if we get the breakdown you'll have plenty of time to jump aboard and ride that wave.

Russell-2000 (RUT) chart, 60-min

A break below 681 would tell us the bounce off last week's low is finished but we'd be left guessing how deep the pullback will be. I'll be following the move live on the Market Monitor to offer potential turning points but for longer term traders it's a bit dicey here. A push from here back above today's high near 716 should have the RUT heading for the 740 area.

BIX banking index, Daily chart

The bounce off the January low could be complete and if so then we're due either a pullback before heading higher again and breaking its down-channel (green) or else a drop to a new low in February. I'm showing a downside target near 212 which was the March 2000 low and it's a Fib projection based on the wave counts to the downside.

If the bullish divergence holds at a new low then it's possible we'll get a much bigger bounce from that low to correct the decline from last year. That would indicate that people are feeling the banks have made it through the worst (heard that one before have you?) and there will be a lot of recommendations to buy the beaten down banks. The wave pattern supports that view--even though it will only be good for a few months, there should be a very good trade on the long side (emphasis on trade).

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

Like the banks I see the need for at least one more decline to finish the wave count from January 2007, with a downside target near 200 (previous price level and Fib projections). I'd actually be interested in buying some stronger home builders down there. They've been sold off so hard that they could be left alone while sellers turn their attention to the rest of the market. But, I still prefer cash.

Oil chart, Oil Fund (USO), Daily

There's a potential neckline forming near $68 on USO ($85 for oil's March contract). If the bounce in MACD is turned back down at or below the zero line we'll probably see that neckline break. Worry about a global recession (and it will be global) would have traders pulling bids out of concern that lack of demand will drop the price of oil. It takes a rally above 79 to confirm oil is in a potentially large rally that could take it to 100 (not likely in my mind but let price lead the way here).

Oil Index chart, Daily

Obviously if oil turns back down and stocks turn back down it could be a double whammy for oil stocks. The wave pattern is set up for some serious selling as per the dark red wave count but could get a little higher (pink) before turning back down. The choppiness of the bounce tells me there's very little chance it will make it much higher (although I've been fooled by this index more than once). Any rally back up to underneath its broken up-channel, currently near 830, which would also be a 62% retracement and near the 50-dma, would likely be an excellent short play setup. But I'd be surprised if it makes it much higher, if at all.

Transportation Index chart, TRAN, Daily

The Transports almost made it back up to its downtrend line from July, currently near 4750 and could still make a last stab up to there (pink) but it's looking vulnerable to turning back down now. The dark red wave count is set up for a 3rd of a 3rd wave down and as explained for the RUT, this would be accompanied by some very strong selling. It takes a break of 4105 to confirm the bearish wave count and any break below the bottom of its down-channel would be a very bearish sign.

U.S. Dollar chart, Daily

The US dollar broke below the January 15th low at 75.20 and that negated the bullish wave count I had on last week's chart. It's still possible there is a slightly different bullish count (green) but any further drop below the November low at 74.48 would strongly suggest we'll see at least a move down to the bottom of its down-channel near 73. The other possibility from here, shown in pink, is for a triangle consolidation to finish playing out in February-March before dropping down to the bottom of its down-channel in April. It now takes a rally above 77.85 to negate both of those bearish wave counts.

Gold chart, Gold Fund (GLD), Daily

Gold shot higher after the FOMC announcement (as the dollar dropped and euro rallied) but it came very close to tagging the top of its parallel up-channel for price action since the August low. The bearish divergence at the new high suggests it won't hold. A triangle consolidation pattern for the dollar could see a pullback in gold and then it will be a matter of determining what kind of pullback it is in order to help determine whether it's a correction (meaning a continuation higher after it's done) or impulsive (meaning a likely break of its uptrend line from August). By this chart I think the upside is risky for gold and on the Market Monitor I've been attempting to point out potential resistance levels to set up a short play. The top of its up-channel near 92.70 is a potential short play setup (about 945 for the April gold contract). If gold reverses lower tomorrow after this afternoon's spike up, then like the equities I see lower prices dead ahead.

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

Tomorrow will be busy for economic reports but now that we're past the FOMC announcement there will probably be little fretting about what it will mean for the Fed. Still, any further signs of a slowing in spending, increase in inflation or a slowing in PMI could cause further anxiousness in an already anxious market.

SPX chart, Weekly

The weekly oscillators look like they're ready to turn back up but if prices continue lower then the oscillators will flatten out in oversold--an indication of a strong trend. As discussed above, particularly with the RUT, if we get another leg lower directly from here, the drop to below 1200 could happen in pretty much a straight line down vs. how I've got it depicted and the subsequent bounces could be much smaller. But we'll have to see how price plays out over the next week or two before that kind of move identifies itself.

The bottom line is that the market is very vulnerable right here. If selling takes hold and the market sells off quickly, breaking last week's lows, you'll want to be flat or short the market. But until that happens I see a equally likely possibility that we're in for a very choppy consolidation over the next month, one that will be marked with lots of volatility and plenty of whipsaws to frustrate both sides. That's why I suggest taking profits early and often if you're attempting to trade short term moves.

If you're looking for longer term plays then you could be challenged. If we get stuck in a sideways consolidation for the next month then selling spreads will be the right play. But if the market breaks down then selling bull put spreads will be disastrous. I don't see a lot of upside but use the upside targets I've shown on the charts to try to sell call spreads above them.

Directional traders simply have to be more careful right now, and that could continue to be the watchword for quite a while. Trading in bear markets is very difficult and as more retail traders try their hands in shorting the market they've actually made it more difficult for everyone else--they're easily punched out of their trades and all that short covering spikes the market much higher but then reverses on a dime once that buying stops. See this afternoon for a good example.

As for tomorrow, I expect to see follow through selling. If it starts with a gap down then of course the risk, if you short it, is a gap closure, which could be a big move. Until Monday's low is taken out understand that any pullback could be bought quickly, especially if there's a little help from our friends (PPT). Any push back above today's high should have you looking to buy pullbacks until the next resistance levels, shown on the charts, are reached. Good luck trading this--it's a wild one.
 

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