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Market Wrap

Market Wrap

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Wednesday, February 20, 2008

Marking Time


1.0 Overview

1.1 Markets at a Glance--Three 'C's--Choppy Consolidation Continues
1.2 Bonds and Credit Spreads
1.3 Economic Reports

2.0 Equities

2.1 S&P 500 Index (SPX)
2.2 Dow Jones Industrial Average (DOW)
2.3 Nasdaq-100 Index (NDX)
2.4 Russell 2000 Index (RUT)

3.0 Selected Industry Groups

3.1 Banking Index (BIX)
3.2 U.S. Home Construction Index (DJUSHB)
3.3 Transportation Index chart (TRAN)

4.0 Currencies

4.1 U.S. Dollar (DXY)

5.0 Commodities

5.1 Oil Fund and Index (USO and OIX)
5.2 Gold Fund (GLD)


6.0 Summary


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1.0 Overview

Today's Numbers

1.1 Markets at a Glance--Three 'C's--Choppy Consolidation Continues

Nice 200-point rally in the DOW off today's low. We've got some pretty wild swings in the market and yet it continues to march in place. The market has essentially gone nowhere since the middle of January. And yet in the last month or so we've seen the DOW swing more than 1100 points and today's close places it within 340 points of the high of the past month's range.

Many of us are having a hard time keeping up with these moves. As those of you who follow my commentary live on the Market Monitor know, I try to keep up with the day's moves and use EW (Elliott Wave) analysis in an attempt to maintain a "roadmap" of where the market is and therefore where it could be headed. It's a good thing I can make changes on the screen instead of a piece of paper--my eraser would have rubbed through the paper by now.

The choppy price action and whipsaw moves are very challenging for traders to follow, let alone trade. If you're struggling with your trading the past month you are not alone. I mentioned a couple of weeks ago that professional traders who have been doing this for 30 years can't remember a more difficult market than the current one. It's a good sign that you should be backing off a bit, trading lightly or not at all, and let the market pick a direction that will hopefully then be tradeable.

The trouble of course is figuring out when the market has established a short term trend that you can join. Since the January low there has been a major battle between the bulls and the bears and the market reverses on a dime with every little bit of news about the banks or bond insurers, who is going to write down how much, how much the Fed is lending the banks right now ($50B), whether the Fed will lower rates or not, etc. Each bit of news is used by the bulls or the bears to support their argument as to why the market should rally or sell off. We traders who are trying to take a little nibble out of the cheese and scurry back into our holes are finding the cheese keeps getting moved.

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One look at the daily charts will show you that this market is coiling for a big move. It may only be good for one shot in either direction before getting reversed again, but a 1000-point move in the DOW is not something you want to let go against you. By the same token, it would be a very nice move to catch for a trade. As always I'll set the charts up with key levels to watch so that we can identify the early part of the move and then ride that wave, up or down, we don't care.

Whether or not we get a blast higher before the market turns back down is the biggest question in my mind. The consolidation pattern we've seen since the January low is a continuation pattern, meaning we should see the decline continue. But the question as of tonight is whether we get a quick pop higher first and I'll show some upside targets to trade in case that happens.

1.2 Bonds and Credit Spreads

But one area that is giving us a heads up for another leg down in the market is what's happening with the credit spreads, which is a measure of bond traders' willingness to accept risk. The higher the risk the larger return they want. Therefore the spread between the riskier bonds (rated less than 'A') and the 10-year Treasury Notes is a good way to see how bond traders are feeling about the market risks.

First we'll look at the updated 10-year yield:

10-year Yield (TNX), Daily

The rally in yields (selling in the bonds) since the January low has yield right up against its downtrend line from October. Slightly higher is the downtrend line from June through the October high. I've been expecting a rally up to the 4.0%-4.3% area and today's high is just under this range. From an EW perspective it would be typical to see a 50% retracement of the June-January decline which would have it testing the December high--near 4.3%. If at any time TNX drops back below 3.5% it will likely mean the bounce is over and we'll get another leg down.

While TNX is rallying, which means bond holders are earning a higher return, the spread between these and the riskier bonds continues to widen. The following chart shows the DOW and an inverse chart of the credit spread (the higher the spread the lower the line, shown in dark blue):

Credit Spread between BAA Bonds and 10-year Note, Daily, courtesy Elliott Wave International

As noted on the chart, the spread is measuring the difference between the Moody's Bond Indices Corp. BAA and the 10-year yield. The spread has continued to widen through the month of January and into February. This says bond traders in this riskier category are demanding a higher return for what they perceive as higher risk. The point to take away from this chart is how the stock market generally follows the credit spread. As bond traders see higher risk in the junkier bonds so too do stock traders see higher risks in stocks, and both sell. Selling in the riskier junk bonds drives yields higher and selling stocks of course drives prices lower.

Notice the divergence between the credit spread and the stock market back in October--the higher high in stocks was not matched by a higher high in the credit spread. The stock market soon followed the bond market down. Now we have a similar negative divergence between the bounce in the stock market since the January low and a lower low in the credit spread (again, higher spread but it's being graphed inversely to better show a match with stock prices). Care to guess who will win in this divergence? My money is with the bond market and therefore being short the stock market is the better play here.

1.3 Economic reports

Housing Starts and Permits

This morning's reports showed the housing market stabilizing a little, with housing starts improving slightly from the previous month but unfortunately permits did not. Starts improved by 0.8% to 1,012K but permits continued to decline, down -3.0% to 1,048K. The downward trend in sales has not slowed yet so these numbers can be expected to decline further. The following chart, courtesy briefing.com, shows graphically how much these numbers have dropped:

From the peak in 2005 the number has already been cut in half and nearly back to 1991 levels. When the number drops down to 800K (probably a little lower since the excesses were so significant at the high) then we'll probably start to carve out a bottom in housing.

New home inventories continue to make new highs and tighter lending standards by mortgage lenders is making it increasingly difficult to obtain a mortgage. The jump in the 10-year yield is also making new mortgages more expensive.

CPI and Core CPI

Inflation remains a worry as it continues to tick up and it came in slightly above expectations. This of course worries those who are expecting the Fed to continue lowering interest rates. The Fed has made it clear that it's more difficult to fight inflation than a slowing economy. With CPI up 0.4% ( 4.3% year-over-year) and core CPI up 0.3% ( 2.5% yoy), both are obviously above the Fed's target rate of 1%-2%. A slowing economy and rising inflation is very worrisome and many more are starting to talk about stagflation and a return to a time similar to the 1970s. Stagflation is not good for the stock market.

Inflation worries also spiked commodities today--gold and oil made new highs (not associated with a new low in the US dollar). Bond yields jumped higher on worries that inflation may continue. All of this is raising concerns that the Fed may be forced to back off on their assurances that they will do whatever they have to in order to alleviate the credit crisis. A rock and a hard place is where the Fed is currently located. They've been painted into a corner and there's no escaping getting paint on their shoes.

The following chart shows the spike up in CPI (red). While the core rate (blue) is less volatile, it too has turned back up from its recent low. The uptrend from 2004 is worrisome. Chart courtesy briefing.com:

With inflation (costs) heading higher, unemployment heading higher, and talk of recession, the almighty consumer may do a little less consuming and that of course will only accelerate the economic slowdown (on a global basis, not just in the U.S.). A consumer-led recession will not be over nearly as quickly as the business-led recession in 2002. And all of this has led to a spike in the misery index, chart courtesy nowandfutures.com:

The index is based on unemployment and inflation--the higher each goes the unhappier people become. Pretty logical. The trouble for the stock market is that unhappy people tend to be sellers rather than buyers of stock. You can see how high the misery index became by the early 1980s, the end of the previous bear market. This index is already higher than it was at the start of the 1970s and it makes me wonder where it's headed. This is very worrisome, and bearish for the stock market.

FOMC minutes
The Fed reiterated that it will do what is necessary to fight the slowing economy (to which I say let the economy and market do what it has to do to cleanse itself) and credit problems but they're starting to express more concern about inflation. Their confusion about which monster to slay has only added to the market's confusion (hence the battle royal between the bulls and the bears). Methinks they now have a two-headed monster and a rubber sword. They acknowledged that core inflation would increase at a faster rate than they had thought back in October. And they're projecting the economy to grow between 1.3% and 2.0%, down from 1.8%-2.5%. So they've ratcheted down growth expectations while increasing their inflation expectations. Sure sounds like stagflation to me. And I strongly suspect those growth expectations will continue to be ratcheted down.

As the Fed stated, "Still, with no signs of stabilization in the housing sector and with financial conditions not yet stabilized, the FOMC agreed that downside risks to growth would remain even after this action [the steep rate cut]." The market is still pricing in at least another half-point rate cut in March. As part of the mixed message though, the FOMC said "...when prospects for growth have improved, a reversal of a portion of the recent easing actions, possibly even a rapid reversal, might be appropriate." Think we've seen a roller coaster so far? Hang onto your hats if they reverse but the economy is still slowing. The stock market will not like it one bit.

And speaking of the stock market, time to check the charts and see what the past month's mess has left us.

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2.0 Equities

2.1 S&P 500 Index (SPX)

SPX chart, Daily

Speaking of a mess--the daily chart has way too many lines on it and I apologize for the spaghetti look to this chart. But there are a couple of things I want to point out. First, we're still in a downtrend--price is battling the top of the parallel down-channel for price action since the October high (blue downtrend line). But price might continue to chop sideways in a triangle pattern. Whether it breaks to the upside for a run to the 1460 area (and then head lower again) or breaks down from the current consolidation is difficult to determine from here. As noted on the chart, we've got the following levels to help guide us:

Key Levels for SPX:
- Short term bullish above 1369 and then it could find resistance around the 38% retracement level near 1387; a little more bullish above 1396 for a run to 1460
- Longer term bullish above 1460
- Short term bearish below 1336, today's low but it would find support above 1317 for another leg up inside the consolidation pattern; more bearish below 1317
- Longer term bearish below 1270

SPX chart, 60-min

Today's rally stopped at the downtrend line from last week's high and this could be the top of a smaller sideways triangle than that shown on the daily chart. This triangle points to another rally leg (if it finds support at or above 1336). I also show a parallel up-channel for price action since the February 7th low, with the top currently near 1380. A quick rally to there could be followed by some swift selling. Play the direction of the break of the key levels shown on the chart.

2.2 Dow Jones Industrial Average (DOW)

DOW chart, Daily

The DOW is also battling against the top of its parallel down-channel from October. A break below today's low could be the signal that the consolidation is finished and the selling will resume (in earnest since the bearish wave count is extremely bearish). Rather than showing a sideways triangle pattern, as on the SPX daily chart, I'm showing the possibility we'll get another rally leg up to the top of a parallel up-channel from the January low. This projects a rally up to near 13300 before turning back down (coinciding with SPX pushing up to the 1460 area). A break above 12767, the February 1st high, would point to that move.

Key Levels for DOW:
- Short term bullish above 12572 and more bullish above 12767
- Longer term bullish above 13300
- Short term bearish below 12229 and more bearish below 12070
- Longer term bearish below 11634

DOW chart, 60-min

Depending on whether or not we have a small sideways triangle playing out, a choppy pullback tomorrow could find support near 12250 and launch a rally leg from there. A drop below 12229 will either be a larger corrective pullback or the start of something more significant to the downside. Below 12070 would likely mean a move down to at least the 11800 area.

2.3 Nasdaq-100 Index (NDX)

Nasdaq-100 (NDX) chart, Daily

NDX has a very nice fitting sideways triangle consolidation pattern playing out so far (as the 4th wave correction within the decline from October, a common pattern for the 4th wave). If anything I'd go with this index as an indicator for where the broader market will head next (the techs usually lead the way but not always, as we saw in October when the techs made their final high almost three weeks after the broader market). If the rally continues in the techs from here, watch 1886 for resistance. It could drop straight from here but the triangle pattern need a little more downside then another bounce before it's ready to head lower, probably around the first of March.

Key Levels for NDX:
- bullish above 1886
- bearish below 1715
- likely to be choppy in between

Nasdaq-100 (NDX) chart, 60-min

I've zoomed in on the potential sideways triangle pattern. If it chops a little lower and then chops up to a lower high by the end of the month it will be a very good setup for a short play for the 5th wave down into early March (which would then set up a long play for a bigger rally to correct the October-March decline). As shown with the pink wave count, a rally from here could take it up to the 1886-1900 area before turning back down.

2.4 Russell 2000 Index (RUT)

Russell-2000 (RUT) chart, Daily

The RUT is also staying within its parallel down-channel from October. It could also be forming a sideways triangle (not drawn on the chart) and which way it will break is a bit of a toss-up. If it breaks higher watch for a move to about 760. If it breaks lower we could see some very strong selling due to the very bearish wave count potential (start a series of strong 3rd waves to the downside).

Key Levels for RUT:
- Short term bullish above 723 and then more bullish above 731
- Longer term bullish above 770
- Short term bearish below 695 and then more bearish below 688
- Longer term bearish below 650

Russell-2000 (RUT) chart, 60-min

The RUT's pattern on the 60-min chart is one of the cleanest right now and shows both wave count scenarios that I consider the highest potential. The pink count shows a little more rally followed by what should be a choppy pullback that finds support at the bottom of the triangle pattern and then rally up to the 760 area from there. The dark red count shows the very bearish scenario is about to unfold in a series of strong 3rd waves to the downside.

You don't need to understand EW to know that the 3rd waves are the strongest moves and this count portends some very serious selling is about to hit. It should sell off from here but the bearish potential isn't negated until it rallies above 723. A break below 695 would be a heads up and a break below 688 could get serious.

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3.0 Selected Industry Groups

3.1 Banking Index (BIX), Daily chart

The pattern of the decline in the banking index the past two weeks is a bit funky looking. It's been a slow drop with lots of overlapping highs and lows within the move down. This is typically found in an ending pattern so a rally out of this is very possible (green arrow). It may be part of a larger correction before heading lower and it takes a break above its February 1st high near 297 to put it on the bullish price path. In the meantime I continue to think we have not seen the final lows for the banks and a move down to 200 continues to look like a good possibility.

3.2 U.S. Home Construction Index (DJUSHB), Daily chart

The banks and home builders continue to look very similar, as though they were joined at the hip. I see the possibility for a brief pop up in the builders but then a turn back down as it heads for what could be the final low near 213. A break of its last high near 410 would put it on a bullish path.

3.3 Transportation Index chart (TRAN), Daily chart

The sideways chop in February for the Trannies looks like a continuation pattern and should resolve to the upside. But the pattern for the rally off the January low suggests the new high will be short lived and reverse lower. The 200-dma could be a good resistance level to short (pick your weaker transport stock with a similar pattern setup).

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4.0 Currencies

4.1 U.S. Dollar (DXY), Daily chart

While commodities (gold, silver, oil and many others) rally, it's not because of a sinking dollar this time. Inflation worries are spooking commodities, and may be indicating what the dollar will do next. The US dollar continues to support the idea that it will stay within a sideways triangle into March before heading lower again (downside target near 72). But if the dollar should rally out of this, and rally above 77.85, there's a good chance we'll then see a strong rally in the dollar. Commodity prices would probably have a hard time staying aloft in that case.

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5.0 Commodities

5.1 Oil Fund and Index (USO and OIX)

Oil Fund (USO), Daily chart

The pattern in oil is starting to remind me of a broadening top formation. This is typically a reversal pattern and it's debatable whether it's nearly done or has another down-up sequence to play out (light green). A rally above 81 would be more immediately bullish but watch for resistance at or below this level. It takes a drop all the way back down below 68.50 (about 85 for oil) to say a top has been found. Keep an eye on oil stocks since they typically lead the commodity.

Oil Index chart, Daily chart

While it's certainly possible to consider the bounce off the January low as a bullish start to a run to new highs, that's not my preferred wave count on the oil stocks. I believe this index is now very close to finishing an a-b-c bounce off the January low that is now close to achieving two equal legs up (839.88). It could head a little higher for a retest of its broken uptrend line from August (near 850).

I like the setup, especially if it works its way slightly higher, for a short play on the oil stocks with a stop just above 850.

5.2 Gold Fund (GLD), Daily chart

It would appear that we might have had a small sideways triangle pattern play out from January and a rally up to the top of its parallel up-channel from August, currently near 95, looks like a good possibility here. But gold and silver give me the impression that it may find a top sooner rather than later. The bearish divergence against MACD is a big warning here not to chase this to the upside. When it breaks down it could go very quickly (which is true for many of the commodities which have built parabolic rallies and we know what happens to those). Tread carefully here. A break below 88.50 (about 900 for gold) would be followed by some fast selling.

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6.0 Summary

Bottom line is we're in a very choppy price environment and traders are getting whipsawed out of their trades. "Drawdown" is a commonly heard expression. Even among us writers on the Market Monitor, each of us using different trading tools, we're all complaining about the same thing--technical analysis seems to be broken (meaning the market is not doing what it normally does following a technical setup that we've seen time and again). This is when you need to take a step back and reevaluate. Drawdowns are a part of our business--they're our costs of doing business.

Normally you'll have periods of drawdowns that make you believe you couldn't trade your way out of a wet paper bag. There will be other times when you believe you're God's gift to the trading world and can do no wrong. One of the tricks that long term traders will tell you is that they will trade lightly during periods when they feel out of synch with the market and then trade with larger than normal positions when they feel like they're in synch. My guess is that most of you feel you're currently out of synch.

This too shall pass. But you want it to pass with your trading account still intact. Don't get chopped up in little pieces and bleed to death from a thousand paper cuts. Know when to trade and when not to trade. The market is battling big time right now so wait for some direction and then jump aboard. As a summary, use the following levels to help guide you in the direction to trade. In between, where we are now, expect a lot of chop and whipsaws. Good luck.

Key Levels for SPX:
- Short term bullish above 1369 and then it could find resistance around the 38% retracement level near 1387; a little more bullish above 1396 for a run to 1460
- Longer term bullish above 1460
- Short term bearish below 1336, today's low but it would find support above 1317 for another leg up inside the consolidation pattern; more bearish below 1317
- Longer term bearish below 1270

Key Levels for DOW:
- Short term bullish above 12572 and more bullish above 12767
- Longer term bullish above 13300
- Short term bearish below 12229 and more bearish below 12070
- Longer term bearish below 11634

Key Levels for NDX:
- bullish above 1886
- bearish below 1715
- likely to be choppy in between

Key Levels for RUT:
- Short term bullish above 723 and then more bullish above 731
- Longer term bullish above 770
- Short term bearish below 695 and then more bearish below 688
- Longer term bearish below 650


 

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