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Market Wrap

Market Wrap

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Wednesday, March 5, 2008

Trading Range Continues


1.0 The Big Picture

1.1 Markets at a Glance--Daily and Monthly Trading Ranges
1.2 Commodities--The Next Bubble
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 Featured 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 Bonds
6.1 10-year Yield (TNX)

7.0 Summary


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1.0 Overview

Today's Numbers

1.1 Markets at a Glance--Daily and Monthly Trading Ranges

The market has been stuck in a trading range since the January low and you can tell it's beginning to frustrate a lot of traders and investors. Traders are getting tired of getting whipped out of their trades and investors are tired of waiting for the market to give them their needed returns.

Even though the trading range over the past six weeks has been fairly wide, neither side can get any traction. Big daily candles on the daily chart are then reversed with a big daily candle in the opposite direction. Rumors keep flying and traders react to them. That was true again today as the boy who cried wolf once again said there's a pending deal to save Ambac and the market rallied to its morning high. Then Ambac announced that they will sell $1B or more in common stock to raise capital and maintain its AAA rating. That disappointed investors who have been looking for more of a bailout and the market gave up its morning rally.

The DOW finished marginally in the green after giving up more than 200 points from its high and then taking back 115 of those and putting them back on the board. We've got volatility and we have our trading range. It's been, and continues to be, a very difficult market to trade. Todd Harrison, who writes for Minyanville, said "The ability not to trade is as important as trading ability." I'd add that it's probably more important. Fighting the urge to trade, when there's not a good setup, is very difficult but very necessary.

Frustration can lead to more mistakes and/or unnecessary risks. Out of frustration in getting stopped out all the time a trader will soon justify not stopping out because he just knows the market is going to come back again and by golly he's just not going to get whipped around anymore. That's when the market goes parabolic on you and you watch in disbelief as your losing position gets bigger and bigger. Another Todd Harrison quote, "And never rationalize your positions. The definition of an investment should never be a trade gone awry." Been there, done that.

Speaking of bad investments, those poor pension fund managers are really getting frustrated as well. Many of these funds have a goal to earn 8% per year on their investments. Stocks did not have a particularly good year in 2007 and what little was made has already been given up and then some. And now Treasuries are returning a pittance (roughly half of their "required" 8%. What's a manager to do? Why invest a greater share of your holdings in stocks of course. Everyone knows stocks are going to go up this year.

Philadelphia's pension fund manager, who manages a $4B fund, has decided that they can't afford to be in Treasuries and has shifted a greater percentage of his fund into the stock market including emerging markets (the ones that look more like bubbles than anything else). The federal government's Pension Benefit Guaranty Corp. announced last month that it plans to shift $15B out of Treasuries and into the stock market.

These managers are doing this in an attempt to cover unfunded liabilities and to meet their return objectives. This is the epitome of lack of fear about the stock market and in my opinion is probably one of the most dangerous things a manager can do with a retirement account. History shows the stock market returns on average +5.3% (from Warren Buffet's letter to shareholders). But when the market has provided outsized returns, as it did for much of the 1990's, it typically returned less than 5% over the next decade at least. We're currently in the sub-par period when investors will probably do better over the next many years being in Treasuries rather than the stock market. That's already been true for the past year.

The relatively poorer stock market returns are leaving corporate and government pension funds underfunded (part of their "contributions" are from gains and dividends). Lack of funding and underperformance in their returns is causing many of these fund managers to take excessive risks. It's the same way the financial wizards got into so much trouble with their financial engineering and look how well that worked out for them. When these pension fund managers start selling, and they will, the added selling pressure is going to be painful for the market to bear.

1.2 Commodities--The Next Bubble

In the land of bubbles (stocks and then real estate) it's interesting to see that speculation is still alive and well, now in commodities. If you look at most commodities you can see a familiar pattern--uptrend lines are getting steeper. This is of course the definition of a parabolic climb. Whether it's oil, precious metals or grains, it seems bulls can't get enough of them right now. Even industrial metals (copper, silver) are zoom climbing.

A bubble is identifiable by how fast price is rising, especially in a parabolic fashion. When people have a hard time justifying, from a fundamental basis, why prices continue to climb it should be a warning sign. We've seen enough bubbles recently to pay attention now. Never mind "it's different this time". The fundamental disconnect appears to be the greatest in commodities that are tied to global economic health, which is waning. We hear this a lot right now about oil--with an economy that's slowing and inventories at above average levels one has to ask why the price of oil continues to climb. If construction is slowing down why is copper rallying to new highs?

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It's not just the run up in prices but also the bullish enthusiasm that is typically seen in bubbles. It seems most, including gold bulls, see another doubling in prices before the year is out. The following data on the number of bulls as a percent of total traders should be an eye opener:

Daily Sentiment Index readings from www.trade-futures.com: Swiss Franc 97%; Euro 98%; Yen 93%; Crude Oil 93%; Heating Oil 93%; Gold 97%; Silver 97%; Platinum 93%; Corn 93%; Oats 94%; Soybean 97%; Soybean Oil 98%; Soybean Meal 93%; Cocoa 98% and the CRB Index 96%. Slightly less but still seeing very bullish sentiment can are the U.S. T-notes (10-year) 83%; Nat Gas 88%; Wheat 85%; Coffee 86%; Sugar 88% and Cotton 89%. At the opposite end is the universally hated U.S. dollar with 7% bulls which of course is essentially the opposite of the euro.

When you see this kind of bullish enthusiasm you should be thinking bubble. And when you think bubble you should be very careful about thinking the long side. It's very common to see commodities finish with a blow-off top so it could be getting close now. This should be the last bubble to pop. Once it does, it should be all asset classes selling off together.

1.3 Economic reports

Today was a busy day for economic reports but there were no major surprises and the market paid little attention.

Before the market opened ADP announced some employment numbers and said the private sector lost 23K jobs. Adding in 25K government jobs it's looking like the nonfarm payrolls number could be closer to 2K than the expected 25K. That could disappoint the market Friday morning.


Productivity--Revised
Nonfarm business productivity came in a tad higher than expected, +1.9% vs. +1.8%, which is a slight improvement over previous estimate of +1.8%. Unit labor costs rose +2.6%, revised up from +2.4%.

Factory Orders
New orders for manufactured goods dropped -2.5% in January which is another sign of an economic slowdown. Durable goods orders fell a revised -5.1%.

ISM Services
The ISM index for February came in at 49.3, a slight improvement over the 44.6 in January (which was the lowest since October 2001). At 46.9 the employment number stayed below 50 for the second month.

The chart of the ISM indices shows a general down trend since the peaks in 2004 and 2005:

After the economic reports were released the stock market proceeded to rally in the morning to a market high at 12:00 PM. You would have thought the numbers showed an end to the economic slowdown. But after the relatively dismal numbers there a lot of hopes for more aggressive Fed rate cuts. We know how well they're working (as in Not--we've had five rate cuts since September 18, 2007, for 225 basis points, and the S&P 500 has dropped 200 points since then). It baffles me why the market still believes cutting rates means good things for the stock market. The all-knowing market needs to go back to school.

At 2:00 PM we got the Fed's Beige Book survey and it confirmed the Fed's belief that economic growth has slowed since the beginning of the year. Eight of the twelve Fed districts reported a "weakening of the pace of business activity." Retail sales are slowing but so are the service industries. There are upward pressures on materials and energy costs but businesses are having mixed results in passing along those costs to customers. In other words their margins are suffering (which INTC just told us). As hard as the Fed is trying to stimulate demand for loans, the demand is down is down.

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2.0 Equities

2.1 S&P 500 Index (SPX)

SPX chart, Weekly

From a weekly perspective it has to be viewed as bearish that prices have been consolidating underneath its broken uptrend line from October 2002 since breaking it in January. I show the possibility for a rally back up for a kiss goodbye (later this month, shown in pink) but at this point there's an equal possibility that price will simply continue lower from here. The dark red wave count calls for a steep and fast selloff so any drop below 1300 could pick up some steam to the downside and get below 1100 before the end of the month.

SPX chart, Daily

The big sideways consolidation since the February 1st high continues to support the possibility for another rally leg that matches the one off the January low. The Fib projection for two equal legs up is shown at 1433 for the pink wave count. But with the bounce off yesterday's low that becomes an important price level (1307). If that breaks then it could usher in a lot of selling over a few weeks.

Key Levels for SPX:
- Short term bullish above 1388
- Longer term bullish above 1440
- Short term bearish below 1307
- Longer term bearish below 1260

SPX chart, 60-min

You'll need to be a little careful over the next day or two. I see a few different possibilities for how price action could play out and I'm only showing two of them on the chart (one not shown is for price to simply drop straight from here and not look back, which is why I say a break below 1307 would be bearish). Two equal legs up from yesterday's low is at 1357, right on top of the 62% retracement of the past week's decline. It could fail at a retest of the broken uptrend line from the January low. The pink price path shows a pullback that stays above yesterday's low and then a continuation higher from there (as part of the larger rally leg up to 1433 over the next couple of weeks).

2.2 Dow Jones Industrial Average (DOW)

DOW chart, Daily

It's the same setup on the DOW as shown for SPX. The upside target for another rally leg is near 13200 (two equal legs up and 62% retracement) which is also where it would hit its downtrend line from October. After the bounce off yesterday's low (12035) any drop back below that level would turn the price pattern more immediately bearish.

Key Levels for DOW:
- Short term bullish above 12757
- Longer term bullish above 13220
- Short term bearish below 12035
- Longer term bearish below 11634

DOW chart, 60-min

Again, very similar to the SPX 60-min chart. If it continues rallying tomorrow, watch where the rally off yesterday's low would have two equal legs up at 12454 and then its 62% retracement at 12481. It might find resistance at its broken uptrend line from January, currently near 12350. Whether it pulls back first or just rallies straight from here, if it gets above 12500 I'd say there's a good chance we'll see the rally leg continue (with pullbacks of course).

2.3 Nasdaq-100 Index (NDX)

Nasdaq-100 (NDX) chart, Daily

For NDX I'm continuing to show a little bearish wave pattern than that shown for SPX and the DOW. The pattern of its decline from October needs only one more low to then set up a larger bounce into May or June. The downside Fib projection for the next leg down (wave 5) is at 1550 which is near the January 2004 high (1560). I think it would make for a very nice long play from there. This same pattern could be true for the other indices as well.

In the meantime it's not yet clear whether or not we'll see another rally leg (pink) that could get up to 1900 before heading back down again. A break below yesterday's low (1707 would be immediately bearish.

Key Levels for NDX:
- short term bullish above 1808
- longer term bullish above 2000
- bearish below 1707

Nasdaq-100 (NDX) chart, 60-min

This chart is slightly different from the SPX and DOW 60-min charts only because I wanted to show the possibility for a pullback first thing tomorrow before either rallying (pink) or continuing to new lows. If it rallies as shown in pink, watch for resistance at the downtrend line from February 1st near 1790.

2.4 Russell 2000 Index (RUT)

Russell-2000 (RUT) chart, Daily

It's the same thing with the RUT--the market is perched on the edge of a cliff for another steep drop or else it's going to rally first up to the 750 area (Fibs and downtrend line from October). A drop below yesterday's low near 670 would be more immediately bearish.

Key Levels for RUT:
- Short term bullish above 724
- Longer term bullish above 750
- Short term bearish below 670
- Longer term bearish below 650

Russell-2000 (RUT) chart, 60-min

The RUT has retraced the least amount of the past week's decline and from both a time and price standpoint could use a bigger bounce to at least correct the decline before heading back down (dark red). If we're instead going to see another rally leg I'm sure we'll see evidence of that in the others (especially NDX) first.

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3.0 Featured Industry Groups

3.1 Banking Index (BIX), Daily chart

The bad data spike on the BIX chart has messed up the oscillators but it's looking like it might be breaking the uptrend line on MACD as it nears the January low. If true then the low is probably not going to hold and a drop down to the 212 target area could be next. But if the broader market is able to put together a rally into opex then we could see the banks do the same (either that or consolidate sideways for a little longer). So far we don't have an ending pattern to the downside and therefore I don't believe we've seen the final lows for the banks.

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

Bullishly I see the home builder index hanging on top of the broken down-channel (blue trend line). If it can manage a break back above 400 there's a good chance we will have seen the low for this index. Otherwise a move down, as depicted in dark red, to the 213-216 area would be a nice finish to the decline.

3.3 Transportation Index (TRAN), Daily chart

The Transports are in a position for a steep decline to new lows before the January low. It remains in a parallel down-channel, having failed at the top of it at its February 26th high. It takes a push back above that 4827 high to turn the pattern at least short term bullish, perhaps up to the 5100 area to test its broken uptrend line from March 2003 again.

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4.0 Currencies

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

The U.S. dollar is getting very close now to the bottom of its parallel down-channel, currently near 73. Its price pattern leaves a lot to be desired at this point so it's tough to tell what kind of bottom it might be if support is found there. It doesn't look like an ending pattern yet but it doesn't preclude a big bounce back up to the top of its channel (shown in green). Certainly a reversal in the dollar could be tough on the commodity bulls.

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5.0 Commodities
Commodities have entered dangerous territory and this includes gold and all the gold bulls who predict $1500-2000 and oil bulls predicting $150 oil this year. It's so common during the bubble phase to simply extrapolate the move to new highs. But when fear starts to strike, the money will exit the commodities faster than most expect.
5.1 Oil Fund and Index (USO and OIX)

OPEC met yesterday and voiced their opinion that they do not need to increase production--supplies are not tight and they don't understand why prices are stubbornly holding above $100. They blame the run-up in oil prices on the sinking U.S. dollar and futures traders who are betting on higher prices in the future. Interestingly they also mentioned the fact that investors have sold other investments to buy oil (and other commodities) in an effort to improve their returns. See my discussion in Section 1.2 on commodities to get a better appreciation for what's happening in the commodity market.

EIA reported oil inventories today and said crude supplies were down 3.05M barrels while gasoline stocks were up 1.66M barrels. Refinery capacity is running at 85.9%

Oil Fund (USO), Daily chart

USO broke above the trend line along the two previous highs. This is the top of what I've been thinking will be and ending pattern (expanding triangles like this at the end of a run are usually bearish). In order for the bearish interpretation of this pattern to hold we'll have to see USO start back down immediately, leaving a throw-over finish. If it instead continues higher than keep an eye on the sharp parallel up-channel, especially where it meets the top of the longer term up-channel from last August at 88.60 on March 12th. It could make for an interesting top for oil's run.

Oil Index (OIX), Daily chart

The oil stocks index stopped at the broken uptrend line from August but there's nothing that prevents it from walking up the underside of it for a bit longer if the broader market rallies and oil heads a little higher. Like the broader market, yesterday's low is an important level now--break that and we should see more selling kick in.

5.2 Gold Fund (GLD), Daily chart

Gold has truly gone parabolic. The uptrend lines are getting steeper and it keeps popping out the tops of its steeper parallel up-channels. Notice how it found the top of its longer term up-channel (bold blue line) as support once it broken above it in February. Now it's breaking above the top of its channel from August so gold bulls will want to see it act as support in a pullback (almost didn't yesterday but it was quickly reversed back up today), currently near 97. In the meantime, the top of the steepest channel, the one from the December low, is currently near 99.30 (which would have gold breaking above $1000).

Gold could continue pushing higher, especially if the publicity around $1000 sucks in the remaining 3% non-bulls into the metal. When this lets go to the downside it's not going to be nice to those who overstayed their welcome. Gold stocks (XAU.X) have not been keeping up with the metal and this is another warning flag.

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6.0 Bonds

10-year Yield (TNX), Daily chart

The 10-year yield should get another leg up in its bounce off the January low. This is actually one of the things that has me thinking we could see an equity rally over the next couple of weeks. Money rotating out of bonds (pushing yields higher) could end up in stocks, especially if money rotates out of commodities as well. But after the bounce the past two days if TNX drops back down below yesterday's low then we could stronger buying in the bonds and more selling in stocks.

7.0 Summary

Hope springs eternal by the bulls wishing (hoping) for a save for the bond insurers. Each little piece of news on the subject squeezes the shorts and gets hopeful bulls buying. Today's announcement by Ambac that it will sell shares to bring in money is the right step even if it's painful. This is a painful step because it dilutes existing shareholders when stocks prices are already depressed. It's especially embarrassing for companies like Ambac (ABK) and MBIA Inc. (MBI) because these mortgage insurers are being forced to sell a lot of stock that they bought back at much higher prices last year. And you thought you were the only one who bought high and sold low.

This will result in hundreds of millions in economic losses for the companies and therefore for the shareholders. So the executives and sales people get paid tens and hundreds of millions of dollars in the good times and the shareholder gets stuck holding the bad in bad times. Capitalism at its worst I'm afraid. But these companies are in survival mode now and must get their hands on lots of capital in preparation for paying for the wave of insured losses in structured credit and mortgages.

As mentioned many times before, if the bond insurers can't cover the losses and ultimately receive ratings downgrades (which I believe will happen) then the bond holders also end up holding the bag and further write-downs will be the continuing saga through the rest of this year. Therefore, if the market rallies over the next couple of weeks as I showed on the charts, look at it as a gift to the bears since the short play from there will be one of the best setups of the year. And if yesterday's lows get taken out, you'll want to short the bounces from there.

Trade the long side with care (and only if you can watch the market during the day) and look for the short plays to set up. Trade with the trend which is currently down. Good luck.


Key Levels for SPX:
- Short term bullish above 1388
- Longer term bullish above 1440
- Short term bearish below 1307
- Longer term bearish below 1260

Key Levels for DOW:
- Short term bullish above 12757
- Longer term bullish above 13220
- Short term bearish below 12035
- Longer term bearish below 11634

Key Levels for NDX:
- short term bullish above 1808
- longer term bullish above 2000
- bearish below 1707

Key Levels for RUT:
- Short term bullish above 724
- Longer term bullish above 750
- Short term bearish below 670
- Longer term bearish below 650
 

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