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Market Wrap

Market Wrap

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Wednesday, March 12, 2008

Watch Those Extremes!


1.0 The Big Picture

1.1 Markets at a Glance--Using Sentiment in a Contrary Way
1.2 Chasing Commodities
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)
3.4 Semiconductor Holders (SMH)

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--

Another hope-filled rally. Too many are calling for a bottom here, thinking we've successfully tested the January low and therefore the bear market is over. Remember this--when fear is pervasive and there is general wailing and gnashing of teeth about the fact that there is no bottom or that we don't know where the bottom is, and the VIX is north of 40, 50 or 60, that's when we'll form a bottom. For as long as there are bottom calls you can bet it isn't the bottom. It's another sign of the slippery slope of hope.

The oversold bounce could certainly be good for additional upside as the market works out of its short term oversold conditions. But I don't think it's realistic to believe we can avoid a recession based on what's happening in the housing market and how much the consumer is being forced to cut back on spending (except on energy and food but thank goodness that's not in the inflation numbers so who cares). And if the economy is heading into a recession (which will likely be more severe than the 2001 recession) I don't think it's likely that we're going to avoid a longer bear market with a deeper decline than what we've seen so far.

So the question tonight is what to make of the rally off Monday's low. We all know that bear market rallies can be some of the strongest rallies you will ever see, often much stronger than anything you'll see during a bull market. A short-covering rally is a wonder to behold sometimes, especially if you're on the wrong end of it. It's why bears need to be especially careful when they see things getting stretched to the downside and too many short sellers entering the market.

Bear markets are tougher to trade than bull markets because emotions are running higher. Fear is much more prevalent, for obvious reasons, and the battle between fear and hope can cause some amazing price moves. And these price moves can really destroy trading accounts if you're on the wrong side and you're not quick to get out of the way. Conversely, if you can catch the swings, bear markets can be extremely lucrative. The trick is to catch the swings--don't overstay your welcome in a big move either way.

It's always difficult to determine where an extreme in the selling could cause a reversal to the upside. Oversold can become much more oversold and the oscillators getting pinned in oversold are of no help. Sentiment indicators, such as put/call ratios or short interest, can give you a heads up but they're often not very good timing tools. One sentiment indicator though that has done very well in showing when we're seeing extremes in the put/call data that comes from ISEE which can be found at the following link.

ISEE has done a better job than most at filtering out put/call data that is not necessarily reflective of trader sentiment (since much of the option buying is for a hedging strategy and not necessarily directional trading). Here's a chart of the past year's data, courtesy ISEE, with the latest updates through yesterday, with the chart of SPX right below it:

I've entered the dates and readings at the extreme lows over the past year and matched it up with a chart of the S&P 500 over the same time period. Whenever the number approaches 60, and especially if below 60, traders should get ready for a stock market rally. It just needs a spark to ignite the short covering (like Bernanke's pre-market bear fry Tuesday morning). Based on the number coming it at 56 after Monday's trading I posted on the Market Monitor Monday night that the bears now have a warning flag out. Unfortunately that might have been too late for some as the opening gap up on Tuesday was huge. But at least you can see that this indicator was a clear warning about the excessive amount of bearishness in the market, as measured by the number of put buyers.

But was Tuesday's rally meaningful? Could have been a one-day wonder rally? Or will it really start the next bull market phase of the market?

For those who have the pleasure of living in an area with four seasons and driving in icy conditions during the winter, you can relate to the following analogy. I always loved getting into a large parking lot (shopping malls for example) and doing "donuts" in the fresh snow. I taught my kids how to regain control of the car after putting them into a skid (I've also been chased out of a few parking lots by security who didn't buy my reasoning for doing what I was doing). The trick of course is to catch the car before it passes the point of no return since once you pass that point you become a rider and not a driver as the car spins right around with you're soon looking over your shoulder for where you're going.

What does this have to do with our market you might ask? The huge run up in the credit market was like taking the car for a spin, literally. The market was put into a skid and it seemed fun at the time. But the Fed let the market skid beyond the recovery point and now we're all riders in this vehicle we call a market. It's now spinning beyond our (the Fed's) control and we have to wait for it to stop (and hopefully not hit anything). As hard as the Fed tries to spin the wheel (pump more money into the banking system) they are unfortunately just along for the ride with the rest of us. The economy simply needs to solve its credit crisis the same way it got into it--on its own, as painful as that's going to be. The Fed and other government intervention will simply drag out the process. You need go no further than Japan to see how effective government action was(n't).

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What have we seen so far in an effort to solve this credit squeeze since last summer? The Fed cut the discount rate last August and then again when it launched the term auction facility in December, and again with its emergency rate cut in January. The US Treasury came up with its "super-SIV" plan. We've seen Sovereign Wealth Funds (foreign buying) invest large amounts of capital into our banks. Warren Buffett made an offer to buy the healthy part of the monoline bond insurers. And early Tuesday morning the Fed announced a huge bailout, er I mean loan package of $200B to be made available to more banks other than just their primary dealers and will accept mortgage-backed paper as collateral. Each of these events created a large stock market rally. Each rally has failed. Will Tuesday's rally be different? I'd prefer not to bet that way, at least not yet. I'll show in tonight's charts where it could all head.

1.2 Chasing Commodities

The bid up in commodities is baffling a lot of experts. Many are saying the declining US dollar is causing the inflationary response in commodities. While the drop in the dollar does cause some increase in the value of commodities, most analysts agree that the prices are now out of whack with reality--the slowing economy and demand for many of the commodities, like oil, combined with increasing inventories should have commodity prices dropping.

The fact that prices are doing just the opposite has many scratching their heads. Many are saying it's different this time (really!) and that global demand and the dropping dollar are clear evidence why the price rise will continue. Well of course they say that. Every bubble has its supporters as to why the price rise will simply continue. I think it's simpler than that--it's evidence of hot money chasing the only thing that's rising today. It's creating a bubble and just like the previous bubbles it will end badly.

One look at many of the commodities, hard and soft, and you can see what should be a very familiar pattern by now--a parabolic rally, as shown in this monthly chart of the Commodity Index:

The commodity index has had a 400+% increase since 2003, and that wasn't even following a down couple of years like the stock market. There are some measurements of the commodity rally that are warning of an impending top to the commodities but not quite yet. This is the last bubble--it's where big money is chasing the last market that's going up, the last big momo market. Stock bulls will say "good, when money rotates out of commodities that'll be good for stocks because where else is the money going to go?"

That would normally be pretty decent logic but in this case, with a collapse in the credit market, which will remove so much of the liquidity that made all these bubbles possible, a credit contraction will collapse the value of all assets and the commodity bubble will be the last one to pop. Still, it's hard to argue with the strength in the commodities and one way to check that strength is with a relative strength chart. So here's an RS chart of commodities vs. the S&P 500:

Since 2000 it's been far better to have your money in commodities. While the bond market has outperformed the stock market during 1998-2008 decade, the commodities have blown everyone out of the water. But notice how the RS chart itself has gone parabolic since the end of 2006. This is the sign of the blow-off top in the making in commodities. The reversal in this chart will likely be swift and painful for commodity bulls who hang around too long (this includes gold and oil).

Remember that a RS strength chart shows the performance of one symbol vs. another. Both could be rallying but if commodities are rallying faster than the S&P 500 index then the RS chart will be "rallying". The opposite should happen here--when all asset classes get sold off, the commodities will likely be leading to the downside as all that hot money exits quickly.

1.3 Economic reports

There were no significant economic reports for today. The oil inventories show a rise in crude by +6.17M barrels and gasoline supplies were up +1.69M barrels. So why are oil prices still rising? There's lots of speculation, including a sinking US dollar but as mentioned above, I'm thinking it's because the commodities market is the last area for hot money to chase.

From a shorter term perspective, the question as of tonight is what did Tuesday's rally mean and does the fact that the market couldn't hold yesterday's highs mean trouble. Let's take a look.

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2.0 Equities

2.1 S&P 500 Index (SPX)

SPX chart, Daily

The price action since the January low has been a very choppy pattern and as such it is not showing its hand as to which way it wants to go. I'm sure I don't need to tell you that. You've probably been wondering the same thing a time or two the past two months. From an EW (Elliott Wave) perspective I look for impulsive (5-wave) moves to give me a sense of which way the trend is. Since the January low we've only been getting 3-wave moves and that leaves open the possibility that we'll continue to march sideways in a big consolidating triangle pattern as shown on the chart (and price action in pink).

We could rally straight from here up to the downtrend line from October, currently near 1420, or we could chop our way lower to a Fib target around the 1225 area by the end of March/early April (shown in dark red). There's just no reliable way to predict which way this market is headed next. I'll be watching the key levels for an indication which scenario is likely playing out--a break below Monday's low near 1272 says down we go and a break above the February 27 high near 1388 says up we go. In between says stand by to be chopped to death.

Key Levels for SPX:
- Short term bullish above 1388
- Longer term bullish above 1440
- bearish below 1272

SPX chart, 60-min

From a shorter term perspective I'm watching to see how the bounce off Monday's low develops. If we get another push higher tomorrow it will create a 5-wave impulsive move off Monday's low. That would indicate at least a short term trend change to the upside and I'll be looking for a pullback to get long for another leg up (shown in pink). But if the market declines tomorrow below Tuesday's early morning high near 1303 it will a warning sign that the bounce from Monday is just another 3-wave corrective bounce and the trend is still down. A drop below Tuesday's mid-day low near 1286 would confirm that. It doesn't mean we can't get another bounce but it does mean it will set up another shorting opportunity.

2.2 Dow Jones Industrial Average (DOW)

DOW chart, Daily

I'm continuing to carry a different wave count on the DOW chart vs. the SPX (and NDX) chart. It's a much more bearish wave count and says the next leg down is going to be a doozy. I'm continuing to show this because of the potential but my preferred wave count is the one showing we need another leg down to finish a 5-wave decline from October which would set up a stronger rally into late May/early June to correct the October-March decline. In the meantime, the key levels for the DOW, like SPX, are Monday's low to the downside and the February 27th high.

Key Levels for DOW:
- Short term bullish above 12757
- Longer term bullish above 13220
- bearish below 11732, confirmed with a drop below 11550

2.3 Nasdaq-100 Index (NDX)

Nasdaq-100 (NDX) chart, Daily

The sideways triangle pattern for NDX, if that's the correct interpretation, says we needed another leg down to finish a 5-wave move down from October. The drop from February 27th, the end of the triangle pattern, is very small and looks very incomplete. Notice though that the rally stopped right at the broken uptrend line that is bottom of the triangle pattern--bearish kiss goodbye today? Bulls beware here. The downside Fib projection near 1550 remains a good downside target if the decline gets underway again.

For those who follow the EW counts on my charts, note that I placed a "4?" at today's high, meaning today's high, not the February 27th high, might have been the end of the 4th wave correction (or it could head a little higher to complete it) and that we haven't started the 5th wave down yet. Later I'll show a chart of the semiconductor holders (SMH) and you'll see why this is possible (SMH looks like it could finishing its sideways triangle pattern, either today or a little higher).

Key Levels for NDX:
- short term bullish above 1808
- bearish below 1672

Nasdaq-100 (NDX) chart, 60-min

The 60-min chart shows more clearly how the broken uptrend line from early February (the bottom of the potential sideways triangle pattern) acted as resistance today. If the market can rally a little higher tomorrow then it will give us a setup to look to buy the next dip after that (shown in pink). Otherwise a continuation lower tomorrow could set up a stronger decline below 1600 next.

2.4 Russell 2000 Index (RUT)

Russell-2000 (RUT) chart, Daily

The RUT's bounce stopped at the top of the parallel down-channel that price has been in since the October high (except for a brief foray above it in late February). If the market can rally a bit more tomorrow it will set up a stronger rally (after a brief pullback from a new high tomorrow) and potentially up to its downtrend line from October near 740. But a continuation lower could lead to a drop to a Fib projection near 600.

Key Levels for RUT:
- Short term bullish above 724
- Longer term bullish above 750
- bearish below 643

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3.0 Featured Industry Groups

3.1 Banking Index (BIX), Daily chart

I drew in a small parallel down-channel based off the trend line along the lows since early February (to help identify where the rally should stop if we've got another leg down coming). The top of this channel is where today's early rally stopped. One more leg down could set up a much stronger rally for the banks and I'll be watching to see if support around 212 holds. If that level doesn't hold then it'll probably head down to the bottom of its longer term down-channel, currently near 180. The banks need to rally above 274 to set it on at least a short term bullish path (pink).

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

The home builders have remained in a similar pattern as the banks but they didn't get quite the euphoric rally off of Monday's low that the banks got. Thanks to Uncle Ben and his liquidity injection plan, the bears got spooked out of their short positions in the banks but bears in the home builders are feeling a little braver. Extra liquidity in the banks doesn't help the homeowner in trouble (especially with mortgage rates heading higher again). I'm showing an idea of a descending wedge for the home builders rather than a parallel down-channel that I have on the BIX chart. This would make for an interesting setup if it plays out this way (dark red) since it would actually be a very good setup to cover shorts in this sector and even try the long side. In the meantime, it takes a break above 400 to say we might have put in a low for now.

3.3 Transportation Index (TRAN), Daily chart

The Transports have been showing signs of bullishness by not even coming close to testing the January low while the DOW did. DOW Theorists have been all over this one declaring this week's low as a bottom because of this. They could very well be correct in that call but I think it's far too early to tell and I have seen much in the way of confirmation of that yet. Let price tell us what it has in mind. The Trannies remain in their down-channel from last July but if it can back above the February 26th high near 4827 then a Fib projection at 5145 and the broken uptrend line from March 2003 coincide near the end of this month. Otherwise a drop back below Monday's low near 4388 could usher in some strong selling in this sector.

3.4 Semiconductor Holders (SMH), Daily chart

I wanted to show the semiconductors because it could be providing some clues as to what's next for the techs (NDX) and as go the techs so goes the broader market (usually). The sideways triangle pattern for SMH doesn't look quite complete yet although the current bounce from the March 4th low should be the last leg within the triangle and it could end at any time (including today's high). A break below Monday's low (like all the other indices) would signal the start of the 5th wave down for the semis, and likely the same for NDX. The downside projection, based on rallying a tad higher first, is near 23.50 (which is closer to 28 if today's high was it for the bounce) is based on equality between the 1st and 5th waves in the move down from July.

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4.0 Currencies

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

The poor unloved US dollar has become even less loved each of the past weeks, as the weekly chart shows. The dollar has now dropped below the bottom of its long term parallel down-channel that's been in place since the late 2005 high. There's a bullish divergence on the oscillators but that's just a heads up that it could be bottoming here. I thought the dollar would find support just under 73 but so far no takers. Now I'm hearing from others that support may not come in until around 68. The shorter term red trend line along the lows is currently near 72 so perhaps some buyers will step in there. It's in a downtrend until it's not--needs to rally above 74 now to break it.

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5.0 Commodities

5.1 Oil Fund and Index (USO and OIX)

Oil Fund (USO), Daily chart

With the dollar in freefall it's certainly giving a boost to commodities as inflation fears are fanned. The bond market is Not saying they're worried about inflation (not to the same extent commodities traders are saying, or justifying I should say). Oil is in a tight up-channel since early February, the top of which is slightly above the top of the longer term up-channel since the August low, both of which are approaching 90 (near $115 for oil). Now that it has rallied to a new high it looks like it will need to pull back and then rally one more time to finish the pattern to the upside, and that's what I've depicted in green, with a final high near 93 next month. That's just a guess at this point but I would not be anxious to short oil yet. Maybe for a trade to the downside but it has to break below 78.50 to tell me we have probably seen the top.

Oil Index (OIX), Daily chart

The lack of a rally in the oil stocks continues to urge caution if your long the commodity. But as I show in pink, it's now a decent possibility for oil stocks to get another rally leg (after pulling back correctively from its late-February high) and that would be complete a 5-wave move up from January and place an exclamation point on its rally (for an excellent short play). A drop back below 802 would negate that short term bullish expectation.

5.2 Gold Fund (GLD), Daily chart

After some careful study of the longer term pattern in gold I'm thinking it has a little higher to rally, like oil. It could use a pullback and then a final leg up into early April to top off a stellar rally. GLD could achieve 103 while the shiny metal could make it up to $1050 before it's all done. Any pullback needs to stay above 92.58 otherwise a top will already likely be in otherwise keep an eye on the trend lines along this year's highs and lows as price should remain inside the slight rising wedge pattern for another few weeks.

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6.0 Summary

Bear market rallies are bear killers as they wipe out days, if not weeks, of profits for short sellers in a single day. Short sellers are a nervous bunch (as opposed to happy bulls who complacently hold onto their long positions) and they'll scream like little children when Uncle Ben yells "boo" as they run for the exits, peeing all the way. We have many more participants shorting this market, not to mention the thousands of hedge funds, than were present in the 2000-2002 bear market. And yet there were still huge short covering rallies during that bear market. Bear markets are very difficult to trade because of this.

Bull markets tend to trend longer so you have the luxury of watching your position profit and set some orderly exits. Exits out of short positions tend to be screams for the exit which can get crowded (making for some difficult fills at times). Therefore if you're trading the moves in this market you have to be satisfied with taking chunks out of the middle, with slash attacks, taking small profits along the way and being content with that. Too many of us want to hang around and get the whole move. Overstay your welcome in a bear market, on both sides, and you'll likely give a big chunk of your profits back.

So be happy with small profits, especially knowing many professionals are getting their heads handed to them right now. And if you're not comfortable trading in this environment, and therefore not trading, pat yourself on the back for being a disciplined and professional trader. Knowing when not to trade is more important than knowing how or when to trade. Protection of capital instead of return on capital and all that.

The big spike up on Tuesday might be all there is although it seems we have more of an oversold condition that needs more than one day to flush it out. That's one reason why I'm thinking if we do continue lower from here that it could be a very choppy affair and we'll see descending wedges forming. Oversold might get a little more oversold but the pattern would set up an excellent long play into May/June.

On the other hand, as mentioned with the charts, another push higher tomorrow would set us up for further upside. A new high tomorrow would be followed by a pullback to correct the rally from Monday (use the Fib retracements to help guide you as to where support might be found in a pullback) and that pullback would be a buying opportunity for another rally leg to at least match the one up from Monday.

Good luck in your trading and take smart setups and exit quickly. Take your little morsel of cheese and scurry back into your hole to enjoy it in a quiet moment. Be back with you next Thursday (Linda and I will be swapping next Wednesday and Thursday).

Key Levels for SPX:
- Short term bullish above 1388
- Longer term bullish above 1440
- bearish below 1272

Key Levels for DOW:
- Short term bullish above 12757
- Longer term bullish above 13220
- bearish below 11732, confirmed with a drop below 11550

Key Levels for NDX:
- short term bullish above 1808
- bearish below 1672

Key Levels for RUT:
- Short term bullish above 724
- Longer term bullish above 750
- bearish below 643
 

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