Sunday, March 23, 2008
Time to Rotate
1.1 Markets at a Glance--Stock Market Finishes On Upbeat Note for Week
2.1 S&P 500 Index (SPX)
3.0 Featured Industry Groups
3.1 Banking Index (BIX)
4.1 U.S. Dollar (DXY)
5.1 Oil Fund and Index (USO and OIX)
7.0 Summary and Review of Credit Situation
1.1 Markets at a Glance--Market Finishes On Upbeat Note for Week
This weekend's newsletter will be longer than usual because of all the charts. If you like to print out the report for reading you can highlight the parts that are of interest to you (to save some ink and a few trees). I wanted to take a look at a few charts that I don't normally cover, including some longer term views in an effort to keep things in perspective about where we've been and where we could be going. To those of you really pressed for time I apologize for the length of this report. Consider a quarterly review which is what I had in mind when preparing it.
In my last report (Wednesday, March 12) I had shown charts of the Commodity Related Equity index (CRX.X) and pointed out the parabolic climb in price. It had tagged the trend line along the highs since 2003 along with some negative divergences at the new highs so it looked ripe for a pullback at a minimum (after an expected push higher which we got). I mentioned it could be good for some money rotation back into stocks and this week we saw a little of that.
While money many be rotating back into stocks it's certainly not a smooth flow. This week's stock market, like last week, was one of the more volatile with daily intraday swings of a couple hundred points on the DOW, never mind the swings day to day. And while commodities pulled back sharper than I thought they would this week (I was looking for a smaller pullback and then a push higher into April), freeing up a lot of cash, that cash didn't all rotate into the stock market. Some money continues to run to the safety of Treasuries which pushed yields a little lower (which looks ready for a reversal).
There continues to be a huge disagreement by big players as to whether we've seen the worst of the credit mess or instead there's another shoe about to drop. Each day brings either new revelations of another financial firm in serious trouble or relief from others as they say they've seen the worst. Since January the stock market has gone nowhere but we've seen the DOW move +/- 700-1000 points a few times. The bulls will say we're hammering in a bottom and the bears will say we're consolidating before the next leg down. Neither has the conviction to hold their positions and short-covering rallies and longs liquidating positions are causing some significant volatility.
After Monday's save by the Fed (orchestrating the buyout of Bear Stearns by JP Morgan) and then another big rate cut on Tuesday we got a big rally into Wednesday morning. Following the Thursday "dip" and Friday's rally back up near Wednesday's high ended up giving us a good week for the stock market. The gains reflected in the week's numbers in the table above reflects the strong gains, especially in the beaten down sectors such as the banks and housing stocks. On the opposite end was anything commodity related.
The selling of commodities and taking profits has been brought about by deleveraging in the credit markets and the resulting drop in value of assets that benefitted from easy credit. This means large investors are selling even profitable positions to help shore up other accounts. "People are cashing in profits in the only markets that have been going up in order to pay for losses in other markets," said Stephen Briggs, a metals analyst at Societe Generale in London.
1.2 Commodities Turn
For the past few weeks I've been warning about the next bubble to pop--commodities. With the strong spike up in prices, especially since last summer when the stock market was peaking, it was clear the rally would end in tears for those who held their long positions too long. But you can't argue with the strength in commodities since 2000. The following chart shows the commodity index (CRB) as compared to the S&P 500 for the past eight years:
The S&P 500 shows the big decline after the 2000 high, back up to that high in 2007 and is now down about 10% from 2000 (in nominal terms but in fact much lower in terms of inflated dollars). Buy and holders in the stock market have been rewarded with a 10% decline in nominal terms (not inflation adjusted) for the past eight years. In the meantime the CRB rallied a little over 100% in the same time period (it's up roughly +90% after this week's pullback). Notice the spike up since mid 2007--that was the blow-off top. If you want to get an idea how the stock market really fared when measured in gold, the chart after the next one will be an eye opener.
A closer look at the daily chart shows the how the rally from January 2007 went parabolic:
When you see a rally get steeper and steeper, draw uptrend lines and when you get to the 4th one you will often find a break of it signals the end of the rally and the break down is likely to be sharp. That's what happened this week. It's hard to see on this chart but this week's decline found support on the 3rd uptrend line (from August 2007). The daily candle is a bullish hammer (actually an even stronger dragonfly doji) but this candlestick pattern is typically more bullish at the end of a longer decline. A 4-day decline doesn't exactly qualify.
So while commodities could get a bounce (and might even be able to make a minor new high as a retest), commodity bulls have now had their warning shot across the bow. Proceed at your own risk of getting blown out of the water. If you're long anything commodity (including the metals) I would look to lighten up on your position if we see a bounce next week. I'll review some charts of oil, gold and silver later to show some potential moves.
I'd like to make one more point for the buy and holders who argue the stock market will always go up over time. I mentioned the S&P 500 rallying back up to the 2000 high in 2007 in nominal terms. The DOW rallied about 2,450 points above its 2000 high and people (in the U.S.) were elated. But if you measure the performance of the stock market in anything else, such as gold or euros, you'd find the stock market has been one lousy place to invest (chart courtesy Elliott Wave International):
This is not a picture of the tech stocks. This is a picture of the DOW and the "rally" since the 2000 high. Do you see a rally? I don't see a rally. I see my holdings (had I held) getting decimated over the past eight years. It's true that gold has rallied strong and that makes this chart look worse. But part of the reason for the strong gold rally is because the US dollar has been pummeled during the same period. The DOW measured in euros is still well below its 2000 high.
Before reviewing Thursday's reports, the following table shows next week's economic reports:
Existing and new home sales on Monday and Tuesday could move the market if there's some surprisingly good news, which is not expected. Bad news has been priced in to a large extent, at least for now. A large drop in Consumer Confidence, reported on Monday, could depress the market. Same for the Durable Goods number on Tuesday--the market is expecting an improvement from last month so another negative number here could spell trouble. Conversely, any unexpected improvement to any of these numbers could spark more short covering and give the bulls a more confident feeling that the market is finding some kind of bottom.
The GDP number on Thursday is expected to be marginally positive and the market would not be happy with a negative growth number. Lastly, on Friday the Core PCE Inflation number is watched closely by the Fed who has already been expressing greater concern about inflation so a higher than expected number here could depress the market out of fear the Fed's hands will be tied and not be able to lower rates any further.
Thursday's reports included the jobless claims, Leading Indicators and the Philly Fed index.
Master them with Hotstix QQQ Trader. We'll show you exactly when to buy and sell the QQQQ and turn you into a master trader who knows how to cut your losses, nail short term gains and rack up some incredible profits.
30-Day FREE Trial:
In addition to the jobless claims number there were four other leading indicators, out of the 10 total, that fell--building permits, delivery times, consumer expectations and stock prices. Four indicators rose: real money supply (no surprise there), interest rate spreads (I'll come back to this one), orders for capital goods and orders for consumer goods. The factory workweek was unchanged.
The following chart shows the deterioration of the leading and coincident indicators and how the leading indicator has dropped into negative territory this year:
Philly Fed Index
The NY and Philly indexes are seen as precursors to what we can expect to see from the ISM (Institute for Supply Management) factory index which will be reported on Tuesday, April 1st for March. February's number was 48.3 and any number under 50 signifies contraction. The fact that the NY and Philly numbers are still negative means we'll likely see the ISM come in under 50 again, which would be further confirmation that we've entered a recession.
The following chart shows how the Philly Fed index has been declining since its high in 2004:
Notice how prices paid are spiking higher at the same time activity has dropped sharply lower. Any stock market rally from here would be in anticipation of the end of the recession before it even officially begins (similar to the 2001 recession). But with much more significant problems facing us (housing market decline, credit collapse, etc.), an expectation of a short and shallow recession is probably wishful thinking. The last time activity slowed down this quickly was in 2001 but notice how prices paid came down with it. We've clearly got a different problem this time around and the Fed has less flexibility in fighting a slowing economy as compared to 2001.
Credit Crunch update
This spread (which is shown inverted so as to match up with the S&P 500) has been a good indicator of stock market direction. The fact that the Fed has been unable to reduce this spread with more money and lowered interest rates is very telling. The spread between the 3-month Eurodollar and the 3-month T-bill (the Ted Spread) has also been widening since the January low and is further proof of the market's reluctance to take on risk. Credit default swaps, used to protect corporate bonds from default, have widened as traders bet the credit-market losses will continue to increase. It says the market has lost its faith in the credit market and as long as that remains true there will likely be more trouble ahead for the stock market, although the market could get a relatively brief respite from the selling.
With the extra length to this weekend's report I'll limit my discussion of each chart and show what I consider the key points. The broader averages look very similar and therefore additional commentary on them is not really necessary.
2.1 S&P 500 Index (SPX)
SPX chart, Weekly
Since the February 1st high it appears as though we might have seen the completion of the 5th wave down for the decline from October 2007. This week's candle is a very bullish looking engulfing candle. So we could see a larger bounce into April/May (pink). An alternative is for another new low (dark red) before starting a larger correction of the decline. The H&S price objective is 1230 which would have price finding support near the June/July 2006 lows. The more bearish possibility (thin dark red line) is for a strong decline that takes the S%P 500 below 1100 within the next month. That possibility is shown a little more clearly on the daily chart:
SPX chart, Daily
The more bearish possibility from here (dark red) shows us to be on the verge of a strong breakdown in the market and from an EW (Elliott Wave) perspective I have to respect this possibility. You'll definitely want your long positions protected (or get out) if this scenario plays out. Otherwise, a drop to about 1225-1230 to meet some Fib, H&S and price level support (light green) could be the next move. The bulls need the rally to continue on Monday--a rally above Wednesday's 1342 high would be a higher high and a break of the downtrend line from December, both bullish. So the key levels are:
Key Levels for SPX:
The 60-min chart merely shows a little closer detail the important trend lines and price levels for traders:
SPX chart, 60-min
2.2 Dow Jones Industrial Average (DOW)
DOW chart, Daily
Same price pattern for the DOW as that shown for SPX. It's interesting how price has been oscillating about the longer uptrend lines from October 2002 and March 2003. I'm showing both trend lines because you can see how price is reacting around both of them.
Key Levels for DOW:
No additional comments necessary on the 60-min chart:
DOW chart, 60-min
2.3 Nasdaq-100 Index (NDX)
Nasdaq-100 (NDX) chart, Daily
The price pattern for the techs is a little different from the DOW and SPX. The downward sloping consolidation of price since the January low is either an ending pattern and will lead to an immediate rally (pink) or else it's a sideways/down correction of the decline from October (indicating a relatively weak sector) and is getting ready to let go to the downside (dark red). Bulls have some work to do to negate the bearish price pattern--they need to get this above 1865. One reason why I'm favoring the downside on this one is because of what I'm seeing in the semiconductors (shown after the NDX 60-min chart below).
Key Levels for NDX:
As shown on the 60-min chart, the key levels for at least a heads up for which way the market could be headed next are last Wednesday's and Thursday's high (1772) and low (1713):
Nasdaq-100 (NDX) chart, 60-min
The semiconductor stocks are typically a good proxy for where the tech stocks will be headed (which in turn is often a good proxy for the broader market):
Semiconductor Holder (SMH) chart, Daily
The tight price consolidation in a contracting triangle pattern is typically a continuation pattern and in this case that means to the downside. Notice how it has consolidated over to the top of the parallel down-channel and this is often a good setup for a short play and in this case it's for a downside objective of 23.38. I've got it labeled as a 4th wave correction and that would mean another leg down to complete the decline from July to then set up a larger rally into May/June. Not shown but a break above the February 1st 30.24 high would negate the triangle pattern and would be at least short term bullish.
2.4 Russell 2000 Index (RUT)
Russell-2000 (RUT) chart, Daily
The RUT has a very similar setup as the DOW and SPX.
Key Levels for RUT:
Russell-2000 (RUT) chart, 60-min
A break above Wednesday's 689.36 high would be bullish but especially if it breaks above 693 to get above the 62% retracement and its downtrend line from December.
3.0 Featured Industry Groups
Banks and brokers got a strong shot in the arm this past week. Many are calling for a bottom here and putting money where their mouths are. It's certainly possible we've put in some kind of bottom and I've been pointing out the past several weeks that short is not the place to be in either the banks or home builders as I saw by the price patterns and price objectives that the downside could be very limited. Short covering could wipe out months of gains for bears who hold on too long. The question now is whether we made the all-important low.
3.1 Banking Index (BIX), Daily chart
Thursday's rally had the banks poking their heads above the top of the parallel down-channel for price action since last year's high. From a price pattern perspective the important high to take out is the 274 high on February 27th. That would likely lead to a rally at least up to its 200-dma near 322. Otherwise a turn back down next week would probably mean a trip down to 200 or lower.
3.2 U.S. Home Construction Index (DJUSHB), Daily chart
The home builders have been mirroring the banking index and it's close to giving us a buy signal like the banks if it too can climb above its February 27th high near 400. There are a few possibilities playing out to the downside if it tips back over here but I'll continue to caution those who want to short either the banks or home builders--there may not be that much more downside even if it does head for new lows.
3.3 Transportation Index (TRAN), Daily chart
The Trannies need to rally above the February 26th high near 4827 to confirm we'll probably see a rally at least up to the Fib target at 5145 (and back up to its broken uptrend line from March 2003). Otherwise the choppy price action continues to support the bearish view that this will tip back over.
The Fed's actions this past week had many leaning the wrong way on commodities and currencies. Many thought a rate cut and more liquidity pumped into the market would both be inflationary and therefore hurt the US dollar and help commodities. With most commodities seeing in excess of 90% bulls and the dollar with only about 7% bulls it didn't take much to tip the boat over. Now the question is whether this past week's moves will hold or if it was instead just a knee-jerk reaction.
Looking at the monthly chart of the US dollar I'm showing how it dropped to the bottom of a parallel down-channel for price action since its 2005 high:
4.1 U.S. Dollar (DXY), Monthly chart
Many of you may have heard that the dollar could sink down to $68 before finding a meaningful bottom. I show a Fib projection at $67.88 where the 2nd leg down in its decline from 2002 would equal 62% of the 1st leg down so there's a reason for that speculation. That remains a good downside target if the dollar only manages a bounce, even if it's a bounce that lasts for a couple of months.
The small red down-channel is shown with the lighter blue lines on the daily chart:
4.1 U.S. Dollar (DXY), Daily chart
The dollar actually dropped marginally below its longer term down-channel and the bounce is currently back up to the bottom of the channel (often times resistance once price has broken below the bottom of a channel). The mid line of the shorter term down-channel from January 2007 is also where the bounce in the dollar stopped. Dollar bulls need to keep the buying going. If price consolidates instead (dark red) it would be bearish for another leg down.
5.1 Oil Fund and Index (USO and OIX)
As mentioned at the beginning of the report, commodities of all kinds dropped hard last week. This included oil:
Oil Fund (USO), Daily chart
The bullish price pattern requires USO stay above 79 otherwise the next support level will be the 50-dma at 76.77, 100-dma at 75.15 and then its uptrend line from August near 73 (about 92 for oil, May contract).
Oil Index (OIX), Daily chart
For the bears this price pattern leaves a lot to be desired as it appears to be a choppy pullback. That suggests another rally leg is coming. A rally above 865 would confirm it. Otherwise it could be set up for some strong selling that will take the index well below the January low.
5.2 Gold Fund (GLD
On Wednesday gold experienced its largest one-day decline in 28 years (which was after the parabolic rally up to its 1980 high). After hitting a high of 1033.90 Sunday night it had dropped as low as 904.70 by early Thursday morning (-12.5%) before closing at 920, down -8% from Friday, March 14.
GLD almost dropped down to the bottom of its parallel up-channel for price action since August 2007 and did drop back below the top of its longer term up-channel from 2005. A break below 88.63 (900.60 for gold, May contract) would confirm a top is in for gold. Then it will be a matter of figuring out how far it will drop down. For starters it would likely drop down near 80 (810 for gold, April contract), the apex of the previous triangle pattern (notice that it found support at the apex of its last triangle into February).
The monthly chart of the gold contract shows how price nearly tagged the trend line along the highs since 2001 and a Fib target at 1043.90:
Just as I showed the possibility for the US dollar to make it a little lower I see the possibility for gold (and other commodities) to push a little higher but ideally gold will not drop any further next week (or the dollar rally) in order for that short term bullish possibility to have much of a chance. As the monthly chart shows, the bearish price pattern shows gold should be putting in a major top and it will have a long way back down to correct the 7-year rally (BTW, 7 is an important number in the market). To all who poopoo a selloff in gold, read my commentary on commodities and the credit market--all asset classes will suffer.
5.3 Silver contract (SI)
While gold had a big drop this past week, silver did an even bigger number on its bulls. Its Sunday night high was 21.44 and Thursday's low was 16.72 for a -22% haircut. It closed at 16.85, down -18% from Friday, March 14. When these metals break down from a parabolic rally they do it with gusto.
Silver tagged the trend line along the highs since 2004 and immediately retreated, hard. The week's candle is a bearish engulfing candlestick at resistance so it looks like a strong reversal signal here. It's close to finding possible support at its uptrend line from August 2007, shown more clearly on its daily chart:
After jumping above the top of its parallel up-channel at the end of February, the pullback found support at the top of the channel (very common) but then the new high on Monday was met with bearish divergence and the double top was confirmed when price broke below the valley between the two peaks (19.28 on March 10th). The bulls still have a chance to drive this back up for one more new high (shown in green) but only if they can hold it above the November high at 16.27. A break below that would also be a break of its uptrend line from August 2007. Like gold, if the metals bounce watch for a retest of the broken uptrend line from December.
10-year Yield (TNX), Daily chart
The 10-year yield has been chopping its way lower (look at all the overlapping red and white candles since the beginning of March). This is typically indicative of an ending pattern so I continue to believe yields are getting ready to bounce. Rising yields means selling in bonds and that money could find its way into stocks. That's why the key levels on the stock charts are important--break those and we could see a good sized rally, especially if the bond market is selling off. Inflation fears may become greater and profit taking in the bond market could be the result.
7.0 Summary and Review of Credit Situation
The Fed did what they had to do on Monday and save Bear Stearns. While it's a bailout with public money (raising all kinds of moral hazard questions), having Bear declare bankruptcy on Monday, and thereby locking up the entire credit market, was simply not an option. They're clearly in the category "too big to fail". The Fed did the right thing here.
What the Fed is trying to do is control the deflation of assets now. They know the economy was leveraged up to its eyeballs the past decade and that it's now crashing down. They're trying to let the air out of the balloon slowly. That will be a very difficult task--when bubbles are pricked they don't squeak air out, they pop. The Fed is attempting to slow down a rapid deflation of the credit market which would be painful for all of us. The economy could end in a tailspin as the vicious circle of deflating assets starts more margin calls to cover loans which then causes more selling (including anything with value) which causes more deflation and then more ratings downgrades, more selling and more margin calls. A collapse of Bear Stearns could have accelerated that process to the nth degree. It was a stick save by the Fed. But how many more stick saves can they do? The offensive players are lining up and taking shots at the goal in rapid succession now.
The approval for Fannie Mae (FNM) and Freddie Mac (FRE) to free up capital was another effort to help the dying mortgage market. By allowing them to drop their reserve requirements they are allowed to leverage up their remaining capital to make more money available to the market. To me this is a desperate act. These companies are already leveraged 28 and 18 times, respectively, and we know this is exactly what has caused massive failures in hedge funds (including Bear Stearns) as the mortgage paper drops in value. Their capital base will simply not be enough to absorb the losses. This is probably where the public money will be "invested" next as the government is forced to bail out both FNM and FRE. And we're not talking chump change here.
Or next for the Fed's stick save attempt could be CIT Group, a company that provides capital for business loans. This is a 100-year old company (owned by Tyco for a short period in 2001) that offers financing to companies and now may need some rescuing itself. It has suffered greatly from the freeze-up in the credit markets. They have been unable to borrow money to pay off its commercial paper coming due this year. They tapped their entire $7.3B line of credit this week and if the credit markets remain frozen they will simply run out of cash and become insolvent, joining the growing list of firms in the same predicament. Their stock price reflects what has been happening:
This chart is all too familiar by now when looking at so many banks and lending institutions. Have we seen a bottom to this carnage? Grab for those falling knives with great care.
So how do we protect ourselves during this difficult time? Going to cash is of course an option (one I've been strongly recommending for a while now). If assets truly start depreciating then cash will do better. Inflationary problems may soon switch over to deflationary problems (which the Fed is clearly more worried about at the moment). But if you prefer to always be invested and not worry about market timing there are other ways to protect your portfolio. Options traders have several tactics they can employ. Here's one example from a reader (thanks John):
John says, "You know what totally baffles me? Even if you are a bull (and who doesnt want to look on the bright side -- I do) why wouldn't someone who has a portfolio of long positions take steps to protect those positions in case they are wrong? Putting on a "collar" is an easy and almost cost free way to do it. Let's say you bought AAPL at $100 and you were one of those lucky folks that rode it up to $200. Now you are a little nervous -- youve doubled your money and you don't want to give it all back. Heres what you do: one, buy front month 190 Puts. They will probably cost you about $3.00; two, since you are a little perturbed about having to spend $3.00 for "insurance" you decide to go out three months and sell the 230 Call. Chances are good that you will collect more than $3.00 for the Calls. Now your "insurance" is free (with maybe some left over).
"Take a look at what happens: Scenario #1, AAPL continues to climb to 225. No harm, no foul. Your stock has gained 25 points. Once you have passed 230 you are now into a "covered call" situation (so whats wrong with that, unless you are greedy and want all the gain with no risk). Scenario #2, AAPL rolls over and heads straight for the earth and drops to $120. Your long front-month puts are now worth $70 (you paid $3 for them). Your 230 short calls are almost worthless so you get to keep that too. You have lost $80 (-40%) of your stock value but your collar put $70 back in your pocket for a net loss of $10 (-5%) for what was a no-cost play."
Some food for thought. As for what we can expect next week, continue to be wary of the roller coaster market. The price pattern makes it very difficult to evaluate possible directional plays. This is a market for gunslingers who can trade intraday quickly. I continue to prefer trading with the trend (down) until we get a trend change but trading with the down trend hasn't exactly been easy the past two months. Stick with the key levels for now as far as identifying the next potential market direction for at least the next couple of weeks. Good luck and I'll be back with you next Wednesday. Live commentary is offered on the Market Monitor so join us there if you're trying to make sense of the wild daily swings.
Key Levels for SPX:
Key Levels for DOW:
Key Levels for NDX:
Key Levels for RUT: