Option Investor
Market Wrap

Another Bottom Call

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Overview--Today's Numbers


1.0 Markets at a Glance--The Worst Is Priced In, Maybe


2.0 Hop Topic--No Fear in the Market
A look at the VIX and what it might mean.

3.0 Economic Reports


4.0 Equities

4.1 S&P 500 Index (SPX)
4.2 Dow Jones Industrial Average (INDU)
4.3 Nasdaq-100 Index (NDX)
4.4 Russell 2000 Index (RUT)

5.0 Featured Industry Groups

5.1 Banking Index (BIX)
5.2 U.S. Home Construction Index (DJUSHB)
5.3 Transportation Index chart (TRAN)

6.0 Currencies

6.1 U.S. Dollar (DXY)

7.0 Commodities

7.1 Oil Fund and Index (USO and OIX)
7.2 Gold Fund (GLD)

8.0 Summary and Key Trading Levels


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1.0 Overview--Today's Numbers



1.0 Markets at a Glance--The Worst Is Priced In, Maybe

Jim Cramer says the bottom is in and we should buy. Of course he said we should buy Bear Stearns right up into the week it took a dump and then after removing his buy signal from his website on Sunday evening he reversed himself on Monday when BSC was valued at $2. Then he said he only meant you're safe keeping your savings in BSC. If anyone is the poster child of lying TV pundits, he's it (and I don't call many of them liars).

At any rate, there are many calling for a major bottom now that we've successfully retested the January low. Some top-notch analysts who I greatly admire are calling for the same thing so I don't discount the possibility that they're right. Let's just say I'm from Missouri on this one (the show-me state). Many feel the worst news is already priced in now and that it can't get any worse. There is enough evidence with today's price pattern to suggest that we may have seen the high for the bounce off the March low. If true then the only question in my mind is whether we get just a pullback before proceeding higher or instead head back down toward the March lows.

Not long ago I talked about the slippery slope of hope and how bear markets cut people to tiny little pieces through all the bear market rallies that they buy into and then take a loss (hopefully not big ones). Hope is what drives people back into the market, hoping to catch a bottom. We've all heard that the biggest gains in a new bull market are made in the initial movement off the lows. Therefore there are many people who try to catch that bottom in hopes it's the real deal. Bear market rallies are wonders to behold and eventually one of them will catch fire and really light up the charts.

So the question, after Tuesday's one-day wonder rally (again), is whether we've started something more significant to the upside or is it instead just a we-hope-it's-a-bottom rally that will soon fizzle like the others have over the past couple of months.

Trading the market from a fundamental perspective is difficult because the market reacts primarily to human emotion which can have very little to do with fundamentals. In fact many fundamentals change over time because of the change in social mood which affects businesses over time. But the market is constantly trying to look ahead and read the tea leaves from a fundamental perspective. That's another thing that drives these bear market rallies (which I'm considering the current rally to be until some key upside levels start breaking).

When participants believe the worst of the news is out, or close to being out, they'll start doing some buying in hopes the market can't go down much more. But when you think of the very difficult problems we're facing it's hard to imagine the worst of the news is already out there. Each quarter we hear large banks say they believe the current write-down will be their last one (because they're sure the market will finally come to its senses and recognize their mark-to-model prices as THE correct prices) and hope takes over and people start buying.



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The other large albatross around this market's neck is the continuing saga of the housing market. It boggles my mind to think there are many market pundits who believe we've seen the worst in the housing market. The problems we're facing in the housing sector are still in the early innings. Between a huge increase in mortgage resets, massive inventory spikes (from overbuilding and now a huge increase in foreclosures) and a problem that is spreading to solid mortgage holders, it's very difficult for me to fathom how we could be close to a bottom in the housing market. I'll show a couple of charts with the home builders chart later that will graphically show why I think we've got some pain ahead of us.

And as home values continue to drop (which will likely be the case for at least another year or two) it will continue to be a depressant to the average consumer. The consumer is already starting to cut back on spending and focus a little more on debt reduction and savings increases. These are good things for our country in the long run (our Federal government should give it a try) but it will hurt the economy in the short run as a slowdown in consumer spending brings the economy to its knees. This will depress the stock market (globally, not just the U.S.).

We will certainly get some strong rallies from time to time (we were very oversold and due a relief rally) but they are opportunities to lighten up on your long positions and try a couple of short positions (even with some reverse ETFs which essentially short the market). Thinking we've made a major low, and "stocking" up on that expectation could be hazardous to your financial health.

2.0 Hop Topic--No Fear in the Market

The VIX has been a good chart to watch over time as it has given some very good buy and sell signals at market highs and lows. You can use your normal technical indicators on the VIX just like you would on any other chart. As you can see from the daily chart below, it has dropped back down to its 200-dma:

VIX chart, Daily



If the VIX drops a little lower it will tag its uptrend line from June 2007, currently near 21.30. Today's low was 22.39 and the 200-dma is currently at 22.82. By the way, that uptrend line (in fact the up-channel) is telling us that the worry level of the market has increased over the historically low levels last summer as the stock market was peaking. This is all very normal and to be expected. If we're truly in a bear market, as I believe we are (monthly chart of SPX later will update why I think that) we will see the average level of the VIX climb and be at historically high levels once the bear market finishes. It also means the volatile swings in the market will continue to increase.

The oscillators for the VIX are down into oversold as it's hitting potential support so if this were a stock I'd be looking to buy it here. A bounce in the VIX is of course bearish for stocks. What's interesting is to look at the buy and sell signals from the VIX since last summer. Here's a chart of the SPX matched up with VIX (I'll review the SPX chart in the equities section):

SPX vs. VIX chart, Daily



The vertical lines show the correlation between the stock market peaks and VIX bottoms and vice versa. The last three times the VIX tested its 200-dma (in October, December and almost in February) it marked highs for the stock market. So here we are again with the VIX landing on the 200-dma and as I'll show on the equity charts, there's a real good chance we're seeing a high for the stock market again. The question is whether it will lead to just a pullback within its trading zone or something more. More on that later.

3.0 Economic Reports



Today's economic reports contained no real surprises and did not move the market much. The market gave up its small gains this afternoon, well after any impact from the economic reports or Bernanke's testimony this morning.

Tomorrow's reports also will not likely be market moving. The ISM Services number is not normally as important to the market as the manufacturing number.

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4.0 Equities

4.1 S&P 500 Index (SPX)


The stock market has been able to bounce off the March lows and rally back up to the top of its trading range, as I've been depicting for a couple of weeks. Now the question is whether the rally will continue or turn around and head back down to the bottom of its trading range. Starting off with the monthly view of the S&P 500 I wanted to show price action since the early 1990s in reference to its 18-month moving average. It's a moving average that has identified itself as important in identifying major trends (cycles) for the market, i.e., whether we're in a bull or bear market:

SPX chart, Monthly



When we've been in a bull market you can see pullbacks found support at the moving average (except for a spike down in late 1998 as a reaction to the LTCM debacle and the last big Fed intervention, er I mean, save. Then the 2000-2002 bear market showed the 18-month average to be resistance during bear market rallies. Then it flipped around again in 2003 and the average became support. Now we've entered a bear market again (SPX dropped below the average in January) so the expectation, until proven otherwise, is that it will become resistance if and when tagged (it's obviously not precise in its resistance and support level). Currently the 18-month moving average is at 1400, not much above today's 1378 high. Based on past experience around this average, the setup is for a short play.

SPX chart, Daily



Price remains ugly and by that I mean the price pattern has been very choppy since the January low. This makes for several possibilities, from an EW (Elliott Wave) perspective because it's corrective price action. I show a couple of possibilities but the bottom line is this--corrective price action means it's a correction to the October-January (or March) decline and not the start of a new bull market. The price pattern says we're still in a bear market decline and the monthly chart says we're in a bear market. Therefore, any rally to resistance should be shorted.

As for what pattern we could be in, the sideways triangle pattern is still my number one choice at the moment (dark red, playing out into May) and that means we'll stay trapped in the trading range we've been in since the January low. It also means today's high could have been it for the bounce off the March low. It takes a push above 1396 to negate the sideways triangle pattern and be potentially bullish. Of course then we'd have to deal with that pesky 18-month moving average at 1400, the 50% retracement of the October-January decline at 1416 and the downtrend line from October near 1420. Needless to say it won't be easy sailing for the bulls even if they're able to press this higher.

Key Levels for SPX:
- cautiously bullish above 1380 (target 1416)
- cautiously bearish below 1312 (target 1275)

SPX chart, 60-min



The bounce off the March low has taken on a rising wedge look although I'm not seeing bearish divergence to confirm it. The short term pattern supports the idea that we'll get one more minor push higher (shown in pink) and topping out possibly as high as 1388. It's why I say cautiously bullish above 1380 because frankly I don't particularly like the upside--too many things for the bulls to stumble over. It takes a break below 1312 to say we've got a top in place for now.

4.2 Dow Jones Industrial Average (DOW)

DOW chart, Daily



Same pattern for the DOW as shown for SPX. The top of the sideways triangle pattern and the 100-dma could be tough resistance for the bulls. A push above 12768, the February 1st high, should have the DOW heading for 13K. Otherwise a break below 12166 would say we've seen the high and look for a move back down to the March low.

Key Levels for DOW:
- cautiously bullish above 12768 (target 13000)
- cautiously bearish below 12166 (target 11770)

DOW chart, 60-min



The DOW stopped just short of a Fib projection cluster located at 12700-12714 (and the top of its sideways triangle pattern). Like SPX, the short term price pattern supports the idea that we'll get one more push to a minor new high (target that Fib zone mentioned above) before it's ready to roll back over. But I believe the risk is now on the long side of the market.

4.3 Nasdaq-100 Index (NDX)

Nasdaq-100 (NDX) chart, Daily



NDX continues to be in a slightly different price pattern than the DOW and SPX. The rally off the March low looks just as choppy and corrective but it has the potential to move a little higher as part of an a-b-c bounce off the January low. It has achieved its first Fib projection at 1839 so it could turn around from here but if the bulls can keep this alive then there is upside potential to 1945 (Fib projection and downtrend line from October).

Key Levels for NDX:
- cautiously bullish above 1832 (target 1945 by mid April)
- cautiously bearish below 1762 (target 1611 by mid April)

Nasdaq-100 (NDX) chart, 60-min



Similar to SPX, the rally off the March low is forming a potential bearish rising wedge but so far is lacking bearish divergence for confirmation of the pattern. Therefore it's possible we'll get a pullback followed by another push higher (green). If we get a minor new high tomorrow, watch for potential failure of the rally around 1890 (top trend line).

4.4 Russell 2000 Index (RUT)

Russell-2000 (RUT) chart, Daily



Like the others, the rally off the March low looks very choppy and suggests it's part of a larger consolidation pattern. But for now the only question is how high the current bounce could get. Two equal legs up from the January low is at 724.52 and only slightly higher is the 100-dma and downtrend line from October. That's why a rally above 731 would be bullish but until then the bulls have their work cut out for themselves. A break below 681, the pullback low on March 28th, would indicate at least a larger pullback is in progress.

Key Levels for RUT:
- bullish above 731
- bearish below 643

Russell-2000 (RUT) chart, 60-min



If we get a little more rally out of this tomorrow watch for potential resistance just under 723. Any rally tomorrow followed by a decline below today's low would indicate a top is in for now (this is true for the other indices as well).

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5.0 Featured Industry Groups

5.1 Banking Index (BIX), Daily chart




It takes a rally above 275 to point to the probability that the banks are in a larger bounce from the March lows. Until that happens the price pattern suggests we have not seen the bottom yet for the banks. However, as I've been saying since the January low, we could be close to putting in an important low and I continue to like the 200-212 area for important support. I'm just not sure yet whether we'll see a more prolonged choppy decline inside a descending wedge as depicted on the chart.

5.2 U.S. Home Construction Index (DJUSHB)

I had mentioned at the beginning of the newsletter that the bottom feeders are out in force right now calling for an end to the bear market and a time to buy. This ignores some very basic and fundamental problems with both the bank (including big hedge funds) and housing sectors. We have a huge unresolved issue with housing and it's not going to go away because we wish it to. And as long as the housing sector is experiencing problems, along with credit problems expanding into other areas, we will probably have a very difficult time in the stock market.

One chart that caught my eye was a long term sales chart, showing sales of new and existing homes since the early 1970s:

New and Existing Home Sales, Monthly, 1973-2007



The pink trend line is the average number of sales over this period. Whenever you see a chart like this that exceeds a standard deviation, especially two standard deviations, from the average you should understand that very rarely does it simply correct to the average and then carry on from there. Very likely we're going to see this swing to the downside and well below the average line, similar to what was seen in the late 1970s/early 1980s.

There's a lot of hope right now that we'll see a much improved housing market this summer (similar to expectations last year, which were dashed and the housing market fell hard) and I suspect there will again be much disappointment. One causal factor this year, that was only beginning to be felt last year, is the number of homes coming onto the market through foreclosure. The following chart of mortgage resets is not encouraging in this regard (chart courtesy T2 Partners):

Adjustable Mortgages Scheduled for Reset



Since the summer of last year you can see the spike up in mortgage resets. It takes about 6-12 months from the time a homeowner starts to miss payments until the house goes into foreclosure. We just starting to see the effect of the initial blast higher in mortgage resets and the number of homes now coming onto the market due to the inability of homeowners to absorb the higher payments. From now until the end probably mid 2009 we will see a huge spike in foreclosures and those homes will only flood an already saturated market.

The spike in foreclosure is one of the reasons many are forecasting a large drop in housing prices yet to come. This can't be good for consumer's pocket books let alone sentiment. And that of course translates into a rough road for the stock market. Does it make me a bear to think this way? Call me what you will. I prefer to think of myself as having a realistic view of the chances for the stock market and I don't think they're very good. Combine this with many of the technical signals from the charts and I will continue to recommend shorting the rallies until I see evidence of a turnaround coming.

But a bearish opinion of the market does not prevent me from seeing short term bullish possibilities and that's what I've been trying to show, especially since the March lows. Even the home builders look like they could bounce further, or at least the potential is there.

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



The price pattern looks more like a corrective rally off the November and January lows and as shown with the parallel up-channel for the bounce, I'm thinking it's a bear flag pattern. Whether the index can make it up to the top of the flag, currently near a couple of Fib projections just under 470, is the question. Today's candle is a bearish shooting star so a red day tomorrow could complete the reversal pattern. From an EW (Elliott Wave) perspective, the wave pattern looks complete here for a completion of the bounce and therefore could turn lower from here (dark red).

U.S. Home Construction Index (DJUSHB), Monthly



I'm showing the monthly chart to show its decline in perspective and to show why it could rally as high as about 580 if the market in general rallies into May/June. The broken H&S neckline crosses the downtrend line from 2005 in June near 580. This is also where the top of the parallel up-channel for the bounce off the January low crosses (it doesn't look parallel on the chart with the log scale used). So that's the upside potential if the index can climb above 500 but there's a lot of work to be done to even get there.

5.3 Transportation Index (TRAN), Daily chart



The pattern of the bounce in the Trannies off the March low is just as ugly (choppy and overlapping highs and lows) as the other indices but that hasn't prevented the bulls from pushing the index higher. This is another area of hope--hope that the shippers will soon see relief from high oil prices and an uptick in shipping volume. I see upside potential to a Fib projection at 5147 (for two equal legs up from January) which coincides with the broken uptrend line from March 2003 early next week.

I consider this one of the better short play setups I've seen in a while. There's no guarantee of course that it will stop there (or that the Trannies will even get there) but I really like the setup. There are a couple of ways you could play the short side: one, find the weaker transport stocks within the index (use a relative strength chart of the stock vs. the index and find the weakest one) and short it; or two, you could play put options on IYT, the iShares ETF.

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6.0 Currencies

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




I haven't seen anything yet to negate my thought that the dollar is going to consolidate for a bit before another leg down (which could ver well be its last before setting up a stronger rally into the end of the year). It needs to rally above 75.43 to negate further downside expectations.

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7.0 Commodities

7.1 Oil Fund and Index (USO and OIX)


Oil Fund (USO), Daily chart



Like the US dollar, we could see oil consolidate for another few weeks before pressing higher again (dark red). The sideways triangle would actually be a good pattern to set up a final rally leg (the sideways triangle typically leads to the last leg up, or down, within a 5-wave move). In this case it would be an end to the rally from January 2007 and set up a longer term decline from there. A drop through 79.40 would negate the triangle setup and then it would be time to watch the uptrend line from August, currently approaching 75.

Oil Index (OIX), Daily chart



If oil consolidate then the oil stocks might consolidate before pressing higher as well. It would help explain the choppy price pattern we've been seeing. The key levels of 865 to the upside and 760 to the downside could indicate a break in that direction but I don't have high confidence yet in either scenario.

7.2 Gold Fund (GLD), Daily chart



While the dollar and oil appear to be consolidating, gold is breaking down. Today's bounce brought it almost back up for a possible kiss goodbye retest of its broken uptrend line from August (just above 90). A continuation lower from here could have it testing 80 in a hurry. But if it does drop lower, keep an eye on 83.45 for possible support (two equal legs down from the March high). A break back above 94 is needed to tell us it's at least consolidating if not heading directly higher.

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8.0 Summary and Key Trading Levels

The price pattern of the bounce off the March lows leaves me feeling bearish about it. It looks more like part of a larger correction of the October-January decline and could be part of a larger sideways consolidation that will take us into May. If true it will be marked with a continuation of the choppy whipsaw price action that we've been seeing. The volatility would probably start to taper off as we near the end of the pattern, and that low volatility is what typically leads to an explosive move out of it. Right now, if that plays out, I think the odds are for an explosive move to the downside.

Obviously we've got time to evaluate that potential over the next many weeks. In the meantime there is some additional upside potential but I consider it risky now to be chasing the long side of the market. Strong resistance levels are just overhead. I'd be comfortable looking for shorting opportunities now so if you prefer not to play the short side then cash is a great place to be.

As anyone who has been trying the short side can attest, it's not an easy game. Even if you're right on direction you have to stomach large rallies that spike a lot of short players out of their position and then watch from the sidelines as the market tucks tail and turns sharply back to the downside. How do I know of this frustration? Been there, doing that.

Of course the bulls are not having any easier time of it. This afternoon's rally and quick turn back down was just another example. New longs are covering just as quickly as shorts. It's what's causing so much of the volatility--there's no conviction on either side and it's part of what makes a corrective consolidation pattern. In this case, I think once the bulls recognize the market is just not going to rally (and that could take several more weeks), that's when they'll step aside and the shorts start will start piling in again. The lack of an up-tick rule only exacerbates the selling once the hedgies pile on.

I've said it before and it's still true--this is a market for credit spreaders (at least since January) as the market marks time and option premium dies on the vine. The risk in my opinion remains more for bull put credit spreads but we've all seen how the market can get carried away to the upside as well. This remains a market for gunslingers who can trade intraday (and watch the market carefully). I have a trader friend who last week entered a couple of orders for a day trade before leaving for the day and came back to a very nasty surprise. Most of his year's profits went up in smoke. Babysit your trades, trade lighter than usual, take partial profits quickly and pull in your stops on your remaining position and by all means be happy with chunks out of the middle of a move. Very few are nailing tops and bottoms and getting the whole run. A large percentage of traders aren't even winning at all.

This will change but not yet so trade carefully and good luck. I'll be back next Wednesday.

Key Levels for SPX:
- cautiously bullish above 1380 (target 1416)
- cautiously bearish below 1312 (target 1275)

Key Levels for DOW:
- cautiously bullish above 12768 (target 13000)
- cautiously bearish below 12166 (target 11770)

Key Levels for NDX:
- cautiously bullish above 1832 (target 1945 by mid April)
- cautiously bearish below 1762 (target 1611 by mid April)

Key Levels for RUT:
- bullish above 731
- bearish below 643
 

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