Option Investor
Market Wrap

The Longer Term View

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Before getting to today's action and since I'm filling in for Jeff tonight I thought I'd take the opportunity to review something a little different. I want to take a look at the longer term view of the stock market (and I mean longer term view--since 1870, yes that's an '8') and in so doing take a look at the difference between using log scale vs. arithmetic scale for price. Typically when you look at a long term chart you want to use the log scale because it shows a more accurate depiction of percentage price change rather than a straight dollar change. This is especially important if you're looking at an index or stock with a large price change during that period.

Because of the additional charts tonight I will not be reviewing my normal slew of charts but instead will get back to those in my Wednesday newsletter. I will cover the four broader market indices to show what I'm looking for this week. I will also take a look at the oil stock index (OIX) since I had recommended a short play last week and it got busted.

Using the S&P 500 I want to review what has happened over the long term and what it might mean for us now and for the next many years to come. In addition to the different price scales I'll review price patterns using prices adjusted for inflation (constant dollars) and compare the same chart with unadjusted prices (nominal dollars). First, in case you missed it in the weekend newsletter, Linda did a great job in identifying the potential longer term risk in the market if we enter another period similar to the 1970s where the market basically went flat but experienced some wild swings (100% increases followed by 50% declines). Here's the chart that she showed of the S&P 500 for 1965-1985:

SPX chart, 1965-1985

As Linda had commented, the period following the high in late 1968 was one of fairly violent price swings. Each rally high in early 1973 and late 1981 were higher than the previous highs but the steep drops between those highs surely tested the staying power of even the strongest "buy-and-holder". Very likely there were many people who got sucked in the new highs and then bailed at the lows, rinse and repeat. Knowing when to be in the market and when to be in cash (or bonds) was a key to longer term investment success during this period.

Now take a look at that period to see how it fits in the much larger picture of the stock market since 1870:

SPX chart, 1870-2008, Nominal dollars, Arithmetic scale

Obviously the large (supersize really) rally from 1982 dwarfs price action in the 110 years prior to 1980. The 1929 stock market crash was a tiny little blip in the history of the stock market and yet by 1932 it had given up 90% of its value. I highlighted the price action between 1968 and 1982 to show the generally sideways to up consolidation during that period. Many would say that by investing for the longer term it was better to just keep investing since "the market is always up in any 10-year period". I guess one could say that when looking at the market in nominal dollar terms (unadjusted for inflation).

But what happens when we adjust the SPX value to compensate for the depreciated value of the dollar (which is what happens in inflation)? The following chart should be a bit of an eye opener:

SPX chart, 1870-2008, Constant dollars, Arithmetic scale

I'm still using the arithmetic scale on this but you can see the period between 1870 and 1970 looks quite a bit different when viewed in constant dollars. The parabolic rally into the 1929 high and subsequent crash certainly looks a lot more ominous. And now look at the period between the 1968 high and 1982 low. Instead of a sideway/up consolidation buy-and-holders actually lost a good chunk of change by holding on during this period thanks to high inflation. The correction into 1982 was about as painful as the 1929 crash and yet most people have no clue it was that bad a period for investors. If they kept investing because the market always turns back up, they were throwing good money after bad for many years.

The price high last year, in constant dollars, was actually quite a bit lower than the 2000 high (vs. a higher high in nominal dollars). This is true for the DOW as well--there really was no new all-time high last year. This is one of the reasons why I believe a new secular bear market started in 2000 and the 2002-2007 rally was a cyclical bull market that was a correction to the 2000-2002 decline. Do you see how the parabolic rally into 1929 was completely retraced? Could the same thing happen to the parabolic rally into the 2000 high? Scary thought.

Now look at the chart above using the logarithmic scale:

SPX chart, 1870-2008, Constant dollars, Log scale

This is where it gets interesting because you can now use some of your favorite technical tools on the chart such as trend lines and channels. On the arithmetic scale you'd be hard pressed to make use of trend lines because of the parabolic rally. Whenever you see a move that's gone parabolic you should immediately use a log scale.

The red trend lines show a parallel up-channel from the 1929 low and SPX rallied briefly above the top of the channel from 1998 to the 2000 high. After dropping back into the channel (a sell signal) price rallied back up to the top of it last year and has since pulled back.

The blue dotted trend line from the 1929 high across the 1968 high is where price found support at the October 2002 low. The blue dotted uptrend line from 1982 through the 2002 low is where price found support last month.

I've slapped some Elliott Wave labels on the chart because I think it tells us what will happen over the next decade or two. Price chopped sideways in a big triangle pattern after the 1929 high and that fits very well as a 4th wave correction in the much longer term rally that started centuries ago (using the London stock exchange figures). Once it finished, at the 1950 low, we need to see a 5-wave move up to finish the larger degree 5th wave up from 1950. The 2000 high should have been the end of the 3rd wave of wave 5 and we're now in the 4th wave correction of the 5th wave.


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That all sounds a bit confusing to non-Elliotticians but I've shown on the chart at the top right what we might see over the next several years. First possibility is another smaller sideways triangle that becomes a fractal pattern of the larger triangle following the 1929 high. Between the small downtrend line from 2000 and the trend line along the highs from 1929 (where SPX bounced in 2002) I've drawn a path for price showing up and down price action into 2016-2018 (about the typical time for a secular bear market to run) before the next rally leg into the 2020s.

I've also shown a bear flag with the two small blue downtrend lines, off the 2000 high and 2002 low. This calls for another steep decline below the 2002 low and could finish by 2010-2011. From an EW perspective the pullback would have to stay above the 1968 high (since a 4th wave correction cannot overlap the 1st wave high by EW rules).

The bottom line out of all this is that the very long term price pattern calls for much more pain for bulls and buy-and-holders. Holding long through the next few years could be very painful, especially if inflation takes an even bigger bite out of your portfolio value.

This next chart is the same one as above but I've included the Consumer Price Index on the chart (which price has been corrected to in order to give us constant dollars):

SPX chart and Consumer Price Index, 1870-2008, Constant dollars, Log scale

If I had moved the CPI line up a little you can see that the stock market basically matches inflation. So the good news is that the stock market is a good hedge against inflation (vs. keeping your money under the mattress). What's interesting about this chart is that each time the stock market drove much higher than the CPI (showing an excessive return vs. the value of the dollar) it got yanked back down towards where CPI says it belongs. It happened after 1929 and again after 1968. If SPX does drop down to the bottom of the bear flag pattern it might coincide with the CPI at that time.

The above charts were created in an Excel spreadsheet with prices adjusted for inflation. The next charts are from QCharts which obviously are nominal values. Looking at a weekly chart shows price action from last year and I'll first look at it with the arithmetic price scale:

SPX chart, Weekly, Arithmetic scale

I've drawn horizontal lines at the January low and February high and so far SPX has rallied back up the February high and stalled. Just a bit higher is the downtrend line from October (near 1410) and then the broken H&S neckline near 1430 and then the broken uptrend line from October 2002 near 1440 (the 200-dma is currently near 1439). So that provides some upside potential if the bulls can keep the bounce alive. After the current bounce completes, which is very corrective looking (choppy with overlapping highs and lows within the bounce off the March low), I expect to see price turn back down towards the January/March lows if not much lower.

But notice where the broken uptrend line from October 2002 goes to when we use the log scale:

SPX chart, Weekly, Log scale

This time it shows that the price dips last year were finding support at this uptrend line. And if we were to rally strong into the summer there's a good chance a retest of the broken uptrend line would coincide with another test of last year's (and the 2000) high. This is of course in nominal dollars and with inflation ticking higher over the past year we know that the dollar is worth less over time.

Moving in a little closer with the daily chart it focuses just on price action since January:

SPX chart, Daily

The sideways price consolidation since the January low and February high is quite apparent here and while price has a little more upside potential to the downtrend line from October, the market is now overbought (RSI) and MACD is showing some bearish divergence against the April 7th high. Whether SPX turns back down from here or a little higher first, the risk has moved over to the long side. Button up your stops.

Key Levels for SPX:
- bullish above 1415
- bearish below 1324

DOW chart, Daily, Arithmetic scale

The DOW's consolidation pattern is a slight up slope since January and looks a little more like a bear flag. The DOW tagged the price projection at 12864 on Friday for two equal legs up from the January low and the downtrend line from October. Today's candle can be interpreted as a hammer doji at resistance. Price also did a small throw-over above the top of a rising wedge pattern for the bounce off the March low. Oscillators are overbought and MACD is showing bearish divergence.

This is a setup for price failure right here but there is slightly more bullish potential to the top of its bear flag pattern near 12950 and even up to its 200-dma at 13087. If SPX manages to rally up to the 1415 area we'll surely see the DOW get up to its 200-dma. Any higher than 13100 would look more bullish. It takes a drop below 12270 to turn the price pattern bearish.

Here's another example of using the log scale when looking at a long term uptrend line, such as the ones from October 2002 and March 2003 that are noted on the above chart. Since January it looks like price is oscillating around those trend lines. Using the log scale you can see the trend lines are clearly resistance:

DOW chart, Daily, Log scale

Since breaking in January the DOW has not been able to recapture them on a closing basis except for one day on February 1st. This chart shows the DOW is not only meeting resistance at its downtrend line from October but also the broken uptrend line from October 2002. Looks pretty good for a short play setup don't you think?

Key Levels for DOW:
- bullish above 13100
- bearish below 12270

Nasdaq (COMP) chart, Daily

The techs led the way higher today and have a little room to grow still. The downtrend line from October is currently near 1934 so almost 20 points higher. The oscillators present the same picture as the others and urge caution if you're long, especially as the market approaches or is at resistance.

I won't show it but guess where the uptrend line from October 2002 is located if you use the Log scale--yep, exactly where price closed today. And what's interesting about today is that the strongest index today showed the weakest market breadth when measured by new 52-week highs vs. new lows, which were 61 to 106. The other indexes (NYSE and AMEX) showed more new highs than new lows today.

Key Levels for NDX:
- cautiously bullish above 1886
- bearish below 1777

Whereas the DOW shows a slight up slope to its consolidation pattern since January (and SPX is flat), the RUT shows a slight down slope:

Russell-2000 (RUT) chart, Daily

The top of the flag pattern was tagged on Friday and came within a point of tagging the price projection at 724.52 for two equal legs up from the January low. It did hit its 38% retracement of the October-March decline at 723.03. So from a Fib and channel perspective it looks like the RUT could be prepared to reverse back down. The oscillators show the same picture as the others. If it manages to push higher there is the 50% retracement and top of a parallel up-channel from March located near 750. A break below 685 would likely mean at least a trip back down to the March low near 643, potentially much lower.

Key Levels for RUT:
- bullish above 725
- bearish below 685

Because I was pounding the table last Wednesday on what I saw as a very good short play setup on the oil stocks (OIX) I wanted to give an update today (since it rallied further and hit my recommended stop level).

Oil Index chart, Daily

OIX had rallied up to its broken uptrend line from August 2007 and had a good EW pattern identifying a complete 5-wave rally from the March low. I liked the setup for a short play and called out one with a stop at 910 (nice and tight since I felt it had to work right away or get out of the way). But the oil stocks weren't ready to roll over and it could have something to do with the continuation of the rally in oil (which looks terminal by the way, especially since it's not being confirmed by the precious metals).

Speaking of precious metals, I'll update the gold chart on Wednesday but a weak dollar and strong euro is not helping the precious metals right now. I'll have more on this but I think it's due to traders anticipating a high in the euro and a low for the US dollar, which I agree with. That's another signal in my book that the current push higher in oil is probably its last gasp.

Back to OIX, I identified some better Fib projections for the rally (for which I kicked myself later since it offered a better setup) and I still like the opportunity to short this index. Once again if you look at the chart using the log scale you will see that the February high stopped just short of the broken uptrend line from August 2007 which is currently just under 930 so there's a little more upside potential by that trend line.

But today price tagged a Fib projection at 913 where the 5th wave of the move up from March equaled the 1st wave and then within the 5th wave it tagged the projection at 921.45 where its 5th wave equaled the 1st wave. Therefore the setup once again looks good for a short play with a stop just above 930. If you're long the oil stocks, just continue to trail your stop higher since once this breaks down it could go quickly.

Economic reports, summary and Key Trading Levels

As you can see in the above table, there will be very little this week in the way of economic reports. Earnings reports, of which there are many, will be more of a short term influence over the market, especially as everyone waits anxiously to see if the majority will beat or miss this week. Beating their numbers or not is of course just a game. Last week GOOG hammered the shorts with a surprise "beat". What most traders are not remembering is that GOOG really only met their previous number before lowering expectations coming into this earnings season. Their business is still down from their previous growth rate. Earnings is a game of smoke and mirrors so be careful about any short term reaction to them.

The bottom line is that earnings expectations are being ratcheted down and will continue to drop as the recession kicks into gear. Consumer spending is going more and more towards essentials (gas and food) and many businesses will suffer a consumer-led recession this time around. The "increase" in retail sales at places like Wal-Mart are thanks to their gas and food sales.

Texas Instruments (TXN) announced earnings after the bell and reported a rise in profits but they are lowering expectations for the future. That of course lowers the 'E' part of P/E and makes it harder to support the current value of the stock. Their stock price got hit in after hours and was down about 80 cents to 29.80 in late afternoon trading. This could be the story we hear from many other companies. Will GE be the only one out there with bad news? Stay tuned.

The volatility index (VIX) is flashing a warning sign at us so it behooves us to pay attention here:

Volatility Index (VIX) chart, Daily

As noted on the chart, but a little hard to see with the squished chart, Friday's candle was a hammer on support at its uptrend line from December 2006. If the VIX drops below Friday's 19.21 low then it will clearly be bullish for equities. But any bounce in the VIX, especially back above its broken uptrend line from June 2007 near 21.70, would be a confirmed reversal signal off a low VIX reading and what's bullish for VIX is bearish for equities. So watch this one carefully over the next few days.

Considering the number of charts showing prices up against potential resistance I think the upside is the risky side right now. I see the possibility for SPX to make a final fling up to the 1415 area (which would be a great setup for a short entry) but it might not get there. Negative divergences are showing up on the shorter term charts and this warns us that the buying strength is losing momentum. This is perhaps a result of short covering that is ending and not enough new longs are entering the market. Traders are waiting to see if resistance breaks or not. If resistance holds then I suspect a lot more shorts will enter the market.

Therefore if you're in long positions it would be wise to tighten up your stops. We could stay trapped in a large sideways consolidation well into the early summer but there is the possibility that we're finishing the correction to the decline from last October. In that case much lower could be in store for us. If you like playing the short side I would be researching short candidates here and now and start nibbling.

Good luck and I'll be back with you on Wednesday.

Key Levels for SPX:
- bullish above 1415
- bearish below 1324

Key Levels for DOW:
- bullish above 13100
- bearish below 12270

Key Levels for NDX:
- cautiously bullish above 1886
- bearish below 1777

Key Levels for RUT:
- bullish above 725
- bearish below 685

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