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How Crude

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Crude oil got the blame today for the big selloff in the stock market. It was as if a light bulb went off and there was suddenly great concern about high oil prices. The market has been rallying almost every day that oil has been making new highs but today the market suddenly paid attention? OK, if the pundits say so. It certainly is an easy one to blame for a market selloff.

Oil had spiked down this morning on the crude inventory report showed inventory gains but then traders decided it was just a short term blip and that there really is a shortage and the speculation on higher prices continued, driving oil to another all-time high. As I'll review in the oil chart, it's just possible we're seeing a major top being put in right now. Or at least a top that will lead to a larger pullback before proceeding higher for one last fling to the upside.

Today's economic reports had very little impact on the markets. The productivity report out this morning showed a stronger improvement in the productivity numbers while labor costs dropped so that's good for businesses. But the good feelings didn't last as the market started selling off shortly after a quick pop up at the open (equity futures were already depressed though). Then home sales numbers for March showed a -1% decline but that was expected and it was a slight improvement to February's.

This afternoon we got the Consumer Credit numbers and they show the consumer digging deeper into debt--$15.3B deeper as compared to +$6.5B in February and more than twice what was expected. When people are paying mortgages with their credit cards you know this is not going to end well. The good news though is that the growth in consumer debt has slowed down some from last year (e.g., November was +$25B).

The following chart is from a report that Linda forwarded to me from John P. Hussman, Ph.D., and an article he wrote on May 5th, providing his market analysis. Sorry the chart is hard to read but I had to squish it to fit this document:

Household Debt as a % of GDP

The chart runs from 1952 to the end of 2007. Other than the flat period from 1965 to about 1985, consumers have been increasing their use of credit and particularly so since 1985. It now stands at 102% of GDP. The 55-year mean is 55%. This is a graphic representation of how much the consumer has supported the economy through borrowed spending (like our government) and how difficult things could become for our economy if one, the consumer can't afford to take on more debt and two, if the consumer starts defaulting on current debt.

Dr. Hussman provided an interesting analysis on the stock market that I thought was worth quoting (the full article can be found at this link):

"Well, having declined nearly 20% from its peak, the S&P 500 has recovered about half of its loss in a period of several weeks, taking the index within about 10% of the all-time high it registered in the mid-1500 range a few quarters ago, with the Dow Industrials down even less. Transportation stocks, in particular, have enjoyed a scorching rally in recent weeks, bettering their prior bull market highs. Despite the fact that our most reliable recession indicators registered a clear warning late last year pointing to an oncoming economic downturn, the unemployment rate stands only about a half-percent above its lows and remains modest on a historical basis. The option volatility index has declined significantly, while credit spreads and advisory bullishness are on the mend. All of this suggests that market participants believe the worst is over, thanks largely to the actions of the Federal Reserve. For our part, the Strategic Growth Fund has achieved positive returns since the market's peak. Still, the Fund has not participated in the recent advance, and remains a few percent below its all-time high, but we are willing to take a more constructive position if market internals improve.

But enough about January 2001."

The last line is obviously the key point. Some things don't change much in this market. Dr. Hussman then went on to compare the decline into January 2001 and the subsequent bounce and how it got so many people thinking the bottom was in and that happy days were here again. The market proceeded to significantly disappoint the bulls from there with some volatile swings in 2001-2002 before doubling its loss into the October 2002 low. As he said in his article, we're not doomed to repeat the past but the analogy holds. The market's rally off the January and March 2007 lows is based on hope that the worst is behind us but these assurances are coming from the likes of Hank Paulson, Treasury Secretary, who also told us the subprime problem would be small and contained.

We haven't even begun to see the unraveling of the credit problem yet and the jobs numbers are actually much worse than currently being reported (they're inflated by the birth-death model that the Bureau of Labor uses which are wrong at major economic turns). We have never avoided a recession when the economy sheds jobs and yet there are many who are declaring the recession is already over before it's officially started.

The housing contraction, slowdown in consumer spending and massive credit inflation that needs to be deflated are all going to make the recession last longer and potentially deeper, than the hope-filled bulls would like to believe. I'll show some charts of the housing sector below and you'll see it doesn't paint a pretty picture. But those are some fundamental reasons I believe the bounce off this year's lows will not hold up.

From a technical perspective the price pattern of the bounce is also indicative of a correction and not the start of a new bull market. Waning momentum and bearish divergences are appearing and it says bulls need to be cautious now. If you like playing the short side I believe your opportunity is quickly approaching. Right now, for me, it's a matter of figuring out where the bounce could end and the next leg down begins. After today's decline it's possible we've seen the high.

Starting with the 30,000 foot view of the market, the monthly chart of the SPX is one I've shown before when I pointed out the importance of the 18-month moving average:

SPX chart, Monthly

When I last showed this chart I mentioned the 18-month moving average has done a good job over the years showing when we're in a bull and bear market. The MA has dropped to 1402 and is being tested last week and this week. Once the MA has been broken, up or down, it's common for it to be testing several times before the major trend continues. In this case I'm looking for a continuation of the down trend.

SPX chart, Weekly

There a couple of things that I'm watching on the weekly chart. The broken neckline of last year's H&S topping pattern is currently near 1430. On the daily chart below note that the 200-dma is also at 1430. The 50-week moving average is at 1442. On the daily chart the broken uptrend line from October 2002 is near 1443. Therefore, if the market pushes a little higher, keep an eye on SPX 1430 and then 1442-1443 for a possible high.

I've drawn the downtrend line on the weekly chart from October through this week's high in order to create a parallel down-channel and show where the next leg down could head to. Assuming for now that we've seen the high, two equal legs down from October (to the January low) is just under 1117 which crosses the bottom of the channel in August. The potential is for a faster decline and to much lower levels so use this only as a guide to what the next leg down (assuming of course we get another leg down) could do.

SPX chart, Daily

We didn't get a new high today for SPX so today's candle is not exactly a bullish engulfing candle but it's close. Therefore it could be considered an outside down day (which is what we've got on the Trannies). Price closed back below the downtrend line from October. If the decline continues tomorrow, watch for support at the May 1st low near 1383 which is also where the uptrend line from March is currently located.

Key Levels for SPX:
- bullish above 1442
- bearish below 1369

SPX chart, 120-min

A little closer view shows SPX closing back below the February 1st high near 1396 and its downtrend line from October. I have a key level to the downside at 1380 because we could be in the final move of a larger a-b-c pullback from the May 2nd high and the leg down Fibs out to 1380. A break below 1380 would also be a break of the uptrend line from March and therefore makes that level doubly important. The a-b-c pullback interpretation would mean another leg up in its rally (shown in pink) which is when I'd be looking to see how it does around 1430 and then 1441-1443.

Based on the pattern of the decline I'm thinking we'll see a bounce tomorrow that will set up a short play. The broken uptrend line from April 15th is near 1409 which would also be a 62% retracement of the decline from Tuesday's high. If the market rallies tomorrow morning, watch to see if price stalls up there.

DOW chart, Weekly

The DOW's weekly chart shows price tagged the 50-week moving average and has now pulled back and closed back below the uptrend line from October 2002 (using LOG scale on this chart). Notice the very long term uptrend line from 1974 which is where the January and March lows found support. This is obviously an important trend line and will be very important to watch if we get another pullback. Assuming we've peaked in the A-B-C bounce off the January low, another leg down that matches the October-January decline would have the DOW dropping down to 10569 and that crosses the bottom of a parallel down-channel at the end of August. I show this only for planning purposes in case you'd like to try a longer term short position (such as LEAP puts). As noted on the chart that level is also near the 2006 lows. A break of this level could usher in much stronger selling. But we've got lots of time to evaluate that possibility should the market start back down.

DOW chart, Daily

The DOW dropped back down to its broken downtrend line from October. Therefore if you're feeling bullish about the market this is an ideal spot to try a long. Resistance turned support is the idea for the play. A little lower is potential support at the uptrend line from March, currently near 12740. If the DOW pushes back up and gets past last week's high near 13133 then I suspect we'll see 13500 area next.

Key Levels for DOW:
- bullish above 13133
- bearish below 12740, confirmed with a break below 12270

DOW chart, 120-min

Not discussed on the SPX 120-min chart but it's the same on the DOW's chart--the bearish divergences at the new price highs since April 18th has been a warning that the new highs were probably not going to hold. But the bears need to get the DOW below 12740 before they can start dancing. In the meantime, this choppy market that's been full of whipsaws says be careful assuming anything. We could just as easily see another run for the roses to a new high for the move up from March.

If we get a bounce tomorrow watch for resistance at the broken uptrend line along the lows since April 22nd, currently near 12910.

Nasdaq-100 (NDX) chart, Daily

The techs have been in a stronger-looking pattern and the pullback today hasn't damaged its chart at all (other than the nasty looking bearish candle from resistance just under 2000). The Fib projections for the move up from March lined up from 1994 to 1999 and that's where price failed. A little higher, if it can get another rally leg, is the 62% retracement at 2021. But at this point, while the chart doesn't look all that bearish, it has met its requirements for an A-B-C bounce off the March low. Therefore it's a good setup for the short side.

Key Levels for NDX:
- cautiously bullish above 2000
- bearish below 1913, confirmed with a break below 1867

Nasdaq-100 (NDX) chart, 120-min

NDX broke down from the rising wedge pattern for the rally from April 15th so that looks bearish. You can also see more clearly the Fib projections just under 2000 where the rally stopped. The new highs were showing bearish divergences. But notice where price found support today--at the mid line of its parallel up-channel from March, the same line that supported the pullbacks since April 22nd. A push back above 2000 should have NDX testing the 2021 level (62% retracement of the October-March decline). Otherwise I'm looking for a bounce to get short.

Russell-2000 (RUT) chart, Daily

The RUT struggled with the February 1st high near 732 for the past week. It's also the level where the 2nd leg up for the bounce off he March low was equal to 62% of the 1st leg up. It broke below the uptrend line from March so that's bearish but it found support at its broken downtrend line from October so that's potentially bullish. I'd look for a bounce to short but if it manages another rally leg then upside potential is to its 200-dma at 750 and then 761.64 for two equal legs up from March (I have my doubts about that one).

Key Levels for RUT:
- bullish above 736
- bearish below 697

Russell-2000 (RUT) chart, 120-min

Watch for a bounce tomorrow to see if it does a retest of its broken uptrend line from March, perhaps around 721. If it recaptures its uptrend line be very cautious about the short side. As explained for the others, the 3-wave pullback from May 2nd may have completed the correction to the rally and we'll see another rally leg get started.

BIX banking index, Daily chart

The banking index almost made it out of the descending wedge pattern. Hope is alive and well in this sector as people attempt to pick a bottom. Nothing has changed and I expect this index to work its way lower over the next several months.

Brokers (XBD), Daily chart

I like to show the brokers every now and then because they will often be leaders in a new bull market so I've been watching how they do against the downtrend line from October. Right now I'd say the brokers will remain inside their down-channel and head for new lows. I've got a Fib target just under 103 which could get hit in June if it plays out as I've depicted. If it instead manages to push a little higher, watch for resistance at its downtrend line from June 2007, currently near 205.

U.S. Home Construction Index chart, DJUSHB, Daily

The little sideways choppy consolidation over the past few weeks suggests lower prices. It looks like a little bear flag. So the next big move in the home builders should be to the downside and I continue to like the 216 area for a final (maybe) low. If it manages to push a little higher first then it should be able to rally up to the top of its rising wedge pattern, currently near 430 (and perhaps a little throw-over finish), before heading back down again.

To get a sense of how strong the housing bubble had become, the following chart shows the long term uptrend (1975-2000) for home prices and how far above the trend line prices had skyrocketed into the 2007 peak:

Home Price Index

These longer term trend lines tend to be mean reverting. That means when prices move above or below the trend line they tend to overshoot in the other direction to get back to the longer-term trend. But just to get back to the trend line home prices need to drop -34%. If we're going to see a drop below the line, which would be typical, then the drop in home prices will likely be more like the 40%-50% that many housing experts are talking about. This chart is not current so I have the Case-Shiller Index showing prices since 1987:

Case-Shiller Index, 1987-2008

The first chart above has the index at 100 in 1975 but Case-Shiller have 100 at January 2000 so the two charts are a little different. But if we take the Composite-20 (third line from the top at the right side of the chart) and figure 34% off its high near 170 we get 112. It's currently at about 145 or "only" about -15% off its high so far. Therefore I think it's safe to assume we've got some more pain ahead for home prices.

Oil chart, Oil Fund (USO), Daily

Oil rallied again today and has many continuing to scratch their heads in wonderment. There's very little fundamentally driving oil higher right now but as in most commodity rallies, the end of the rally goes longer and higher than expected. But as I show on the chart for USO, I think this is as good a place as any for oil to top out and reverse back down. The Fib projection at 98.62 has been achieved and price pressed up to the top of its uptrend line from last year and the trend line along the highs since March, both crossing where price hit today.

It can certainly continue to rally but the bearish divergence against the April high helps confirm the wave count that calls the leg up from May 1st as the 5th wave for the rally off the low at the end of March. That says at a minimum we should get a pullback to correct that leg up and more bearishly we're finishing the longer-term rally and will start a much larger decline.

*** I like the setup here for a short play but obviously I'm attempting to pick a top and we know how dangerous that can be. If we get a pullback tomorrow just use today's high as your stop level.

Oil Index chart, Daily

The oil stocks have a similar setup as oil but in this case it looks like stocks could be a day ahead of the commodity. I like a short on this index with a stop at yesterday's high. Whether we get just a pullback or something more can't be known yet but I like the odds for a deeper pullback.

Transportation Index chart, TRAN, Daily

The Transports are flashing a warning sign after today's bearish engulfing candlestick (outside down day). So far the index has found support at its March 2003 uptrend line that it recovered five days ago. If it closes back below this trend line it will look like a head fake move (bull trap).

But if today's decline finished an a-b-c pullback from May 2nd then we should get another push higher in which case I would look for a move to the top of its parallel up-channel from March, currently near 5550. A Fib projection for the 3-wave bounce off the January low is also up near there (wave-c = 162% of wave-a) and makes for a good upside target.

U.S. Dollar chart, Daily

The US dollar has managed to rally up to the Fib projection at 73.687 where the bounce off the March low has two equal legs up. The high on May 2nd was 73.698. It's also at the top of a parallel down-channel from last year's highs. Therefore it's possible we'll now see the dollar start back down to a new (and I believe final) low. It needs to get above 75.40, the early-January low to negate that possibility and indicate we've already seen the low for the dollar.

Gold chart, Gold Fund (GLD), Daily

The US dollar has had a 3-wave bounce and so far gold has had a 3-wave pullback. I am bearish gold and therefore have to be bullish the dollar so obviously I'm watching both carefully for signals here. If GLD pushes above 89 and breaks its downtrend line from March then I suspect the dollar will be heading for a new low. But until that happens I'm thinking GLD will work its way down to 79 and potentially lower to its uptrend line from July 2005, near 74.

Economic reports, summary and Key Trading Levels

There is nothing in tomorrow's economic report schedule that is expected to move the market (Friday either). It will be left on its own to fret about the price of oil and the potential impact on inflation.

If oil does start to pullback more significantly tomorrow then one could make the argument that it will make the stock market feel better and it will rally. But I think the stock market is not paying much attention to oil. It's a handy excuse or reason for why the market does what it does when the pundits can't figure out anything else to say.

It's a tough call for tomorrow and Friday. My first reaction is that today's decline, being impulsive as it was, was the sign of a trend change and based on that I will be looking for a bounce tomorrow to short. I provided some levels to watch for potential short entries. But because of the possibility that today's impulsive decline was the end of a 3-wave pullback from the May 2nd high, I suggest not getting stubborn about shorting the market. Try it, keep your stops tight and if the market keeps rallying against you then switch sides. Anything more than a 62% retracement of the decline from Tuesday's high would have me thinking new highs are coming.

If we get another rally leg started I'll be watching SPX which I think has some better upside targets to watch than the DOW. SPX 1430 and then 1441-1443 are the upside levels to watch. NDX 2021 is another level I'd watch. But be careful if playing the long side--trade it now and be ready to bail. The signals from the charts tell me we're close to topping out for either a pullback or something much more bearish. Protect profits in any long positions and you can always get back in. It doesn't make much sense to let the market move against you if you can take some money off the table. Even a retest of the March lows, which many are looking for, would be giving up a lot of gains. If the March lows don't hold, and I don't think they will, then it could get very painful for stubborn bulls.

This market is not rewarding stubbornness. Those who are making money are those who are regularly taking profits off the table. It can be frustrating watching the market continue without you when you've removed yourself from a trade but we all know it's a lot more frustrating giving your profits back. And of course never ever let a profit turn into a loss. Bad trading discipline if you let that happen.

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

Key Levels for SPX:
- bullish above 1442
- bearish below 1369

Key Levels for DOW:
- bullish above 13133
- bearish below 12740, confirmed with a break below 12270

Key Levels for NDX:
- cautiously bullish above 2000
- bearish below 1913, confirmed with a break below 1867

Key Levels for RUT:
- bullish above 736
- bearish below 697
 

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