Option Investor
Market Wrap

Flame Out

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Techs and small caps have been on a tear lately and the bulls have been burning bear butts all the way up. Even with the blue chip indexes up respectably today the RUT was smoking to the upside with the techs in close formation. But then like watching your bottle rocket as a kid peak out and roll over, so too did the RUT and NDX this afternoon. They didn't even deploy their chutes--straight into the ground and they buried themselves in little holes as they finished in the red.

If you look at the end-of-day numbers in the table above nothing looks too bad. In fact the numbers look good. The DOW finished up 66 points (the most widely reported index by mainstream media) and the S&P 500 finished up 5.62. The market breadth numbers were looking good for most of the day and the blue chips again held respectable numbers. But the RUT and NDX may have spoiled today's party with potentially key reversals. That's an early call and we'll need to see how tomorrow plays out but after a strong run higher, into some solid resistance levels that I'll review with you, they did not finish well.

Today started out strong after this morning's economic numbers and had equity futures in the green after spending a good portion of the pre-market in the red until 8:30 AM. The CPI numbers were deemed good (in that lower inflation numbers leaves the door open for further rate cuts from the Fed). Further rate cuts would of course be a sign that the Fed continues to worry about a slowing economy and a continuing credit crunch. A troubled economy would of course not be good for the stock market but don't confuse facts with emotion. This market is hyped up on hope (traders' version of dope, as in drugs, although come to think of it, the other definition of dope works too) and the choppy rally off the March low has been based on spoonfuls of hope, dished out every day by the likes of CNBC, Ben Bernanke and Hank Paulson. (However, Paul Volker has less cheery things to say about what might happen if the market loses confidence in the Fed).

The afternoon swoon set off some alarm signals so I'm leaning bearish against today's highs but I do see the possibility for another push higher before potentially stronger resistance is met. For one, the NDX would close its January 4th gap near 2052 and therefore to see the market work its way a little higher, with this afternoon's decline just part of the whipsaw price action, would not be all that surprising. It's clearly a time for both sides to be very cautious. Bears have been getting fricasseed with each new high looking like it could be the last, including today's. But bullish sentiment tells me the bears might finally be giving up and bulls are getting complacent. If this market has taught us nothing else it has taught us not to get complacent, no matter which side of the fence you like to play. As always, I'll review the setups and key levels to watch.

For those who are interested in US Treasury rates (perhaps buying a home or looking to refinance), the 10-year yield is a good one to watch. It's possible the bounce in treasury rates off the January low is complete as of today's rally. I'll review the chart of TNX at the end of this newsletter.

Before getting into my normal charts I wanted to take a quick look at some of the sentiment indicators since I believe they offer us appropriate warning signals (not trading signals, just warning). First is the VIX:

Volatility Index (VIX), Daily

The VIX dropped slightly below the bottom of its bullish descending wedge (confirmed with the bullish divergence on MACD), which could have been the throw-under finish, and almost tagged support near last October's low near 16. That low of course coincided with the stock market top. So we've got VIX down to the equivalent level as last October and yet price is not at the October highs. This is classic bullish complacency in a bounce that is correcting the decline from October. To me it only reinforces my belief that the next leg down in the larger decline will be accompanied with very strong selling as the hopeful bulls quickly shed their hope-filled stocks.

The bullish hammer at support for the VIX is a strong warning of a reversal in the making. If tomorrow sees a VIX "rally" it will confirm the reversal. A reversal in the VIX is of course bearish for stocks. But confirmation of an important bottom in the VIX (and potentially a top for the stock market) won't come until VIX rallies over 20.

Along with the VIX I like to watch the call/put ratio published by the International Securities Exchange. As I've mentioned previously, they do a better job than others in identifying the speculative plays which is a better indication of sentiment rather than cloud the picture with hedge plays, straddles, condors, etc.

ISEE Call/Put Index, Daily, courtesy ISE.com

Readings at or above 150 have typically been a warning that bullish enthusiasm, as measured in call buying, is reaching an extreme. Yesterday's number was 150. The previous highs just above 150 in the past month have not meant market highs but once again, we're seeing a lot of call buying while the market is barely making headway to the north. The speculative juices are flowing for an upside breakout and this chart tells me the bulls may not get their wish.

SPX chart, Daily

After stalling at the 50% retracement of the October-January decline at the beginning of the month, today's rally took SPX back up near that level (1423). The 200-dma continues to drop lower and is currently at 1428. So if the market can press a little higher be careful about resistance at 1423-1428. If it can clear that area it should be able to make it up to close its January 4th gap at 1447 which coincides with its broken uptrend line from October 2002 by next Monday. But today's daily candle is a bearish shooting star and I'll show why on the 60-min chart we should take that reversal pattern a little more seriously than I might otherwise when it's in the middle of a trading range.

Key Levels for SPX:
bullish above 1425
bearish below 1384

SPX chart, 120-min

I've got the move down from the high on May 2nd counted as the 1st wave down in a new decline. For those who follow EW (Elliott Wave) counts, that move down is a leading diagonal which are common in 1st waves and allow for overlap between the 1st and 4th waves of wave 1, normally a no-no). Following the low on May 9th (last Friday) is a 3-wave correction with equality between the two up-legs at 1417.82. I have the key level to the downside at 1384, the May 9th low, but a drop below Tuesday's low near 1396 would be a bearish signal. Therefore, I see upside potential to 1431-1447 unless it breaks below 1396 first. In that case I would want to be on the short side of the market.

So to keep it simple I would stick with the long side above 1418 (but be very careful of a fast reversal) and short below 1396. In the meantime I like a short against today's high.

DOW chart, Daily

For a few days at the beginning of the month it was looking like the DOW had a decent chance of plowing through a lot of resistance and making it above its 200-dma. It even pulled back and found support at the broken downtrend line from October. But last week I mentioned the high on May 2nd looked more like a throw-over finish above its rising wedge and until that level (13132) is broken I have maintained a bearish stance against that high. Today's rally may have capped off the bounce to correct the May 2-9 decline. It met resistance again at the broken uptrend lines from 2002/2003 and the top of its shallow up-channel from January and did not quite make it up to its 200-dma now at 13015.

Key Levels for DOW:
bullish above 13250
bearish below 12715, confirmed with a break below 12270

DOW chart, 120-min

Similar to SPX, the DOW has potentially completed a 3-wave bounce to correct the May 2-9 decline. It slightly exceeded the level (12971) where it had two equal legs up from May 9th. It rang the bell with a retest of the broken uptrend line along the lows since April 22nd. The next big move should be well below last Friday's low near 12715.

This is such a nice short play setup that my recommendation is to now be short the DOW against today's high. The important high for bears is the May 2nd high near 13132 but I think if today's high is exceeded so too will the May 2nd high be exceeded as it runs potentially up to 13250. A break below 12715 says short each bounce thereafter.

Nasdaq-100 (NDX) chart, Daily

NDX had a nice bullish day going again today until the sellers hit it this afternoon. It managed to rally marginally above its 62% retracement of the October-March decline (2021) and tag the top of its parallel up-channel from March. The daily candle is a bearish shooting star and a down day on Thursday will confirm the reversal pattern. But if the bulls manage to turn this back around, look for a run up to 2052 to close the January 4th gap. I've been wondering if that gap is way too obvious and may never get reached.

Key Levels for NDX:
cautiously bullish above 2052
bearish below 1946, confirmed with a break below 1867

Nasdaq-100 (NDX) chart, 120-min

Today's rally took NDX up to its broken uptrend line from April 15th through the April 30th low, and just shy of the top of its parallel up-channel from March. Support will be at its uptrend line through the May 9th low, currently just under 1989, and then the mid line of its up-channel which has provided support since April 22nd. That level is currently near 1973. If those levels give way we should see the key level at 1946 quickly tested. But if the bulls can push this back up it should be able to make it up to the 2040 area if not close the January 4th gap near 2052.

As with the others, I like a short against today's high. Watch for confirmation with a break of the above mentioned support levels. I consider any push back to new highs too risky to trade the long side, at least until it can rally above, and hold above, 2052.

Russell-2000 (RUT) chart, Daily

The RUT has been very strong since last Friday's low. But one look at this daily chart and it's a screaming short play to me. The RUT came within pennies of closing its January 4th gap at 745.01. Way too many traders sold too early on that. Today's high shows a brief throw-over above the rising wedge pattern and then dropped back inside (sell signal). The daily candle is a gravestone doji (more bearish version of the shooting star) against resistance--the day's gains were completely given back. The new highs since early April have bearish divergence. And when I tie all this in with what I'm seeing on the VIX and ISEE charts, well, let's just say this one is being handed to bears on a silver platter. Will it work? I have no idea what the rest of the week will bring but I'll take a setup like this one every day of the week until the cows come home.

This is a classic short play setup--short against today's high. Just be smart and don't go overboard and by all means use proper account management and stops.

Key Levels for RUT:
bullish above 745
bearish below 714

BIX banking index, Daily chart

Following the drop from the beginning of the month the BIX has essentially gone sideways. This looks like a correction before proceeding lower. Short against 266.

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

The drop from early April has been followed by a big sideways choppy mess. I interpret the mess as consolidation before proceeding lower. Short against the May 7th high near 390. If it manages to press higher I'd watch for resistance near 425-435.

Oil chart, Oil Fund (USO), Daily

The daily candles on this chart, at resistance, have me thinking a topping formation rather than consolidation before proceeding higher. Oscillators are rolling over from overbought. It might finally be time for the oil bulls to take a breather. The bigger question in my mind is whether we'll see a choppy/sideways kind of pullback before pressing higher again (green) or if we'll see something much more bearish. I'll have to wait and see what kind of decline we get (assuming of course we'll get one).

Oil Index chart, Daily

Oil stocks have been hugging the underside of the uptrend line from August 2007 but the bearish divergences at the new price highs tell me it's about to let go. Whether it freefalls or chops gently lower before pressing higher is the question, like for oil. But look for at least a pullback in this index.

Transportation Index chart, TRAN, Daily

The Transports have been struggling since the beginning of May at the top of its parallel up-channel from January. So it could fail at any time. But I see the potential for a continuation higher to 5600 and up to the top of its steeper up-channel from March. That's also the bullish price objective from an inverse H&S pattern with the neckline as the downtrend line from last October. If the Trannies rally without the DOW following then it will be another warning sign so keep an eye on this index.

U.S. Dollar chart, Daily

I still can't quite figure out the next likely direction for the US dollar. It achieved two equal legs up in its bounce off the March low and remains stuck at the top of its parallel down-channel from January 2007. A trip down to 70 could be next if the dollar hasn't yet found a bottom. But the price action since the May high does not look bearish and that has me thinking it could be consolidating and getting ready to finally break its downtrend line. That would likely be followed by a move up to the $75 area. A break of either the May low (72.73) or high (73.90) should set the next direction for at least a couple of weeks. Gold has me thinking the dollar will rally.

Gold chart, Gold Fund (GLD), Daily

Gold remains in its downtrend since the March high and I see no reason to feel bullish about the shiny metal. I know, such blasphemy. Gold bulls have many sound arguments as to why gold should continue rallying strongly. My email inbox is filled every day with recommendations to buy this newsletter or that one and get rich buying gold, especially as a hedge against financial Armageddon and a continuation of the loss in the US dollar.

In my opinion, the biggest negative factor for gold, that many gold bulls are not considering, is the ongoing credit crunch. Easy money made investing in just about everything, gold included, too easy. A credit crunch will significantly drain the system of money and it will require the sale of assets to pay for losses (primarily by those institutions heavily invested in dubious paper). Winning investments will be sold and commodities like gold will get hit. At least that's the theory. But theory aside, gold is in a downtrend and that's the way I recommend trading it until it reverses.

As I mentioned at the beginning of tonight's newsletter, I see the potential for a reversal in yields and thought a heads up is warranted for those who might be affected by a drop in rates (not that it will necessarily find its way into lower mortgage or other loan rates).

10-year yield (TNX), Daily

Bullishly, TNX broke its downtrend line from June 2007 and then used it as support in the pullbacks this month. But the bounce off the January low has achieved two equal legs up at 39.67 (3.967%) and the recent highs are showing bearish divergence. Today's candle is a hanging man doji at Fib resistance. Therefore, the risk is for a reversal from here and head back down.

A couple of reasons would cause a drop in yields. One is a lessening threat of inflation. In my opinion it won't be long before the dreaded 'D' word (depression) gets bandied about and that is of course just the opposite of inflation. I believe that is our biggest risk heading forward as the continuing collapse of the credit market deflates all assets. We're clearly seeing that happening in the housing market. A deflating housing market has never meant good things for our economy. And it's not just U.S. homeowners suffering this problem. Housing problems in many European countries are starting to dwarf what we've seen so far in this country.

My only recommendation at this point is to simply think about your own financial situation and have some contingency plans in case things get worse for our economy and the stock market. If by some magic we're able to dodge the consequences of the past decade's excesses then you will simply have spent time preparing for something that never comes. But if you're prepared and know what you will do with your various financial accounts, your job, and insurance (be sure to have policies with sound companies) then you won't be blindsided.

I don't mean to be all doom and gloom and I hesitate to even mention any of this but I think it's important to think about the possibility that the current bounce off the January/March lows is merely a setup for a lot of disappointment in those who firmly believe the worst is behind us. It's not and to think otherwise is simply Pollyannaish. There are serious financial structural problems that have not gone away. The Fed has been able to paint over the cobwebs but they're still there and in plain sight. Just be prepared for the bearish possibility, that's all.

Economic reports, summary and Key Trading Levels

Tomorrow's economic reports will not likely move the market much. The Industrial Production report could spook traders if it comes in a lot worse than expected (which is for it to be slightly negative for April). But I don't think we'll see any big moves pre-market.

For the past couple of years at least we've seen a lot of volatility in the market starting the Thursday prior to opex week, and that day has often been the head fake day--whichever way that Thursday went you could often bet on opex finishing strongly in the opposite direction. I think because so many have figured that pattern out that it's becoming less common.

But opex activity does seem to start on the previous Thursday and Friday and then taper off significantly by Thursday and Friday of opex week. So a relatively slow day tomorrow would not be a surprise. Friday's of opex tend to be a real snoozer as most of the opex position squaring has already been accomplished. And of course European settlement, such as for SPX options, is Friday morning so those indices no longer have an influence on the market.

Countering the expectation of a slow day on Thursday is the potential setup for a down day. It could be accompanied by some hard selling especially if some hedging starts kicking in to protect the remaining open long positions such as sold puts (a favorite of institutions). Either buying the puts to close them or selling stock to hedge them creates additional selling pressure. So stay on your toes as things could get interesting. We've been in such a choppy environment for the past two months (since January actually) and as traders we only care about a trend we can grab onto and stick with it for more than a day. If that's to the downside next, so be it--trade it but remember bear market rallies are bear killers. Take profits too soon is the mantra in a bear market.

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

Key Levels for SPX:
bullish above 1425
bearish below 1384

Key Levels for DOW:
bullish above 13250
bearish below 12715, confirmed with a break below 12270

Key Levels for NDX:
cautiously bullish above 2052
bearish below 1946, confirmed with a break below 1867

Key Levels for RUT:
bullish above 745
bearish below 714

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