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Market Wrap

The Fed Takes Away the Punchbowl

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While the crude inventory report this morning (10:00 AM) spiked crude prices, and helped fan inflation fears which helped gold, there were no major economic reports, or reports otherwise, to move the market. This morning's decline in the blue chips was not being matched by a decline in the small caps (RUT) and that kept me from thinking much about the decline. I was thinking just another choppy day ahead. Then the Fed minutes released this afternoon basically told the market "what you see is what you've got".

The Fed was forced to sharply boost its inflation outlook, raising it to 3.1%-3.4%, up from their previous forecast of 2.1%-2.4%. That's nearly a 50% increase and no small adjustment. The rate reduction at the last meeting was a "close call" and most agreed it would be the last. What? No more rate cuts? Sell Mortimer, sell!!

It's not as if the rate cuts have helped but it's all about psychology and hope and the market wanted more of that good stuff that inflates bubbles. Rate cuts certainly have not translated into much lower rates between banks (such as the LIBOR), or mortgages, or many other loans for that matter. Those rates are more a factor of liquidity, or lack thereof, than the Fed funds rate. The credit crisis still smolders...

So the market had their little hissy fit today and the big question now is whether they will get over it and continue buying anyway or whether it will change the psychology of the market enough to tip it back over. I want to jump right into tonight's charts because there's a lot to cover. I believe this has been a pivotal week and the market is speaking to us loud and clear.

I'm going to look at the different time frames for the SPX to show why it's a good idea to keep checking multiple time frames as you watch for what the market is doing. Starting with the monthly chart, let's review how it's behaving around the 18-month moving average.

SPX chart, Monthly

I've shown this chart a few times and suggested the 18-month moving average is one of the easiest ways for us to determine whether or not we're in a bear market. Forget what you hear on CNBC or the multitude of organizations that track data showing whether we're in a recession (which is always reflected with a bear market). Just listen to the charts. The closing price for the month is the important price and we've still got six trading days remaining in May so anything can happen.

But so far the rally above the 18-month moving average, which is at 1402, has not held. In fact if the monthly candle were to close around this level it will leave a bearish shooting star at resistance (it will be even more bearish if it closes lower than the month's opening price--it will have a red body). That reversal signal is not confirmed until a red candle follows (meaning a down June) but this candlestick pattern is a big warning right now about a potential reversal. In combination with an inability to close above the 18-month moving average, it's a signal to get very defensive against another leg down in the bear market.

On the monthly chart it looks like a near perfect tap on the broken uptrend line from October 2002 (a nearly picture-perfect kiss goodbye so far) but the daily chart shows the rally did not quite make it up to that broken uptrend line:

SPX chart, Daily

Monday's high stopped just short of resistance marked by the broken uptrend line from October 2002 near 1448 and it did not quite close its gap from January 4th at 1447.16. Clearly there were too many anxious bears who saw that resistance level and jumped in early (along with nervous longs wanting to take profits before that resistance level was hit). Monday's daily candle was a shooting star (or more bearish gravestone doji) and then Tuesday's red candle confirmed the reversal signal. Whether it will only be a short term reversal followed by another new high (pink) or a longer term reversal remains to be seen. A break below 1384 that stays below would confirmation that we're going to see a stronger decline.

Key Levels for SPX:
- bullish above 1460
- bearish below 1384

Looking at the daily chart one wonders why SPX stopped where it did (other than traders jumping in, or out, before resistance), just shy of the broken uptrend line from October 2002 and gap closure. The weekly chart shows one reason--the broken H&S neckline from last year:

SPX chart, Weekly

The H&S neckline runs from March 2007 through the November 2007 low. It was broken on the drop in January. What was support is often tested as resistance and that's exactly what happened. Also, the 50-week moving average is at 1438. SPX managed to rally two points above that average. The combination of the H&S neckline and 50-week moving average proved too difficult for the bulls to charge through.

The 120-min chart shows a little closer possible support at the broken downtrend line from October 2007:

SPX chart, 120-min

The broken downtrend line from October 2007 happens to be at 1384, the same level as the previous low on May 9th. I would be surprised if buyers do not step in there. Assuming we'll see a bounce it's a question how high the bounce will get. Perhaps a rally back up to 1423 to tag the 200-dma and broken uptrend line from March by early next week. Or maybe something less and finish before Friday. Or maybe even back up to a new high. We can't know what's next so I'll be watching, and reporting on the live Market Monitor, for evidence of how corrective the bounce becomes (or impulsive) to try to determine where it could top out. If there's no bounce off support at 1384 then it could get ugly to the downside.

DOW chart, Weekly

The DOW's weekly chart shows price struggled with both its broken uptrend line from October 2002 and again its 50-week moving average. Weekly oscillators have begun to roll back over. It's hard to feel bullish when looking at this chart.

DOW chart, Daily

I've been showing the DOW's daily chart the past few weeks with the log price scale because it showed the uptrend lines from 2002/2003 having an influence on price action (the January, February, April and May highs were bumping into this trend line. Now that price has dropped down I'm using the arithmetic price scale because that lowers the trend lines and I want to watch to see how price reacts around them. They're currently at 12410 and 12480 and as depicted on the chart I'm showing that they'll be support (we'll have to wait and see).

The double top at the May 2nd and 19 highs was confirmed a top by today's drop below the valley between the tops--the May 9th low near 12715. On a bounce watch for possible resistance now at that 12715 level.

Key Levels for DOW:
- bullish above 13325
- bearish below 12715, confirmed with a break below 12270

DOW chart, 120-min

A closer look at the DOW shows the clear break below both the May 9th low near 12715 and is back below the broken downtrend line from October. After a break of a downtrend line the bulls never want to see price back below that downtrend line. That's an indication of a failure to break out so it will be important to watch price behavior around this downtrend line. A reversal right back above it on Thursday could mean no harm no foul. Another daily close below it would be bearish. A rally back above 12860 would mean there's a good chance for at least a rally back up to the broken uptrend line from March, perhaps up near 13K by the time it gets there in a couple of days.

Nasdaq-100 (NDX) chart, Daily

I'm sticking with the log price scale for NDX because it has the uptrend line from October 2002 in close proximity for support. NDX found support today at its 200-dma (1957.55), closing only marginally below it. The October 2002 uptrend line is near 1940 and just below that is its uptrend line from March near 1930. I would be surprised if the techs dropped much further than that tomorrow but if they do then look for the next level of support near 1886 which is the 38% retracement of the October-March decline. This also coincides with the broken downtrend line from October which is currently near 1900. It takes a rally above Monday's high near 2151 (came within a point of closing the January 4th gap) to suggest a move up to at least 2100.


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It is often helpful to use trend lines on oscillators and I show two of them on RSI. Notice the break of the shelf of support on RSI that has held pullbacks since April 22nd and the break of the uptrend line from March (before price has broken its uptrend line)--this is a sell signal. You will often see RSI break its trend line before price and that gives you your heads up for what's about to happen to price.

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

Nasdaq-100 (NDX) chart, 120-min

Right now the decline from Monday looks like a 3-wave move (albeit a sharp 3-wave decline). If we get a small consolidation followed by another low, which would create a 5-wave move down, we would then have confirmation of a trend change. It's possible the decline will be finishing a larger A-B-C correction from the high on May 2nd but that's a bit of a stretch for an EW interpretation (one I would try to use if I wanted to throw in some bullish bias). But any strong rally back above 2000 would suggest the 3-wave pullback is just a correction to the rally and look for higher highs. Today's decline was the first break below the mid line of its parallel up-channel since it climbed above it on April 18th.

The semiconductors gave us a heads up on Monday that not all was well with the rally--they quit early (10:00 AM high on Monday) and traders started taking their tech marbles home while the blue chips kept rallying (1:00 PM high). I was posting on the Market Monitor on Monday to pull your stops up tight if you were long and to start looking for a short entry. The semis continue to point to a top in place:

Semiconductor Holders (SMH) chart, Daily

SHM tagged its 50% retracement of the July-January decline (at 33.98) and then left a bearish shooting star on Monday. Tuesday's gap down and red candle confirmed the reversal signal. Today it closed back below its 200-dma and back under the top of a parallel upu-channel for its bounce off the January low. The price pattern of this bounce is clearly corrective and fits well as an a-b-c correction to the decline from last year. I expect this sector to easily break the January low. But it found support today at its 38% retracement (32.22) so watch for a bounce to correct this week's decline. Whether that bounce turns into one more attempt at a high (perhaps tagging its broken uptrend line from October 2002 near 34.75) or just a correction of this week's decline is the question.

Russell-2000 (RUT) chart, Daily

The RUT has also broken its uptrend line from March and by that measure it signals the leg up from March is finished. I have it counted as an A-B-C bounce that corrected the October-March decline and retraced almost precisely 50% of that decline. It also managed to close its January 4th gap on Monday, something the SPX and NDX were not quite able to do. In fact the RUT was looking downright strong the past two days, holding up better and not declining as much as the blue chips. By the end of the day it was still not down as much as the others. I found this a bit surprising since I would have expected fear to rip into the owners of small caps but so far that hasn't been apparent. The May 9th low, which the DOW broken today and SPX is close to testing, is relatively far away for the RUT (near 714).

So if we're to see another rally attempt I'd play it in the small caps and look for a push up to the 760-770 area. But if selling takes hold in this market look for the RUT to do some serious catching up as fund managers do a collective uh-oh and bail en masse. Many are strongly thinking a bull market here so recognition from these folks could be accompanied by some very strong selling days (if I'm correct in my opinion that we're starting the next bear market leg down).

Key Levels for RUT:
- cautiously bullish above 745
- bearish below 714

Russell-2000 (RUT) chart, 120-min

Even if the uptrend line from March is drawn off the May 9th low (instead of April 15th) the RUT has broken its uptrend line. As mentioned about the NDX, the decline from Monday is so far only a 3-wave decline and as such could be just a correction to the rally. A rally back above today's high (742.57) would leave the pullback as a 3-wave correction and point to new highs coming (it's possible it would turn into a larger pullback first but regardless it would be bullish for new highs). As depicted on the chart, if we get a further drop, consolidate and then drop again, it will create a 5-wave decline and that's what I look for when identifying a trend change. It's possible we'll get a larger bounce off the 714 level (assuming it will drop to there) that creates a right shoulder of a H&S topping pattern. Something to watch for.

BIX banking index, Daily chart

There are two potential triangle patterns that interest me on the banks. The first one is the descending wedge that I've been showing for a couple of months now. This pattern calls for a lot choppy price action (as the bulls and bears duke it out deciding whether the worst is over or not--editorial comment, NOT). It calls for a continuation lower in a very choppy fashion well into the summer months (shown in dark red). The banks, in this pattern, would not sell off as hard as the broader market (most of the hard selling in the banks is probably finished although from a percentage standpoint the banks could still get hit very hard).

The other triangle pattern is a sideways triangle (light red trend lines) and the BIX is nearly at the bottom of it after today's decline (this is the uptrend line from March). That pattern calls for another rally back up to the top of the triangle (shown in pink) before a more severe selloff. So the BIX is at an important point here and only further price action will give some clues as to which scenario will play out (but both point lower eventually).

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

The home builders broke firmly below support by the trend line along the lows since mid April and the uptrend line from January. But the decline stopped at its broken downtrend line from February 2007. That leaves the door open for another rally attempt and if this index can push above 390 there's a good chance it will make up to the 440 area before turning back down to new lows. Watch first to see if a bounce finds resistance at the previous lows (350) or the broken uptrend line from January (360). If it instead continues lower from here then support will likely be found near 300 and then near 280 (2002 lows and close the gap from the January 18th close (that was a nice little bullish island reversal back then).

Transportation Index chart, TRAN, Daily

The Transports, which many have been using as a sign that confirms a new bull market is upon us, continues to look relatively strong. Today's decline stopped at its uptrend line from March and above the broken-and-recovered uptrend line from March 2003. If the TRAN can hold above 5200 we could see another rally attempt. First resistance in that case would be the top of its parallel up-channel from January, currently near 5450. A break much below 5100 would spell trouble for the Trannies.

As for the DOW Theory buy signal, I am no expert in this area but my interpretation is a little different than what I'm hearing from many others. The TRAN made a new all-time intraday high on Monday (and by the way left a flaming sell signal with that shooting star, confirmed the next day with the red candle) but the DOW is nowhere close to making a new all-time high. This a major bearish non-confirmation of the new high in TRAN. After the DOW followed the TRAN below its August 2007 low back in November, that created a DOW Theory sell signal. We're still on that sell signal and it takes a new all-time high in the DOW to confirm the new high in the TRAN. Until that is done the only thing we have right now is a huge non-confirmation of the TRAN's new high. We'll just have to see if the DOW pulls the Transports down or the Transports can keep rallying and pull the DOW up.

U.S. Dollar chart, Daily

The US dollar has broken back down in the past few days and is now nearing potential support at the bottom of its long-term down-channel which it broke back above in late April. At 71.65 that's also at the uptrend line from March. Whether it bounces there, or high it bounces, can't be known yet but that's the first level I'll be watching for support. A continuation lower would likely have the dollar sinking at least to 70.

Oil chart, Oil Fund (USO), Daily

Today's oil inventory report showed a big drawdown in crude supplies. Some of that may have been due to the fact that refineries started cranking out a little more product and therefore were able to draw down some of the crude supplies. Regardless of the reason it spooked traders into thinking shortage and they bid the price up (again). We either have an honest-to-goodness rally that won't stop until $200 or else we've got just another bubble top in the making.

I've drawn uptrend lines since the rally from August and we're now into the 5th steeper uptrend line. Does this look familiar? It should by now. How many bubbles are we going to see created by hot money looking for a home? As I said, we are either at the beginning stages of a huge, and I mean huge, rally in oil or else get ready for another pop. If the uptrend lines start breaking that will be the sound of the pop and don't be looking to buy the dips in that case.

I like to use the oil stocks as a "leading indicator" since commodity stocks will often show the way. Right now we have a potential bearish reversal pattern on the oil stocks after giving up today's rally:

Oil Index chart, Daily

Just another shooting star up at resistance. That's becoming a common candlestick pattern and is indicative of several markets topping (my interpretation at the moment). A red-candle day tomorrow is needed to confirm the reversal signal. If oil stocks do reverse back down then I believe oil will soon follow. If we instead see a choppy sideways/down consolidation (shown in green) that finds support at its uptrend line from March and the recovered uptrend line from August 2007 then keep looking higher for these stocks. It takes a break below 930 to confirm we've seen the high for now at least.

Gold chart, Gold Fund (GLD), Daily

With Fed saying they're looking at a higher inflation rate than originally forecast, the dollar dropped and gold rallied. Gold rallied a little higher than I thought it would today so it's definitely possible my bearish view on gold is wrong. Any continuation of the rally tomorrow would have me abandoning my recommendation to short this rally. Upside potential for GLD is to the $95 area which is where the top of its parallel up-channel from 2005 is located and a Fib projection for a possible A-B-C bounce off the April 1st low (where the 2nd leg up will equal 162% of the 1st leg up). That kind of move is depicted in pink. There is of course more bullish potential if it can rally much above 95. A drop much below 88.50, confirmed with a drop below 87.50, would likely mean we'll get another leg down (dark red). Gold is at an important level here.

Economic reports, summary and Key Trading Levels

Tomorrow's only economic report is the jobless claims data so the market will be completely on its own tomorrow.

At this point we've got some strong sell signals in most of the equities and that's the way I'm leaning. After the March low I've been looking for a rally to complete the 3rd wave up and I believe it now has. If true then the correction to the October-January/October-March decline should be finished and that sets us up for another leg down in the bear market. The wave pattern for the bounce is either extremely bullish and suggests some huge upside moves are coming or else the choppy overlapping nature of the rally is indicative of a correction to the decline. Until proven otherwise I'm sticking with the bearish interpretation.

One reason to feel bearish about the rally is the lack of market breadth. Look at the rally of the NYSE vs. the advance-decline line. The drop off in advancers to decliners at the new price highs since March is rather telling:

NYSE vs. advance-decline line, Daily

We saw this kind of divergence at the October 2007 highs when comparing to July. I used this chart then to warn of a market top and I'm using again to warn of another top. The VIX dropped down to support at its October 2007 low and has now bounced sharply back up:

Volatility Index (VIX), Daily

VIX has broken its downtrend line from the end of March and is back above the December 2007 low. If this were a stock I'd be buying it. That means it's bearish for stocks. It takes a break above 20 to confirm but it's certainly a heads up here for a change in tenor.

Therefore my recommendation for those who prefer to be long the market, especially if you believe we're in the beginning stages of a new bull market recovery, is to simply identify your puke point. At what level will you acknowledge that the market is not doing what you thought it should be doing and then step aside while you reassess (which by the way is much easier to do when you're flat--no emotion is involved with what should be a rational assessment). If you like playing the short side of the market, look for bounces up to resistance as opportunities to test it. Some like to play breakdowns but I've found it difficult to manages my stop levels since reversals into short-covering bear market rallies can be brutal.

We're only at the beginning stage of a breakdown if that's what's happening so there is no need to rush short entries. Wait for a good setup. By this time next week I should have a better idea as to whether this is just a nasty little pullback or the start of something more significant. I will of course be updating my views daily on the Market Monitor.

Good luck and I'll be back with you next Thursday as Robert and I switch days.

Key Levels for SPX:
- bullish above 1460
- bearish below 1384

Key Levels for DOW:
- bullish above 13325
- 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:
- cautiously bullish above 745
- bearish below 714

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