Option Investor
Market Wrap

Oil Gets the Credit

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Oil is on everyone's radar now and each little blip gets breathlessly reported as to what it might mean for the economy and by extension for the stock market. Today's move though was more than a blip and it was actually a wild day for oil traders. Apparently the oil inventory report came out a little early and caught traders by surprise.

The initial numbers released showed a large inventory drawdown of 8.8M barrels. That would be bullish for the price of crude and the price of oil spiked up from about $129 to a little over $133 in about 10 minutes time. Before the release of the inventory numbers equities had rallied off their morning lows and were making new daily highs. But in that same 10-min time span that oil spiked up equities spiked down and were making new daily lows, with the DOW shedding nearly 60 points in the process.

And then came the "never mind" message and they all reversed themselves in the next hour. Equities actually reversed much faster and were making new daily highs again in the next 15 minutes. Anyone trying to trade the first 90 minutes today got some severe whiplash. The oil inventory report, when officially released at 10:30 AM, showed the inventory drawdown was due primarily to delays in crude-oil tanker off-loadings on the Gulf Coast. Gasoline supplies fell 3.2M barrels while distillates were up by 1.6M barrels. Refinery capacity was unchanged at 87.9%. So overall it wasn't a particularly scary report.

The net result of all this was not supportive of the oil bulls' cause and they started selling. By the end of the day oil had given up a little more $6 from its high (that's $6000 per emini contract (QM) so you can imagine the pain some felt with the big contracts). But try not to cry for the oil bulls. Actually commodities in general had a bad day. The metals and grains also experienced some hard selling today. The commodity bubble is showing signs of leaking and when bubbles start leaking you should stand back--it's like water over the levee and once it starts to leak it starts to accelerate.

The US dollar found support (chart later) and got a pretty good bounce today. That puts further pressure on commodity prices. All of this was interpreted as bullish for the stock market and so it rallied. The DOW was up about 130 points before selling off in the afternoon and gave up 80 of those points. The question, as I review the charts, is whether we've seen the high for the bounce off Friday's low (or Tuesday's, depending on the symbol) and will now see the stock market start down again. That's what we'll review in the charts, starting again with the weekly chart and zooming in from there:

SPX chart, Weekly

Last week's red candle produced a bearish engulfing candle, or an outside down week. This occurred at trend line resistance (the H&S neckline and right at the 50-week moving average. MACD is hinting of rolling over (this is a lagging indicator). On a longer-term view like this the wave count looks good for the resumption of the decline from October.

SPX chart, Daily

The daily chart shows price dipped slightly below the broken downtrend line from October on Friday, found support at its 50-dma and has since recovered back above the trend line. This is bullish. That makes Friday's low near 1373 the key level for the downside. Based on the impulsive look to last week's decline I'm leaning bearish and believe this week's bounce is a correction of the decline and will head lower again (dark red). It takes a rally above last Monday's high (May 19) near 1440 to turn the pattern at least short term bullish. The RUT did this today and that's a big caution flag for bears (chart later).

Key Levels for SPX:
- cautiously bullish above 1440
- bearish below 1373

SPX chart, 60-min

The 60-min chart shows the impulsive look to last week's decline, labeled as a 5-wave move. If that's the correct interpretation then it signals a trend change (to the downside) which means the bounce off Friday's low should be just a correction of last week's decline. So far it's labeled as an a-b-c bounce (in dark red) and the bears must see a decline from here. Any rally back above today's high near 1406 will turn the bounce into an impulsive move (labeled in green). That will mean one of the counts is wrong (either last week's decline or the current bounce) and all it means is caution for both sides.

This chart tells me to be short against today's high (short a bounce tomorrow to lower your risk), cautiously bullish above today's high and then if we see a new high, look to buy the pullback that corrects this week's rally.

DOW chart, Weekly

Last week's decline found support on the uptrend line from October 2002, using the arithmetic scale here. When using the log scale it shows the rally off the March low failed at that same trend line. A break below Tuesday's low near 12442 would also be a break of that long-term uptrend line and be potentially bearish. If that happens, watch the weekly chart with the log price scale since the much longer-term uptrend line from 1982 (actually 1974) is where price found support in January and March. That uptrend line is currently just above 12K:

DOW chart, Weekly, using log scale

DOW chart, Daily

After breaking support at the May 9th low near 12715 I had mentioned to watch for it to become resistance. The DOW made it a little higher today, to 12726, but basically resistance held. The correction to last week's decline could be finished and like the SPX I am recommending a short against today's high. If today's high is exceeded then there's a lot more bullish potential. The daily chart shows both uptrend lines from October 2002 and March 2003, which are close together (I only show the one from October 2002 on the weekly chart above). Notice how those trend lines are essentially in the middle of the shallow up-channel from January. As long as the mid line of an up-channel holds it remains bullish. Therefore a break below Tuesday's low near 12442 would be doubly bearish.

Key Levels for DOW:
- cautiously bullish above 13137
- bearish below 12442, confirmed with a break below 12270

DOW chart, 60-min

Like the SPX, the wave count is a good setup for a short play here. The bounce off Tuesday's low is a 3-wave move and that's corrective. If the market rallies tomorrow above today's high it will create an impulsive 5-wave move and suggest higher still after pulling back to correct this week's rally (shown in green). Now we let price tell us which pattern is going to play out.

Nasdaq-100 (NDX) chart, Daily

I had mentioned above for the DOW that the mid line of a channel is important to watch. While NDX was rallying in April and May the pullbacks kept finding support at the mid line of its parallel up-channel from March. It then dropped below the mid line last week and found support at the bottom of the channel (uptrend line from March). Today's rally found that mid line to be resistance which is very common (broken support often turns into resistance). As with the others, short against today's high is the recommendation. Since NDX is close to the May 19th high near 2051 you could use that as your stop but I like to keep my stop as tight as possible when I've got a good reason for it. The good reason here is that another push higher would create an impulsive rally for this week's bounce and could imply we'll see a rally above the May high.

Key Levels for NDX:
- cautiously bullish above 2051
- bearish below 1943, confirmed with a break below 1867

Russell-2000 (RUT) chart, Daily

From an EW (Elliott Wave) perspective, the RUT is the spoil sport. It rallied to a new high today, above the May 19th high and that means last week's decline was obviously not the start of something more bearish. But all along the RUT has had a different pattern and was the only one I could not count impulsively (the highs and lows of the decline overlapped). It's possible the RUT will have made a new high here but will not be confirmed by the others. That would be considered bearish non-confirmation.

The RUT did manage to close its January 4th gap at 745.01 (missed by a few cents on May 19th) and just barely missed tagging its 62% retracement of the October-January decline at 751.03 (today's high was 750.69. It also was not able to hold onto its 200-dma (at 746.73). I left an internal uptrend line from March in place and you can see the RUT as not able to recapture it as well (on a closing basis) so it remains resistance. Bearish divergence so far exists at the retest of the May 19th high. Sounds like I'm trying to talk myself into feeling bearish about the RUT doesn't it?


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Because of the overlapping nature of the rally from April I do not have a high confidence level in the wave count. In these cases I love to use trend lines for confirmation of a count and right now the trend lines and moving averages are telling me the RUT has run out of juice. As with the others I recommend a short against today's high but definitely get out of the way if today's high is exceeded. It might only make it up to about 760 before pulling back more deeply but the bulls have been running strong in this index and I would not want to fight it. I just don't have the confidence, based on what I'm seeing in other markets, to recommend a long on this one.

Key Levels for RUT:
- cautiously bullish above 745, more bullish above 760
- bearish below 719

BIX banking index, Daily chart

I show a dotted uptrend line from March because that uptrend line was broken this week and today acted as resistance. Yesterday the BIX found support at the previous lows in March and April. It's possible we'll see another bounce back up to the downtrend line from March which would be the top of a descending triangle (declining highs, flat bottom) and it would be the last leg within that triangle. That would be followed by another decline (shown in pink). My preferred wave count shows a continuation lower to the bottom of the larger descending wedge (bold purple) as part of a choppy decline into the summer as the banks hammer out a bottom.

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

The home builders look a little different than the banks but they continue to track fairly closely. A bounce in the banks would likely be accompanied by a bounce in the builders (pink) but I think the builders will also work their way lower into the summer as they too work to find a bottom.

The housing market is very important to the psychological well being of most people. Whether we rent or own, almost everyone watches the real estate market. We're either happy with our equity buildup, envious of others who have equity, or thankful that we don't have to worry about selling or buying. But we all watch. A declining market is depressing. Not only that but it takes food off our tables. So much home equity has been withdrawn over the years that it afforded many a lifestyle they wanted to continue but couldn't afford otherwise. With the home-equity piggy bank tapped out most people are being forced to live within their means. Combine this with high energy and food prices and it doesn't take a rocket scientist to understand why consumer sentiment is in the toilet.

The stock market has never held up when consumer sentiment is down and right now it's in the weeds and heading into the mud. Unfortunately home prices probably have further to fall, some say much further. The latest data from the Case-Shiller 20-city house price index show real prices falling at a steepening rate. You can download the data from the S&P site at this link: http://tinyurl.com/3cz3kg

The report shows sales figures (of only homes that have had prior sales so they can compare apples to apples) since 1987. They zeroed out the values as of 2000 and show relative performance of the various cities around that year. I graphed the data to get the following chart (I apologize for its small size--too much data makes it hard to read):

Case-Shiller Home Price Indices, 1987-March, 2008

I pointed out some of the high-flying cities on the chart and it's hard to read most of the others. Detroit is down at the bottom and has dropped into negative territory (below 2000 prices). There's a very good chance several, if not all, of the other cities will follow Detroit to below 2000 levels. Whenever you see a spike well above a long-term average (which is about where 2000 prices were) it's very common to see a correction to the other side of the average. Without seeing the individual cities you can see all have turned down sharply since 2006-2007 highs.

The drop in real estate values has been very depressing and consumers have been reining in their spending. That will likely continue at an even faster pace. If this all comes to pass you can take it to the bank that the stock market will not hold up well. I hate to keep sounding bearish about all this but I don't want to stick my head in the sand and make believe all is OK with the world and that my investments will be fine. They won't be fine and the smart investor today is one who at least attempts to time the market. There will be good times to be long the market and other times to be in cash and/or short. This is one of those times to at least consider a large cash position.

The economists tell us everything will be all right. These are the same ones who missed the tech bubble and collapse, and resulting recession, and the home bubble and collapse. They said the subprime problem would be small and contained and now they're arguing about whether or not we're going to have a recession. Sometimes book smarts gets in the way of common sense and right now common sense tells me to get out of the stock market. As a contributing writer to this newsletter I feel it's only fair to tell you what I think and not what you want to hear. You do what you want with that information.

Back to the charts, the Trannies have been more bullish than the broader market so it's been an important index to watch for clues what may be happening. So far it's not terribly bearish and keeps me from getting overly aggressive about the short side.

Transportation Index chart, TRAN, Daily

The May 19th high was a good reversal signal and I continue to believe short against that high is the correct position to be in. It's the key level to the upside. Last week's decline looks very impulsive (no overlap between the highs and lows of the declines and bounces and it formed a 5-wave move). That either finished a slightly larger consolidation from the May 2nd high (labeled as the end of the 4th wave, in green) or else it was the start of a new decline (dark red). A break of Friday's low near 5121 would likely usher in stronger selling. We'll just have to let price tell us which pattern is playing out here.

U.S. Dollar chart, Daily

Support for the US dollar held at the bottom of its longer-term down-channel from 2006 and its uptrend line from March. It is once again challenging its downtrend line from August 2007 and closed above it today. This bounce looks like it has potential to rally above the May high and make it up to at least the top of the short-term up-channel and the mid line of the longer-term down-channel which cross near 74.40.

Oil chart, Oil Fund (USO), Daily

There are no bearish divergences at the last high and that always makes me suspicious of the decline from the high. Bearish divergence is not a requirement and in fact often times the last high in commodities, because it's often a blow-off top, shows no divergence. The breaking of its uptrend line from May 1st is a bearish sign but oil bears need to see the May 15th low at 97.69 give way in order to declare a high of some importance has been put in.

Oil Index chart, Daily

The trend line along the highs since August 2007, which acted as resistance until it was broken on May 16th, has been acting as resistance again once price broke back below it on Tuesday. It found support at its uptrend line from March so obviously the bulls want to see that trend line hold and a get a bounce back up. If it drops lower tomorrow then expect a bounce after that to find both trend lines to be resistance on a retest and an opportunity to short the oil stocks from there.

Gold chart, Gold Fund (GLD), Daily

Gold has sold off sharply the past four days and another bounce back up to a new high (green) is looking less likely. The overlap of the bounce high on May 9th (87.59) leaves the bounce off the May 1st low as a 3-wave move which means it's a correction of the decline from the April high. That suggests we're going to see some strong selling in gold and probably right down to support near 80 before a bigger bounce again.

For those who would like to trade GLD but do not want to buy and sell the ETF shares, a reader just shared with me some information that says options will soon be traded on this. Thanks to Al for sending me the following: "According to Barron's, options on the gold ETF, symbol GLD, may start trading as early as June 2nd, although I have not yet been able to confirm this with the exchange.

"These options are the first result of a newly-signed Memorandum of Understanding between the SEC and the CFTC to work together to adapt to the modern financial landscape, where the line between commodities and equities is no longer so well-defined. Options on GLD will trade just like any other option series listed at the CBOE. Each contract will represent 100 shares of GLD, and there will be a full complement of puts and calls, at multiple strike prices, at multiple future expiration dates."

Economic reports, summary and Key Trading Levels

Today's GDP report was considered good in that it wasn't as bad as expected. We're hearing that a lot lately--"well, it wasn't as bad as we thought it might be and therefore that's good news for the market." Another interpretation is that the economy is slowing and that's not good for the market but it's taking longer to correct the overheated market and the massive credit expansion. It all depends on how you want to view the economy and how much hope you pile on.

Tomorrow's reports could be market moving since they will show how much the consumer is spending and whether consumer sentiment drops further which would likely mean even slower spending. The PCE (Personal Consumption Expenditures) Inflation number is something the Fed watches very closely and therefore any spike in that number would crush any remaining hopes that the Fed will cut rates further. The Chicago PMI (Purchasing Managers Index) is often a good heads up for what the ISM (Institute for Supply Management) report will show. Any further slowdown could depress the market further.

I'd say we've got a good setup for a down day on Friday although it might start off with a bounce. If we do get a bounce, use it to try a short entry with your stop at today's high. If the bearish price pattern is correct we're due for some strong selling to kick in and take us well below the May lows. At least your stop can be kept relatively close.

If we get a rally above today's highs (following the RUT) then I would be cautiously bullish following a pullback into next week. It's a tricky spot here and there's some whippy price action that's making tight entries (especially for those trading futures) very difficult. If you like options, try a few put options on a bounce tomorrow. Buy slightly out of the money a few months out and that way a stop at a new daily high will barely hurt. If the market heads down like I think it will, those OTM puts should provide a handsome return.

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

Key Levels for SPX:
- cautiously bullish above 1440
- bearish below 1373

Key Levels for DOW:
- cautiously bullish above 13137
- bearish below 12442, confirmed with a break below 12270

Key Levels for NDX:
- cautiously bullish above 2051
- bearish below 1943, confirmed with a break below 1867

Key Levels for RUT:
- cautiously bullish above 745, more bullish above 760
- bearish below 719

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