Option Investor
Market Wrap

Shifting Sands

Printer friendly version

Anyone who has stood at the waterline at the beach as the water rushes back and forth over your feet will understand the analogy of standing, or building, on shifting sands. You obviously want to build upon rock instead of sand (although I guess that's not a problem with all the building going on in Dubai, although come to think of it...nah, we won't go there). The rally off the March low has been built on hope--hope that the credit problem will be contained, hope that the Fed really can save the banks, hope that the economy will have experienced only a mild and short-lived recession.

I've been a non-believer in the hope-filled expectations that the stock market will end the year higher than it began. I felt we would get a big rally leg off the March low, gave some upside targets along the way and we achieved them. Since the high in May I've been looking for the market to turn back down. Whether it will only pull back a little and head higher again, or chop sideways in a big consolidation between the January/March lows and May highs, or head to new lows, no one can know for sure. I like to show alternative ideas on my charts, with key price levels, and then let price tell me which scenario is likely playing out.

I happen to believe at the moment that the bounce off the January/March lows is finished and we'll head to new yearly lows next. Now it's a matter of watching price action to see how and when I should change that expectation. While I may have bearish opinions about the economy and credit fiasco, I try hard to let price control my trades and keep my bias out of the way (hard to do). I consider the large problems facing our economy, namely an unwinding of the massive credit increase since the late 1990s, to be a fundamental issue that will have a negative impact on our markets (global markets). But I look for other more technical indicators to either support my opinions or refute them. One "indicator" is consumer sentiment.

I have pointed out in the past how consumer sentiment is closely correlated with the stock market. This makes sense if you believe the stock market swings primarily due to emotional mood swings rather than fundamental reasons. I've often stated that fundamentals follow the emotional swings in the masses. When people get worried, frustrated and angry they reign in their spending and tend to sour towards the stock market and turn bearish. When they're feeling positive and bad things roll off their backs like water off a duck's back then they feel comfortable enough to spend their money and feel good about the stock market and turn bullish.

For a long time we've had consumer sentiment that has been OK but not great, and certainly not as high as it was in the latter part of the 1990s and 2000. I downloaded the University of Michigan Consumer Sentiment monthly data from 1986 and matched it up with the monthly closing prices of the DOW Industrials. The following chart shows the result:

Consumer Sentiment vs. DOW Industrials, 1986-2008

The vertical gray bars show when consumer sentiment turned down, specifically in 1990, 2000-2002 and then since the rebound high in 2004 (which was a lower high than 2000). In 1990 the stock market turned down with sentiment (looks like only a small drop due to log scale used for the DOW and its large rally since 1990). The stock market again turned down in 2000 and reversed back up with sentiment in 2003. But since 2004 there's been a real disconnect. While consumer sentiment has been steadily eroding, with a brief bounce in 2006, the stock market kept rallying. Consumer sentiment has nose-dived since early 2007 but the stock market has barely budged to the downside.

I believe this is about to change and it could change in a big way. I think the stock market will follow consumer sentiment and head for new lows. This has been a very consistent relationship until the past few years and I just don't see it staying this divergent for long. This is just one more indicator that has me thinking the stock market will work its way back down at least to the 2002-2003 lows over the next year or two.

But the market does not move in a straight line and while the past week has been negative it does not preclude another rally leg tomorrow as part of a larger declining pattern. I want to review some longer term charts of the DOW before getting into my regular charts. The first chart is a monthly chart since the 1960s, from Elliott Wave International. There's a very interesting long-term uptrend line that they pointed out:

DOW chart, Monthly, courtesy Elliott Wave International

The bear market of the late-1960s/early-1970s arguably ended at the low in 1974. Drawing an uptrend line from that low through the October 2002 (bold green) low shows how many times the DOW used that line for support and resistance (blue circles on the chart). One could argue that this trend line is an important one. The red uptrend line from August 1982 through the October 2002 low shows where the DOW found support on the pullbacks in 2005 and 2006. It's hard to see but the May high also stopped at that red uptrend line (easier to see in the next chart). What's interesting about the green uptrend line is that the DOW found support there in January and March of this year.

These trend lines are shown with a closer view on the following weekly chart:

DOW chart, Weekly

The weekly chart shows the red uptrend line from August 1982 stopped the rally in May (and the initial bounce in January). The green uptrend line from 1974 is where the January and March declines found support. It's also where the 2000 high (12750) is located so it was a doubly important support level. It's not hard to understand why the bulls felt excited about the buying opportunity. After all, we are still in a very long term up trend. Trading with the trend tells us to be looking to buy pullbacks.


Earn $2,000 Each Month with a Conservative Options Strategy

We will show you how you can make $2,000 in cash each month using your existing portfolio equity as collateral. This low-risk strategy works no matter which direction the market goes. Best of all, it is easy to implement and no previous experience with options is necessary.

Take a complimentary 30 day test drive. Click Here:


My bearish calls for a stronger decline this year are therefore obviously early. It takes a break of the green uptrend line, currently near 12080, to get Paul Revere racing through the townships yelling "the Bears are coming, the Bears are coming!" As I indicate with the pink price scenario, we could get another bounce off that uptrend line and head back up for a new yearly high. That would obviously be a bullish move even if it's unable to top last year's high. Therefore a drop to the uptrend line (assuming we'll get it) will be carefully analyzed for the possibility I should reverse long.

After the DOW pulled back from the red uptrend line, which is using the Log price scale, I shifted back to the arithmetic scale to show on the daily chart (along with the uptrend line from the March 2003 low):

DOW chart, Daily

On the daily chart the uptrend lines from October 2002 (which is actually the one from August 1982 through the October 2002 low) and March 2003 show how much the DOW has been using them, primarily for support on pullbacks (highlighted in yellow). Today's doji candle is just below both trend lines and therefore the DOW is in danger of breaking down here. But if tomorrow is an up day the candlestick pattern will be a bullish morning star reversal pattern. The bulls need to keep their fingers crossed for a bullish day.

Key Levels for DOW:
- bullish above 12800
- bearish below 12340, confirmed with a break below 12270

DOW chart, 60-min

The downtrend line from October could be a magnet that attracts the DOW for another retest of it before letting go (shown in pink). That would be a run back up to about 12450. Otherwise short against today's high is the right place to be for now.

SPX chart, Daily

SPX is fighting to hold support at its broken downtrend line from October. It has not been able to hold onto its 50-dma just above at 1381. The spike low in August 2007 at 1370 continues to provide support as well. A break below 1370 therefore could usher in some strong selling. If the bulls can muster up another rally I see upside potential to about 1415. It takes a rally above 1425 to turn the price pattern more bullish at this point.

Key Levels for SPX:
- cautiously bullish above 1425
- bearish below 1370

SPX chart, 60-min

Yesterday's and today's rallies were both stopped at the downtrend line from May 19th and therefore that makes a good trend line to keep an eye on if we get another bounce up to it tomorrow. Short against today's high, or against that downtrend line (which will be near 1385 tomorrow morning), is the suggested place to be right now. We could see a minor new high above today's and then a turn back down from there (shown in pink) and it takes a rally above 1401 to turn the price pattern more bullish.

Looking at the weekly chart of NDX I noticed a couple of interesting things. First is the parallel up-channel from October 2002:

Nasdaq-100 (NDX) chart, Weekly, arithmetic price scale

This weekly chart is using the arithmetic scale which keeps the trend lines of the up-channel parallel. The mid line of the channel is where NDX has currently stalled. NDX has oscillated around the mid line during its rally and it could do so again but so far this is a bearish chart. It's common for price to bounce off the bottom of its up-channel, find resistance at the mid line and then drop out of the channel.

But bullishly NDX is still solidly within its up-channel and back above its 50-week moving average, something that has consistently led to more rally so I have to respect the bullish potential for the techs. This follows a bounce off its 200-week moving average in March. If the blue chips were looking stronger I'd be more bullish the techs right now but the non-confirmation from the blue chips, similar to what happened in 2000, is a warning shot across the bow of the USS Bullship.

Now when I take this chart and view it with the log price scale it changes rather dramatically:

Nasdaq-100 (NDX) chart, Weekly, logarithmic price scale

First of all, the parallel up-channel is hardly parallel. Adding to the bullish view from the chart above is the fact that NDX has climbed back above its broken uptrend line from October 2002, right where the 50-wma is crossing. If NDX continues to push higher from here it could very well be pointing to new highs above last October's. Very interesting setup here and it has me a lot more cautious about my bearish stance on the stock market. Bears need to see the techs back below the mid-May low of 1943, shown a little more clearly on the daily chart:

Nasdaq-100 (NDX) chart, Daily

NDX had a double bottom near 1943 last month and a double top near 2050 last month. Double your pleasure in a trade that breaks one or the other as those are the key levels and the direction you should trade this index following the break. As with the longer term up-channels, the parallel up-channel from March is still holding but NDX is finding resistance at the mid line of the channel. Interesting times for NDX here.

Key Levels for NDX:
- cautiously bullish above 2051
- bearish below 1943

Nasdaq-100 (NDX) chart, 60-min

Even though the May 30 high is only 10 points below the key level on the daily chart at 2051 I think if 2041 breaks then so too will 2051 and therefore use a break above 2041 to position bullishly. The same in reverse--if yesterday's low near 1979 gives way I believe so too will 1943 so play the break below 1979.

Russell-2000 (RUT) chart, Daily

The RUT remains the more confusing index for me at the moment. It seems to be marching to the beat of its own drummer and I'm just not able to follow its beat. It's whipping back and forth and I can't figure out if it's bullish or bearish. If it continues to chop higher, as shown in pink it will be an ending pattern. If it spikes higher then it'll obviously be bullish. If it drops below its uptrend line from April, currently near 730, and especially if it drops below the May 23rd low near 719, it will be bearish. In between is a coin toss and I'd rather key off the other indices for now. Note though that it's been struggling under its 200-dma near 746 which is why I think it will be bullish if it can rally above and hold above that level.

Key Levels for RUT:
- cautiously bullish above 746, more bullish above 775
- bearish below 719

BIX banking index, Daily chart

The banking index continues to slide down that slippery slope of hope as those who keep hoping the worst of the banking write-downs is behind us then find out that well, maybe not. The descending wedge pattern suggests lots of choppy price action ahead but it should continue to work its way lower into the summer.

In the "what, are you kidding me?" category is an accounting method adopted by banks that has given them false gains that they've been able to report over the past quarters. Over the past year many banks reported profits based on revaluing their bond debt. They've argued that since they're being forced to revalue their assets (all those abc derivatives on bonds) from mark-to-model to mark-to-market that they should therefore be allowed to revalue the debt on their books. This has been approved as Statement 159 by the FASB (Financial Accounting Standards Board) which makes me wonder who's on that Board? Trouble is there's no control over how they're doing this.

As an example, Merrill (MER) added $4B of revenue to their bottom line for the past three quarters to account for the dropping value in their debt (the bonds that are losing value). So basically the banks can now post substantial gains as a result of the decline in their own creditworthiness. By this line of thinking the bank will be able to claim the highest value when their debt is devalued to zero (huh?).

These additions to the bottom lines of banks have essentially masked $160B in write-downs over the past year. And we wonder why there's a lack of transparency in the banking industry? Until there's clarity with what's happening it remains a game of cat and mouse between bulls and bears in the banking sector. But it all smells pretty fishy to me, the dead kind.

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

After breaking below its uptrend line from January the home builders are trying to hold onto the broken downtrend line from February 2007. The pattern has me wondering if we're going to get a small fractal of the pattern that played out from the mid-April low. The price pattern is corrective enough to suggest we could see another rally leg (pink) before tipping back over but I think instead, like the banks, we'll see the home builders work their way lower into the summer.

Transportation Index chart, TRAN, Daily

The Trannies have refused to break down. Between the techs and the transports I have to give the bulls their due. Until both start breaking down I think bears need to pay close attention and be careful here. A break back above the May 19th high near 5537 would be bullish. Watch the uptrend line from March since it should hold if the bulls remain in control. It takes break below the May 23rd low near 5121, with a heads up if it breaks below the trend lines near 5240, to put the bears back in control.

U.S. Dollar chart, Daily

It's a choppy climb but the US dollar bulls are keeping the dollar afloat. MACD is back above zero but if the rally doesn't continue it could end up leaving a nasty bearish divergence against the May 7th high. If the dollar rally continues, watch for resistance near 74.40 where the top of its parallel up-channel from March crosses the mid line of its longer-term down-channel from 2005-2006. A drop back below the May lows just under 72 would suggest a move down to at least 70.

Oil chart, Oil Fund (USO), Daily

Oil is still in an uptrend but it's showing a sign of weakness by breaking its uptrend lines. But it has pulled back to its uptrend line from April 1st and has not yet broken below its May 15th low at 97.69 and therefore has not turned the price pattern bearish. In the meantime there remains the possibility for another rally leg (green) and if we get it I suspect it will be the last.

Oil Index chart, Daily

The oil stocks are on a slightly different path than oil but appear to be leading to the downside now. This is typical (commodity stocks lead commodities) and is a heads up that we may have seen the high for oil itself. The break today below 930 is a bearish sign. It takes a rally back above 978 to negate the bearish signal.

Gold chart, Gold Fund (GLD), Daily

Gold is trying hard to hold onto its uptrend line from August 2007 which is where it found support in mid May, end of May and the last two days. Obviously traders think this uptrend line is important and a break of it will likely hit a lot of stop orders. It takes a break below 85 to turn the price pattern bearish and a rally back above 92 to keep the hopes alive for new highs in gold. As usual, keep an eye on what the dollar is doing.

Economic reports, summary and Key Trading Levels

Tomorrow is very quiet as far as economic reports go, with only the jobless claims on deck. The market will be left to fend for itself and I don't know of anything significant that could move the market tomorrow morning.

The current price action reminds me of distribution as it chops higher and then sells off quickly. That might be my bearish-colored glasses tainting my perspective but that's the way it looks. Internals today were neutral except for the higher number of new 52-week lows vs. new highs. We've got divergence between the techs and small caps looking more bullish vs. the blue chips looking more bearish. This kind of divergence is typically not a healthy sign for the market but it's by no means a timing signal, just a warning.

Another warning is what I see happening with the 10-year yield (TNX). Since the end of the 1990s stock prices have tended to be in synch with yields (so counter to bond prices). Money has rotated from bonds to stocks and back again. I see the potential for yields to tip over here. Back in March 2007 I had shown a weekly chart to show the rising wedge pattern that was developing since the June 2003 low. Based on the EW (Elliott Wave) pattern and the rising wedge I was showing why I thought we'd see a relatively quick decline back to the 2003 low (and below). Here's the chart from March 2007:

10-year Yield (TNX), Weekly, March 2007

I was looking for one more rally leg up to the 5.4% area and then let go to the downside. Here's the updated chart through today's close:

10-year Yield (TNX), Weekly, present

TNX didn't quite make it up to 5.4% (its high was a little over 5.3%) and then yields collapsed from that high in June 2007. Since the January 2008 low we've had an a-b-c bounce for what I believe is a correction of the June-January decline and will be followed by another leg down that easily breaks the January low. TNX has so far failed at its 50-week moving average (the blue moving average). If stocks remain in synch with yields, as I believe they will, this is a bearish omen for the stock market.

It also means the Fed will not be raising rates but instead will be forced to lower rates further as they follow TNX. It also means we'll probably see inflation abate and probably renewed fears of deflation will soon be discussed (if the pattern plays out as I've depicted). Flight to safety in Treasuries, no matter what the return, would be the reason this scenario plays out.

The VIX closed above its 50-dma today, the first time since March, and it poked above its May 27th high. These are buy signals for VIX and therefore sell signals for the stock market. But there's just enough evidence in VIX to suggest bears need to be cautious here as I see the possibility for VIX to drop sharply back down (as the market rallies). This leaves me thinking both sides need to be cautious until we get a little more price action to point the way. Keep an eye on those key levels on the charts and play the break. I think the market is overall bearish but it does not preclude another rally leg above today's high as part of a larger upward correction. Continue to trade the market and not get locked into an opinion about which way it's going to go.

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

Key Levels for SPX:
- cautiously bullish above 1425
- bearish below 1370

Key Levels for DOW:
- bullish above 12800
- bearish below 12340, confirmed with a break below 12270

Key Levels for NDX:
- cautiously bullish above 2051
- bearish below 1943

Key Levels for RUT:
- cautiously bullish above 746, more bullish above 775
- bearish below 719

Market Wrap Archives