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Market Wrap

Just Another 200-point Swing

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The DOW rallied 200 points off yesterday's low and today it dropped 200 points from its high. All in a day's work. To say the market is a wee bit volatile is an understatement. This afternoon's decline looks like it caught many traders leaning the wrong way with bullish trades, probably in anticipation of the rest of the week being bullish. This week is typically bullish and after yesterday's strong recovery it looked good for a continuation higher. As bearish as I am about the stock market even I was expecting to see another rally leg into Thursday following an afternoon pullback today. Unfortunately for the bulls the pullback turned into a rout instead, as the market dropped below yesterday's lows.

By just about every measure the market is oversold. To which the bears say so what. They point out how much and for how long the market was overbought in the 2003-2004 and 2006-2007 rallies. Those rallies produced brief and shallow pullbacks and the march higher continued. Declines are not the same as rallies and corrections tend to be sharper and shorter in duration. Short-covering produces a much more panicked move than longs covering. When longs panic and finally decide to cover en masse is when we see the spike low and v-bottom reversal. Tops instead tend to be rolling affairs.

Tops in stocks tend to be a slow-motion battle between the bulls and the bears with the bears holding out for more (they get greedy) and the bears are convinced the market has no merit being that high. Bottoms are a result of fear--fear by those holding long that maybe there won't be a bottom. The bears get greedy and start piling on until a few start covering and then trailing stops start getting hit and before you know it we get a v-bottom reversal.

It's interesting that commodities trade the opposite. Tops tend to be spikes to the upside followed by a v-top reversal. That's because buyers are buying on fear rather than greed--fear that inflation is running away or that the commodity in question is getting scarce. Sound familiar? So the buyers panic and want to get in at any price until someone starts selling and then trailing stops start getting hit. But at bottoms there's a big argument between the bulls and bears about the state of the commodity market, what the fundamentals are and bulls believing that the fundamentals support higher prices. So bottoms tend to be slow-motion rounding bottoms.

So as we look at the price decline, especially from May 19th, we're seeing an acceleration lower (it has developed a waterfall appearance). These often lead to a v-bottom reversal (mirror image of a parabolic spike leading to a swift and large decline). With the stock market being as oversold as it is, and the selling accelerating, we might not be far away from a flush to the downside (otherwise known as capitulation or more euphemistically as puking ones position). The hard part is we don't know if that will happen or at what level it will happen. For now the trend is down and that's the direction we should be trading it. If you're a long-only investor then it's a good time to be on the sidelines and let this play out. I hope the warnings I've been providing since last fall have helped most of you at least protect your positions.

The day looked like it was going to start out well when I saw equity futures up nicely during the pre-market hours. But then the ADP jobs number came out and that brought the futures back to the flat line. ADP reported a loss of 79,000 private-sector jobs so when you add back in about 20,000 government jobs that says there were about 59,000 jobs lost and this is what the market is expecting to see reported by the government tomorrow. Anything drastically different could swing the open.

Not helping the employment picture was news by the outplacement firm Challenger Gray & Christmas that corporate-layoff announcements were up +21% for the first half of the year with nearly 476K job cuts announced. The layoff announcements are accelerating as the months go by so the news is getting worse rather than better. It's confirming the fact that the economy is in fact slowing down. Most of the layoff announcements have come from the financial sector, especially the mortgage sector but I suspect the problem will not be contained to this area, just as the subprime mortgage problem wasn't contained. It's a spreading disease called credit contraction and we're only in the beginning stages of the process. You want to get yourselves out of debt and have money in the bank as fast as you possibly can.

Orders for factory goods rose by +0.6%, primarily from orders for computers and defense equipment. Durable goods orders remained flat.

Not helping the market today was a report about one of the Fed heads, Frederic Mishkin, speaking in Israel today and he talked about inflation vs. the slowing economy. His words essentially depressed the market because he said it's rather unlikely that they'll be able to raise rates to fight inflation because of the depressive state of the economy. He said the financial system is in the hurt locker (my words) and will be hurting for some time and continue to depress growth. He concluded with "I hope it would pick up next year." Prior to this we had Fed expectations for the economy to improve in the second half of 2008 and into 2009. That expectation has now apparently turned into hope. Isn't that part of that slippery slope of hope?

Without a sustained rally today the charts continue to look rather bearish. We could be close to a capitulation event or we could be close to a big reversal back up, or anything in between. Let's see what the chart setups look like.

SPX chart, Weekly

The weekly chart of SPX looks, well, weak. I pointed out last week that we have a confirming sell signal from MACD and this week you can see that it has clearly rolled over and has a long way to go before being oversold. RSI is approaching oversold as measured against the January and March lows. SPX is now very close to confirming the DOW's break of the January/March lows (by breaking below 1257) and I suspect we'll see that break this week. Depending on the price pattern we could be getting close to a big bounce back up (pink) or a continuation lower to below 1200 before setting up a larger correction. Regardless, the pattern is bearish and the longer-term trend is down.

SPX chart, Daily

Using a parallel down-channel for price action since the May 19th high you can see that price is not far from the bottom which is near 1253 tomorrow, which of course is slightly below the March 17th low at 1257. As long as price stays in the lower half of the down-channel (today's bounce failed at the mid line) stay bearish the market. It takes a break above 1292 to confirm the first wave down from May 19th is complete and that it's into a correction of that decline. As shown in pink, that kind of bounce, probably into the end of July, would be an outstanding short play setup. In the meantime I see the possibility for the market to continue stair-stepping lower (with the possibility for big and short-duration rallies in between) to below 1200 by the end of July.

Key Levels for SPX:
- cautiously bullish above 1292
- bearish below 1273

SPX chart, 60-min

The 60-min chart shows a slightly steeper down-channel from the June 5th high and SPX has been tapping the bottom of this channel since last Friday's low. Tomorrow could see SPX finding support around 1253 and should be a time for a slightly larger bounce into next week. It will likely be a choppy sideways/up kind of correction so it won't be any fun to trade. Above 1292 would likely be an easier-to-trade move.


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The one thing to watch with these parallel channels is how price behaves around the bottom (of a declining channel or the top of a rising channel). Notice how price dropped out of the larger down-channel from May 19th last week and then found it to be resistance for today's bounce. This is very typical price behavior. If price drops out the bottom of the steeper channel (red) then we'll know the price decline is further accelerating (water-falling lower). That would be clearly bearish, as it was when it fell below the blue channel, but then you need to start watching for capitulation.

DOW chart, Daily

The DOW's daily chart looks very similar to SPX--price has declined in a tight parallel down-channel since its May high. Like SPX it found the mid line of the channel to be resistance today and is now heading back down towards the bottom of the channel again, currently near 11060 tomorrow. Unless the DOW can rally back above 11430 stick with the trend and look to sell the rallies.

Key Levels for DOW:
- cautiously bullish above 11430
- bearish below 11400

DOW chart, 60-min

I had originally drawn the down-channel slightly differently (off the initial highs and lows) and then a steeper channel from the June 17th high. You can see how price has been struggling underneath these channels since breaking below them. The DOW has been one of the weaker indexes (first to break the January/March lows) and to see it breaking below its channels is not a surprise. It may be time to draw in a new steeper down-channel and see how price does inside it.

Nasdaq-100 (NDX) chart, Daily

The bottom of the down-channel for NDX is near the uptrend line from October 2002 and gap closure from April 15th, all in the 1785-1795 area and I'd be surprised if we don't get a bounce from that level, as depicted on the chart. The larger degree pattern is down so here again, if we get the bounce it will be a good opportunity to short it.

Key Levels for NDX:
- cautiously bullish above 1875
- bearish below 1850

Russell-2000 (RUT) chart, Daily

The RUT shows the "waterfall" look as the selling has started to accelerate. I've said many times that we will see selling in the techs and small caps start to out accelerate the selling in the blue chips once fund managers realize they bought into, literally, the idea that we'll have a rally this year. That's why we saw the RUT outperforming on the upside. We will now see it outperform on the downside. If the decline sticks to the Fib relationships between the individual waves it should soon find support around 660 and then bounce back up to perhaps the 670 area. As depicted that could mean a bounce back up to retest the broken downtrend line from October. But trying to pick a bottom for a counter-trend long play is difficult at best. In a downtrend it's better to take profits on short plays and then wait to reinitiate. Surprises will be to the downside now.

Key Levels for RUT:
- cautiously bullish above 695
- bearish below 683

BIX banking index, Daily chart

I thought the banks would find support in the 178-180 area and for a few days it looked like they would. The banks are actually showing some relative strength (not hard when they've been beaten down as much as they have). I think the chances of additional downside have now increased since they weren't able to hold above 180. It's really painful to think about where this index could eventually bottom out (perhaps down near 100). After a high above 400, a 75% haircut is hard to imagine. These aren't tech stocks! In fact, for a painful reminder for some, this monthly chart shows why you want to use stops no matter how strong you think the stock/sector/market is. Emotions rule, not fundamentals (of course we became painfully aware how poor the banks' fundamentals became, and still are).

BIX banking index, Monthly chart

Ouch. There will be many who kick themselves for not stopping out when that long term uptrend line was broken back in July 2007. Don't let your other holdings suffer the same ignominy.

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

The price pattern for the decline from the April high is clear--it looks like it's into its 5th wave down and when finished (maybe near 216) there's a good chance the decline in the home builders will be finished. It could be dead money for a while but it's not hard to get a 50% rally from 200 than when it was up at 1100. But, we'll see how it looks if and when it gets down there. The 2000 low for this index was near 125.

Transportation Index chart, TRAN, Daily

Another index that was outperforming to the upside is playing catch-up to the downside now. It too has developed a waterfall decline appearance. It might find support here at its old inverse H&S neckline from last October. But I see an equal possibility that it will break below it and then find it to be resistance on a bounce as it continues to drop back down towards its January low.

After the DOW failed to confirm the TRAN's new high in May (DOW Theory non-confirmation), a drop below the January low would be a DOW Theory sell confirmation. There were many in the media who appeared confused about this back in May.

U.S. Dollar chart, Daily

The US dollar closed below its uptrend line from March and that looks bearish for the dollar. If it doesn't immediately reverse tomorrow but instead continues lower, and especially with a break below the May low of 71.82, we can expect to see the dollar work its way down to new lows this summer. That would of course be bullish for the euro and commodities.

The ECB (European Central Bank) decides tomorrow (8:30 AM EST) whether or not to hike interest rates. Just about everything Trichet has been saying the past few weeks indicates they will raise rates and the euro, and commodities, have been rallying in anticipation of that (makes for a more attractive investment than the US dollar). If the ECB decides to hold rates steady look for a fast reversal of the recent gains (and a rally in the dollar).

Oil chart, Oil Fund (USO), Daily

Oil broke out of its sideways consolidation and appears to be heading for the top of its channel. As noted on the chart I have three upside targets: 118 is a Fib projection for the 5th wave of the rally (which will be followed by a much larger decline than we've seen this year), 120 is the projection out of the sideways consolidation pattern, and then 122 is the top of the channel.

Oil Index chart, Daily

Oil stocks took a nose dive this afternoon and produced that big red candle inside its consolidation pattern, which looks more like a sideways triangle than a rectangle. And interestingly, this consolidation pattern is bearish and I expect to see price break down from it. But I think first it needs one more push back up to the top of the triangle pattern before letting go. If it drops below 921 tomorrow then the consolidation is finished and it's starting the next leg down.

Gold chart, Gold Fund (GLD), Daily

Gold's pattern continues to look bearish. The multitude of 3-wave moves is indicative of a corrective pattern and not one that says we're going to see a strong rally from here. It's possible we'll see gold chop its way higher but I'm still having my doubts about any strong rally. As depicted in dark red, I'm looking for gold to top out around the current level and start heading south at a high rate of speed. This chart says the ECB is going to hold rates steady tomorrow. I could of course be completely wrong on this one but it sure looks ready to reverse to me and I can't think of another reason why gold bulls would run scared from here. But much higher than 94 (953 spot price) and I'll have to join the bulls (or at least go neutral).

Economic reports, summary and Key Trading Levels

Tomorrow morning we've got the ECB rate decision at 8:30 AM which will affect the US dollar, euro, commodities and maybe even our own Treasuries, it will very likely have an impact on our stock market. And then we'll get reports on earnings (the Fed does not want to see wage inflation creeping in here) and the jobs report. So we could have some early fireworks in the futures tomorrow morning. How that will translate to the cash open is anyone's guess. Just be aware the morning could be a little wild. Throw in a day before a long weekend when fewer traders will be at their desks and the lower-than-normal volume could make for a volatile morning.

The bulls have one more chance to make this week the bullish one that it normally is. That means they need to get the DOW at least up to 11353 and SPX to 1279. From today's closing prices of 11215 and 1262 that should be a piece of cake (after all, we've been easily swinging 200 points in the DOW). Holding onto those gains seems to be the challenging part lately.

The bottom line is we're in a downtrend and a pretty steep one at that. For those who don't like to play the short side, and admittedly it's often the tougher direction to play, continue to stay safe on the sidelines. Picking bottoms is generally a very difficult trade and especially so when we're in a steep decline as the current one is. It's far better to look for a bottoming signal and then buy the pullback after that. It can be frustrating to miss a big v-bottom (not that I'm predicting one) but it's even more painful to bleed to death by a multiple cuts from your attempts to catch falling knives.

If you like attempting short plays you've got your downtrend lines and channels for your guide. Keep an eye on Fibonacci retracements and your other favorite trading tools to identify when a bounce may be getting ready to roll back over. As they say, the trend is your friend so go with it. Just stay aware of those short-covering rallies that tend to blow up bears' accounts. Trade it, don't fall in love with it. Take profits and don't kick yourself for missing some of the move. Congratulate yourself instead on getting a piece of it before they come roaring back to get you. Grab that little piece of cheese and scurry back into your hole to enjoy it.

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

Key Levels for SPX:
- Cautiously bullish above 1292
- bearish below 1273

Key Levels for DOW:
- cautiously bullish above 11430
- bearish below 11400

Key Levels for NDX:
- cautiously bullish above 1875
- bearish below 1850

Key Levels for RUT:
- cautiously bullish above 695
- bearish below 683

Keene H. Little, CMT
Chartered Market Technician

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