Option Investor
Market Wrap

It's Time to Buy

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I say that facetiously (so don't go out and buy the market yet) because Jim Cramer is now saying "Sell everything. Nothing's working." His throwing in the towel has me thinking maybe we're reaching a tradable bottom soon. Soon is the key phrase here. Soon could be here or it could be in a few days down near DOW 10900 or it could be the end of next week (opex week) down near 10500. The only thing I have to ask Jimbo is where was he 20% ago last October? Did he really think, like so many wanted to believe, that the credit crisis and bank fiasco was going to be contained? Did he really think a consumer slowdown caused by declining home values and empty home equity piggy banks was not going to result in a recession this time? The warning signs were pasted all over the wall and yet he and many others simply ignored them.

So now Cramer's crying the blues and telling us we should sell everything. Since he was telling us to buy at the top and to keep buying during the decline, including Bear Stearns the day before its demise, do you suppose we might be able to use him as a contrarian sign for a bottom here? What's got him upset is that so many of his (well-paid) friends are losing their jobs on Wall Street. I could be forgiven for not having a lot of sympathy for the mega-rich money changers losing their jobs and joining the real world.

Certainly investor mood has turned sour enough to suggest we're oversold to the point where we can expect a decent bounce back up. Robert did a great job covering sentiment indicators in both last night's newsletter and his Contrarian piece. He showed the volatility index (VIX) chart and pointed out some things to watch for in order to confirm a bullish reversal in the market. I have a slightly different (OK, bearish) take on VIX and think that it's not showing us enough fear. I don't necessarily expect a capitulation event in the market because quite frankly it's way too early to expect one. Not until much lower levels and a lot more fear has registered will we likely see a "puking party", to use the market's vernacular.

If we compare the VIX and SPX charts since last October we see that the market is making lower lows and yet the VIX is nowhere near the January and March highs:

SPX vs. VIX chart, Daily

SPX has been making steady new lows since breaking the March low this month but VIX is still well below its November, January and March highs. It's as if investors are less concerned about today's lows than they were about the January/March lows. Have people become numb to the fact that the market just keeps dropping lower? If so it would help explain the fact that total trading volume has been dropping since the May high. A lack of volume in a strong price decline (as opposed to seeing lower volume in a normal pullback in a strong bull market) indicates that there's more selling to come. Selling pressure has picked up but buying pressure has clearly waned. The combination shows up in lower volume numbers and that's what we're seeing.

There are other sentiment indicators such as bullish vs. bearish advisors, put/call ratios, American Association of Individual Investors (AAII) sentiment data, etc. InvestorsIntelligence.com reports bearish advisors now outnumber the bullish advisors by the largest margin since 1994. A first reaction to this would be to load up the truck on call options--this market is ready for a reversal now! I'd suggest keeping that truck unloaded for the moment. Some interesting data from Elliottwave.com reports that bearish advisors outnumbered bullish advisors for 46 weeks straight, or nearly a year, back in 1994. So this is not exactly a market timing tool. Once the bull market of the last half of the 1990s got into gear the bullish advisors outnumbered bearish advisors for 5-1/2 years. Currently we've seen 4 straight weeks where bearish advisors outnumber bullish and therefore one could say we're only in the infancy stage of this bear market.

Another sentiment indicator I've shown before is the call/put data from ISE.com. This shows the number of calls and puts being purchased primarily for speculation (they have a proprietary way of filtering out hedge plays and spreads). This is the chart of the data since last October:

ISEE call/put data, Daily, courtesy ise.com

Note the low readings in January and March. This reflects a high number of puts being purchased relative to calls. You can see the opposite back in October when more traders were buying calls (at the market high). Now look at the current readings in the past month--if anything the number is trending up. As the market has been sinking lower more people are buying calls in anticipation of finding a bottom! If I went with nothing else this chart alone would keep me playing in the bears' sandbox.

The bottom line here is that you will hear many calling for a bottom because the market is oversold, that there are too many bears, too many put buyers, we're more bearish than any time since 2002 (or 1994). To which you must say "so what". Price is the final arbiter and the price pattern is bearish. Downtrend lines and down-channels have not been threatened and moving averages continue to hold down the bounces. The trend is your friend.


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As most of you know, I was looking for a top to the rally most of last year so I've been known to fight the trend and look for a reversal. But I look for signs in the price pattern (wave analysis), a loss of market breadth during rallies, Fib targets being hit, etc. and was able to pretty well nail the high in October. I like to play reversals but it's too early for me to be looking for a low.

We're getting closer to a tradable bottom and I'll show some downside targets and some upside key levels to watch in case we find a low sooner than I expect. When we start hitting some important downside targets and I see some market breadth numbers showing bullish divergences I'll then be looking for a reversal and recommending some long plays that could be good for a nice rally into August/September. After that I'll want to be short for a big ride back down (but that's a few months away). For now the downside is getting a little riskier (but not as risky as the upside) and I'm watching for evidence of bottoming (by price action, not by sentiment or Jim Cramer or any other talking head on CNBC). On to the charts:

SPX chart, Weekly

The price pattern on the weekly chart suggests lower prices, perhaps to about 1190 by the end of the month. Before we find a meaningful bottom (something good for a rally of more than a couple of weeks) I suspect we'll see MACD buried further than it was back in January and March. But I show the possibility for a stronger bounce (pink) from here. We are oversold and it would not be difficult to get some serious short covering going. If you're playing the short side don't get complacent.

SPX chart, Daily

SPX is following the mid line of its down-channel lower. I show a drop to the bottom of the channel in the next few days to be followed by a bounce back up to the top of the channel and then down again into the end of the month. It's possible the new low around 1220-1225 (which should be strong support) will mark a longer term and tradable bottom (pink) and it will be worth nibbling on some long plays if and when it gets there.

Note my comments on the chart by MACD and RSI. There are hints of bullish divergence but nothing strong yet. When a trend is about finished, meaning the leg down from May, you will very often see RSI break its trend line first so that's what I'm watching here. If RSI breaks its downtrend line, it doesn't mean price can't make a new low but if it does make a new low and RSI is testing its broken downtrend line, that's usually a very good trade setup (on the long side in this case). Something to watch for over the next week or so.

Key Levels for SPX:
- cautiously bullish above 1292
- bearish below 1278

SPX chart, 60-min

This afternoon's bounce has the potential to continue tomorrow morning up to about 1270 where a Fib projection and trend line could cause trouble for the bulls. The primary message I'm getting from the price pattern is that we're seeing a correction of the decline and nothing more bullish than that. Therefore continue to look for setups on the short side for a move to lower lows.

DOW chart, Weekly

A recap of price action since the May high shows the DOW gave a kiss goodbye to its broken uptrend line from August 1982-October 2002. Ms. Market gave the DOW a mighty slap in the face for that unwanted kiss. The break of the green uptrend line is a Major break--that uptrend line was used as support and resistance since the 1974 low, including the January and March lows (the last touch before that was October 2002). As shown in pink we could see a bounce all the way back up for a retest of that broken uptrend line and if it managed that kind of a bounce it would be a MOAP (Mother of All Puts) setup. I have my doubts we'll see that. I think the DOW has a better chance of moving lower, possibly as low as 10500-10700 into the end of the month, and then a bigger corrective rally into August/September before selling off again.

DOW chart, Daily

Like SPX the DOW is in a narrow down-channel since the May high and is not threatening to break out of it. The least resistance is down and I see the likelihood for a drop to around 10700 in the next few days and then a bounce into the end of opex (next week). I'll then have to see evidence of the kind of bounce we get to see if we'll get a bigger bounce into August (pink) or just back up to the top of its down-channel and a final low by the end of the month/first of August before breaking its down-channel.

Key Levels for DOW:
- cautiously bullish above 11500
- bearish below 11400

DOW chart, 60-min

Again, just like SPX, I see the possibility for a little more choppy consolidation into early next week before dropping lower again or we could start down in earnest right away on Friday and make a low by early next week.

Nasdaq-100 (NDX) chart, Daily

NDX has been stronger than the blue chips but it too sports a nice parallel down-channel for its decline and is not threatening to break out either. A move above 1875 is needed to confirm a more bullish move has started (pink) but I think we'll see another move lower after the current price consolidation finishes. A downside target near the March low by the end of this month is depicted.

Notice though that RSI has broken its downtrend line. This is a warning flag for bears. We could still get a new low but it may not be nearly as deep as I'm showing. If NDX makes a minor new low with bullish divergences on MACD and RSI I would cover my short positions and nibble on some longs. Whether from here, a little lower, or from the March low, following a new low should be a healthy multi-week rally to correct the decline from May.

Key Levels for NDX:
- cautiously bullish above 1875
- bearish below 1780

Nasdaq-100 (NDX) chart, 60-min

Downtrend lines continue to hold NDX down so use them to guide your trading. If we get a little higher bounce tomorrow morning keep an eye on the downtrend line from June 25th, currently near 1850, which stopped Wednesday's rally. If it can make it higher the top of its down-channel is near 1883. The price pattern suggests we'll see lower before we see the top of its channel challenged.

Russell-2000 (RUT) chart, Daily

The RUT looks like NDX. You can see it consolidating on top of the downtrend line from October. It may chop sideways for a little longer before continuing lower. If it can get above 685 then it could be at the start of a larger rally to correct the decline from May (pink).

Key Levels for RUT:
- cautiously bullish above 695
- bearish below 685

The banks have been in the news a lot lately. Probably because earnings season is here and there's a lot of worry about how they'll do. Everyone knows there's a lot of dirt under their carpets but everyone's afraid to peek. Even our fearless Treasury Secretary Paulson was out defending the latest to take some verbal hits--Fannie Mae and Freddy Mac. He has been quick to defend them against those who say the companies are insolvent (including by William Poole, the former president of the St. Louis Federal Reserve bank). This is the same Paulson who told us the subprime problem would have no impact on the economy and would be contained. This is the same Paulson who told us repeatedly over the years that the U.S. government supports a strong dollar (as it collapsed lower each time he opened his mouth). Paulson has no, zero, nada credibility and yet the market was relieved to hear his calming words.

Actually I may be being a bit harsh. He's probably right--they probably aren't insolvent. Each has the American taxpayer to bail them out if they should default.

But speaking of earnings, the banks have a little help from a rule change. Under a rule introduced in February 2007, after much lobbying by the banks, the financial companies are essentially now allowed to show higher profits (or lower losses as the case may be) if their credit rating worsens. Huh, you say? Yep, as their credit ratings decline, making their stock price less valuable, they are allowed to write down the value of their debt. More mark-to-model shenanigans by the banks. When they report their earnings we will know even less than usual about what their real earnings are. This will make the stock market reaction to their reported earnings that much tougher to gauge. Stay aware.

BIX banking index, Daily chart

Based on some Fib projections I thought the BIX might find support around the 157 area and the leg down from early May looks like it could be complete, or near complete. I've tentatively drawn in a parallel down-channel based off the two lows in March and July. The wave pattern calls for a sideways/up choppy correction, probably into September and I'm showing a relief rally up to about 190 by then. This could be a result of relief over the banks' earnings (although as stated above, those earnings will be dubious at best). Regardless, the move down from May needs to be corrected before they continue lower.

For additional downside projections I needed to go to the monthly chart:

BIX banking index, Monthly chart

With the BIX well below the 2000 low and no lower prices to find support it becomes difficult to figure out where support might come into play. Using daily, weekly and monthly pivots can help and so to can Fibonacci projections. Based off the move up from 2000 to 2007, it is very common to find support (in this case) at the 127% projection of the prior move. That's shown at 157.08. Whether it finds support here or not is anyone's guess but it's something to watch for. The next common Fib support levels are 138% and 162%. I think before all is said and done the banks will probably see the 162% level down at 86.97 but probably not until later this year or next year.

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

Other than the downtrend line from February 2007, which price has been oscillating about since March, I've drawn in trend lines that show a potential descending wedge developing since the April high. This could be significant for this index since I've got a wave count that is looking for a final low and the 5th wave often forms a descending wedge (in a decline and a rising wedge in a rally). I show hints of bullish divergence at the current low and this helps confirm the bullish descending wedge pattern.

If the broader market gets into bigger trouble later this year it's hard to imagine the housing stocks having a grand old time to the upside but I think this index is about done to the downside and should be left alone. I don't like it for a long play in a down market but nor do I like it for a short play. However, for a trader, trading the housing stocks on the long side soon could work--it doesn't take much of a rally from these lower levels to get a nice 50% return. I continue to like the 216 downside target and it could be achieved by the end of this month.

Transportation Index chart, TRAN, Daily

I show the Trannies stair-stepping lower into August but it's possible the wave pattern is even more bearish than what I've depicted. It's possible we're about to get a flush to the downside that takes the index well below 4000 in the next few weeks. I'm not predicting that will happen but just warning that the price pattern suggests it could happen. But until it breaks below 4600 there remains the possibility for a larger bounce in the index, especially if the broader market manages the same.

U.S. Dollar chart, Daily

After a little head-fake move below its uptrend line from March the US dollar did quick recovery back up inside its parallel up-channel. It has pulled back the past three days and could retest the uptrend line which is currently near 72.30. A break below 71.82 would confirm a breakdown in the dollar with a likely move to new lows for the year (despite Secretary Paulson's words to the contrary). But if the dollar can hold up here, it should be able to rally to a new high for the bounce from March and make it up to near 75. Depending on what the dollar does here should have a significant impact on commodities.

Oil chart, Oil Fund (USO), Daily

Oil remains in its up-channel from March (and longer term uptrend). The uptrend line from March is clearly important to traders so a break of it will be a big deal. But until that happens, the trend remains up.

Oil Index chart, Daily

While the commodity has continued to rally, oil stocks have not done so well. They could be ready for at least a bounce though. The move down from May achieved two equal legs down at 863.23 which was tagged today. I show a bounce back up to the apex of its previous sideways triangle pattern (typical support/resistance) just shy of 950 before rolling over again. A rally above 972 is needed to turn the price pattern bullish again.

Gold chart, Gold Fund (GLD), Daily

After tagging the top of a parallel up-channel for price action since the May 1st low, price pulled back last week but on Tuesday it successfully tested the broken downtrend line from April. It could fail here but I'm showing just a little higher to 94.71 to complete a 5-wave move up from June. That should complete the larger 3-wave rally from May 1st and I believe it will be a good short play setup there. As depicted in dark red, the next big move should be a decline to the 78-80 area.

Not shown on the chart (gets too crowded) are the Fib retracements of the March-April decline. The 62% retracement is at 94.00 so in between today's closing price and the 94.71 Fib projection for the move up from June.

For those who follow the actual price of gold, here's the chart of the gold contract (August):

Gold contract, August (GC08Q), Daily

It's the same pattern obviously and the same setup. The Fib projection for the 5th wave in the move up from June is at 964.30 and the 62% retracement of the March-April decline is at 967.80. I think this is the area where the gold rally will end, if not a little lower.

Economic reports, summary and Key Trading Levels

The Michigan Sentiment could move the market if it's more disappointing than the market expects. Many in the market are trying to discount the consumer sentiment and think it's different this time and that the consumer sentiment is not as important as it once was. Too much money on the sidelines (which is bogus by the way--funds are holding record low levels of cash as a percent of assets), Sovereign Wealth Funds, pension funds, you name it--they're all given credit for why the market will rally this year. And let's not forget that the market Always rallies in an election year.

But the consumer does matter and matters a lot. When 75% of our GDP is based on consumer spending and we have a tapped-out consumer (although they're trying mighty hard to continue credit card spending) then it makes sense to assume we will have a consumer-led recession and they're usually worse than business-led recessions.

From an Elliott Wave perspective, the market is in the early stages of the 3rd wave down (the 1st wave down was the October-January (or October-March) decline, followed by the 2nd wave correction into the May high and now wave-3 down has started. The 3rd wave is called the recognition wave because it's when the majority recognize that their previous bullish assumptions (that we'll have a modest growth year and a positive year in the market) were wrong. It's when the selling starts to accelerate as the majority start to exit their long positions. When the reality hits that we're not going to have a positive year (we're not there yet), that's when we'll start seeing very strong selling days. We haven't seen that yet and it's reflected in things like the relatively low VIX readings.

But before those kinds of days, which I think will be after the summer, we should be finding a bottom soon (this coming week or the end of the month) and get a multi-week rally. It won't be a pretty rally unless you put "pretty" in front of choppy. The summer could be a very challenging time to trade the market. Can't afford gas to go to the lake, can't trade, business is slowing down--oh joy, what do I do now? Read. Read and study and be ready to trade the market more quickly (long term trades are difficult at best and buy-and-holders will probably not be happy with their results).

If you're not comfortable trading the short side, practice on paper this summer. Paper trade buying and selling puts, sell credit spreads, read how to do these, take seminars/webinars. If there's one thing we have too much of it's information available at the click of a button. Use that power to expand your knowledge since different market conditions require different trading techniques. Traders get better over the years only if they know how to swing at all the different pitches and hit at least 40% of them while controlling their losses.

Lastly, remember we're heading into opex week. The Thursday prior to opex tends to be a head fake day for the Big Boyz to load up on cheap front-month options. The trouble with today is I'm not sure which direction was the head fake. Just stay aware that opex activities tend to skew the market in directions that are not necessarily reflective of longer term trends, even intraday. Whipsaws are common so trade light and trade quick.

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

Key Levels for SPX:
- cautiously bullish above 1292
- bearish below 1278

Key Levels for DOW:
- cautiously bullish above 11500
- bearish below 11400

Key Levels for NDX:
- cautiously bullish above 1875
- bearish below 1780

Key Levels for RUT:
- cautiously bullish above 695
- bearish below 685

Keene H. Little, CMT
Chartered Market Technician

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