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Market Wrap

Scare Bear

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After talking about limiting the ability for traders to short Fannie Mae and Freddie Mac, along with a handful of protected investment banks, the bears got a little scare. Add in some better than expected earnings reports from some banks (not hard to do when they've been beaten down so bad) and you have a good recipe for a bear fry. From Tuesday's low to Thursday's high we saw the DOW gain 544 points. Amazing what a little short covering can do.

The big question now is whether or not this is just a bear market rally that should be shorted (just not the banks, leave those protected entities alone--wink) or if instead we've got the start of something bigger to the upside. We'll just have to review the charts and see what they're telling us but the bottom line is I think it's just a bear market rally. However, I do think we're very close to a tradable bottom, one which should be good for a multi-week bounce.

Could we be witnessing a little money rotating out of commodities and into stocks? It's only a relatively small move so far but oil appears to have peaked, or at least it looks like it may be due for at least a larger pullback than anything we've seen for a while. It dropped down below $130 today and that's after breaking its uptrend line from April 1st. I'll review the potential significance of that break later with the chart of USO. Gold appears to have topped for now as well. Equities could use a little boost, both from actual money flowing in as well as a psychological lift from an abatement in commodity inflation.

JP Morgan (JPM) got things rolling this morning after reporting before the bell earnings that were not as disappointing as had been expected. I think this will be a common theme--not as bad as had been expected. So much bad news has been priced in that it could clearly be a case of sell the rumor, buy the news. JPM reported net income down -53% after writing down more mortgage related loans and other leveraged loans, in addition to the $540M write off from the Bear Stearns "acquisition". Sounds pretty awful right? JPM rallied +10% on the news. You just can't keep a good bank down.

As I had pointed out on the banks' chart last week, I've been looking for a bottom in that index and a multi-week bounce to relieve some of the oversold conditions (before it heads lower again). I suspected the earnings reports would be met with relief that things are not worse than expected and that's exactly what we're getting. However, things are still very bad in the banking industry. There's a reason the SEC feels it's necessary to protect the investment banks from big bad bears and their desire to exploit the weakness in that industry. The SEC wants to prevent "naked" short selling which is selling stock without first borrowing it from your broker. You can still buy puts and sell single stock futures so there are ways to get around directly short-selling the individual stocks' shares.

The one question I have is why it's OK to buy contracts for oil where the commodity does not exist (there are far more long contracts held than there is oil to cover those contracts), which heavily favors the investment banks, and yet short sellers cannot short the banks' stocks where they don't exist. Me thinks the regulators are skewing things to protect their banking buddies. But then again, that is no surprise. It's always been thus.

Many people are noting how oversold the market is and therefore we should be looking for a buying opportunity (for more than just a bounce). What many are dismissing, or not thinking about, is the fact that we're not in a bull market. Most comparisons of market data are to relatively recent data, say since the 1990's. We had a bull market that ran from 1982 to 2000 so to compare data in a secular bear market (which I believe we've been in since 2000) to the previous bull market is not an accurate comparison. What really needs to be done is compare to the previous bear market which ran from 1966 to 1982.

I mentioned last week that many sentiment indicators are showing deeply oversold and when that happens it can certainly lead to some sharp rallies. But bearish sentiment is not necessarily indicative of an approaching low. I had mentioned bearish newsletter sentiment ran for 46 weeks straight back in 1994 and that was during a secular bull market! We're currently running 5 weeks straight. Hardly oversold by that measure.

I've made mention many times in the past year that consumer sentiment will lead us into a much more severe recession than most have been predicting. In fact I dare say it will be far worse than a recession and a reason I've been so adamant about people protecting their portfolios. The market may not recover for a very long time and for baby boomers it could be a long-term devastation to their retirement accounts. The following chart shows consumer expectations since 1967:

Consumer Expection, 1967-June 2008, data from Conference Board

The latest data shows it's at an all-time low. This is lower than at any time during the previous bear market. The stock market is a reflection of social mood and right now social mood is in the toilet. If you don't want your investments there I strongly suggest you move to cash. Inflation will soon turn to the 'D' word in which case cash will appreciate instead of depreciate. It's one of the few investments in which that will be true.

But as I mentioned above, I think the market is nearing a tradable bottom. It has either already made it and we'll see a multi-week rally into August or else it has one more new low to get out of the way and then a rally into late August/early September. If I've got the larger price pattern correct it will be the last good chance to get out of long positions and batten down the hatches.

One of the problematic areas is credit. Before the 1929 stock market crash there were very similar conditions that led up to it. Massive credit creation, corporate buyouts, LBOs, etc.--it was all part of the roaring twenties. Then the crash. Today's credit creation dwarfs what happened before 1929, by orders of magnitude. The financial market is in the hurt locker and the best the Fed, SEC, Treasury and whoever else wants to try to save the banks, can do is slow down the inevitable contraction. The following chart shows what's been happening to the credit market since it peaked in 2007:

Bank Credit plus Commercial Paper, 1970-June 2008, data from Federal Reserve Board

Just like the chart on consumer expectations the amount of credit has dropped (OK, crashed) to a level that is below where it was even in the last bear market. Credit is the lubricant for our financial machinery and without it the machinery comes to a screeching halt. The authorities will kick it every now and again, squirt a little 3-in-1 oil on it (rate reductions, let more banks use the discount window, stop the bears from shorting, etc.) and get it moving again. But it's broken and the only way to fix it is to rid the system of the massive excesses that created the problem primarily in the last 10 years. The amount of write-downs yet to come is staggeringly large. It's going to be painful but the sooner we get it over with (which they won't allow, same as what's been happening in Japan) the sooner we get back to health and on a growth path. In the meantime we need to hunker down, trade carefully for income or slow growth and protect, protect, protect.

And with that I'll get off my soapbox and take a look at today's charts.

SPX chart, Weekly

At this point I don't think SPX will reach the bottom of its parallel down-channel for price action since last October's high (currently down near 1150) but I would stay prepared for that possibility. If we do get another leg down to finish the first wave down from May 19th there is a Fib projection near 1290 (so essentially a retest of Tuesday's low. I have some other Fibs pointing to the possibility for a drop down to 1170 (where there's also price level support from 2000 and 2004/2005) which is right in between the 1150 and 1190 levels. But once the next leg down finishes (assuming we're going to get it) the market should then be ready for a rally into August/September with an upside potential target around 1300. After that bounce is when it will get ugly (we haven't seen ugly yet).

SPX chart, Daily

The bounce off Tuesday's low has brought SPX up to its downtrend line from June 5th which is the top of its parallel down-channel. The wave pattern calls for one more leg down (dark red) before it will be set up for a multi-week rally. However, if SPX manages to push above 1278 then I think we'll already be into the multi-week bounce (pink).

Key Levels for SPX:
- cautiously bullish above 1278
- bearish below 1265

SPX chart, 120-min

The rally off Tuesday's low looks potentially bullish but so far the advance looks more like a sharp 3-wave move which makes it a correction. The 2nd leg up for the bounce came close to achieving 162% of the 1st leg up at 1265, just a point above its downtrend line. If this is correct then the next big move will be back down to a new low below Tuesday's.

One of the reasons I'm considering the sharp bounce off Tuesday's low as only a 3-wave move (and therefore only a correction and not the start of something bigger to the upside) has to do with the fractal nature of EW analysis. The previous 4th wave of a smaller degree (part of the 3rd wave down) was also a very sharp 3-wave advance where the 2nd leg up also came close to achieving 162% of the 1st leg up. This is labeled wave (iv) on above chart and was the rally from the July 7th low to the July 9th high. Now we've got a similar pattern this week and it's for another 4th wave correction but a larger degree. If this is correct then what will follow will be another decline just as it did following the July 9th high.

DOW chart, Daily

The DOW also ran into its downtrend line from its May 19th high. Unlike SPX it had fallen out the bottom of its parallel down-channel repeatedly but kept holding on. The wave count calls for another leg down to at least a minor new low below Tuesday's. It might make it down to the 10,700 level this time. But if we get a pullback followed by a break above today's high it will be bullish for at least a rally into August, perhaps up to 12K.

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

DOW chart, 120-min

Zooming in closer you can see how the DOW parked itself right up under its downtrend line. Following stinky earnings reports after the bell, including GOOG, it's looking like we'll start the day back down on Friday. The next low should be a good setup to trade the long side of the market but be careful about catching those falling knives. As shown in pink, a pullback followed by a press higher would be bullish and also a good opportunity to nibble on the long side (for a trade only).

Nasdaq-100 (NDX) chart, Daily

NDX did not quite make it up to its downtrend line from June 5th and as shown on the 120-min chart below I see upside potential to 1880 before turning back down. Well, I saw upside potential until GOOG laid a stink bomb after hours and cleared the floor of bulls. NQ dropped more than 14 points to a low shortly after 5:00 PM. What the futures will look like come Friday morning is anybody's guess. I show more downside potential on the NDX chart than I did on SPX or DOW. If it were to drop below 1700 as depicted I suspect the DOW and SPX would not be making just minor new lows. Hopefully the pattern will be clear enough to start suggesting on the live Market Monitor when to be looking for a long play to set up. Least resistance remains to the downside for now.


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Key Levels for NDX:
- cautiously bullish above 1880
- bearish below 1780

Nasdaq-100 (NDX) chart, 120-min

I've drawn in a parallel down-channel just for the price action since mid June as a guide. NDX closed just above it and I thought there might be a good chance to see 1880 before heading back down (or at least pulling back as depicted in pink). A gap down in the morning could leave today's move above the channel as just a little throw-over.

Russell-2000 (RUT) chart, Daily

The RUT is the bullish one without a doubt. That's no little throw-over above the top of its down-channel. That's a clear bullish break and of all the indices this one gives the clearest indication that we've seen the low for now and that we should be looking for only a pullback before pressing higher (pink). Respect that possibility if you're short the market. But the dark red wave count, like the others, is looking for another leg down to finish the 5-wave move down from the June high. But the RUT has been on a slightly different path than the others (including a new high in June when the others made a lower high below the May highs) and therefore this one may be marching to the beat of its own drummer. Regardless, bullishness in the small caps should be making bears nervous.

Key Levels for RUT:
- cautiously bullish above 700
- bearish below 670

I'm including a chart of the Wilshire 5000 this week because I consider it more "the market" than the others. I like to watch this one for confirmation if I'm getting mixed signals between the above indices.

Wilshire 5000 index (DWC), 240-min chart

The pattern in DWC is clean and it shows the need for another leg down to complete a 5-wave decline from May. If today's high marked the end of the 4th wave correction then the 5th wave projects down to 12218.60 where it would be equal to the 1st wave (which was the initial decline off the May 19th high). A lower projection at 11825.20 is where the 5th wave = 162% of the 1st wave, a common projection in a strong move which this has been. Keep your eye on those two levels if we get another leg down.

BIX banking index, Daily chart

The 2-day rally in the banks is a clear example of short covering. After 2-1/2 months of solid selling it's no wonder. We don't know if there will be any follow-through buying after some of the shorts are finished taking profits off the table. As depicted I think we'll see a pullback (perhaps with the broader market decline to a new low) and then another rally leg up to the top of its down-channel from the March low. I think we'll then see lower lows for the banks into the fall (but not as hard selling in the banks as we'll probably see in the other sectors).

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

For over a year now I've shown a downside projection for the home builders index at 216.19 which is two equal legs down from its 2005 high. Tuesday's low was 221.11. Starting from the July 2005 high of 1120.47 I'd say that's in the ball park. So is that it? Have the home builders seen the final low? While that's certainly possible I think they're ready for a bigger bounce but we probably haven't seen the final lows yet. For now though I would not be short this sector unless it breaks below 216. In that case I'd say the home builders are in serious trouble (as if they haven't been already?).

Transportation Index chart, TRAN, Daily

The Trannies have had exaggerated movements as compared to the broader indices but the pattern is the same and it calls for another leg down for its decline from May (for a possible retest of Tuesday's low only). From there we should see a nice bounce into August.

U.S. Dollar chart, Daily

The US dollar broke below its up-channel from the March low and that certainly looks bearish for a move to a new low. There is a Fib projection for the 5th wave down that's near 68 if the dollar keeps declining. Notice that today's rally found resistance at its broken uptrend line so a kiss goodbye here could be a bearish sendoff. Otherwise, the pattern has been very choppy and the decline from June could be just part of a larger upward correction and we'll see another rally leg develop (pink). It needs to get back above 73.16 to suggest the more bullish possibility will play out.

If the dollar tanks it should be good for commodities but I'm getting the opposite impression from them. This is the one thing that has me thinking the dollar may fool us and develop some strength soon.

Oil chart, Oil Fund (USO), Daily

Oil has broken its uptrend line from April 1st. After the bearish divergences confirming a potential rising wedge pattern the break could be significant and a retracement of the wedge would have oil back down below $100 relatively quickly (by September, which would coincide with a stock market rally). For USO the equivalent level would be back down to the $70-$80 area. I don't know if we'll get it but a bounce off its uptrend line from February could be a good setup for a short play--buy some October or December puts for a ride down to 80. The dark red depiction is how a typical impulsive decline from the July high would look.

The bullish possibility is that we'll see the price of oil consolidate sideways through most of August before proceeding higher (shown in green). A rallying oil market could help depress the stock market after it bounces into late August/early September.

Oil Index chart, Daily

The oil stocks have been forecasting a pullback in oil and the decline in the oil stocks does not look finished. I show, in pink, the possibility for a rally back up to the 950 area, which is very possible if the broader market is rallying, but I think the higher probability is for a continued decline to test the March low if not a little lower before it's set up for a bigger bounce.

Gold chart, Gold Fund (GLD), Daily

It's harder to see with GLD and easier to see on the gold contract chart, but the move up from the June low looks like a completed 5-wave move. That suggests at least a pullback to correct the June-July rally (shown in green) before pressing higher again. But there's a larger 3-wave bounce off the late-April low that suggests the bounce in gold is over and now we'll get a strong decline back down to the 80 level. A break below 92 would be bearish. A push back above 97.50 would be bullish. Watch the US dollar for some clues as well, and what's happening in the oil market.

Economic reports, summary and Key Trading Levels

The numbers out of the housing market were better than had been expected but new construction on single-family homes still fell another -5.3% to another 17-year low. A change in data collection procedures for multi-family units in NY helped push up total starts by +9.1% but I'm not sure about the apples vs. oranges comparison there. Excluding the Northeast data showed total starts were down -4%.

The Philly Fed index showed a continued slowing in manufacturing, the 8th month in a row. The good news is that it was less negative than last month. It was in line with expectations. The bad news is the prices paid component--75% of the companies reported paying higher prices for their goods while only a third reported being able to raise their own prices.

We've had a very bullish two days in the market but the hard part in a bear market is determining whether or not the rally is just a quick spurt of short covering or instead is the start of serious buying. Right now it looks more like short covering. There was about a 3:1 buying to selling ratio yesterday and closer to a 2:1 ratio today. That's not indicative of strong buying pressure following a washout kind of low. Buying was strong but I don't think strong enough to warrant a recommendation to buy the next pullback.

However, if we get a strong pullback that corrects the 3-day rally that is then followed by a rally above today's high (or tomorrow's if we see another high before pulling back) it will be a bullish sign and then I'd look to nibble on some longs. But remember, it's a trade to the upside for at most a few weeks. It's not a buy and hold for a long play into the end of the year.

Bears need to be cautious now. If we're due a 5th wave down for the decline from May, these are typically less trustworthy than the others. They can even end truncated (not giving us a new low below Tuesday's) or they can extend (such as with a move down to SPX 1170 instead of the Fib projection to 1190). My point is that you're pressing your luck by shorting the market now if you can't watch the market during the day. We're close to getting a bigger bounce than we've seen, whether it's from here or from a new low first.

Trade carefully now and be quick to take profits. Good luck and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1278
- bearish below 1265

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

Key Levels for NDX:
- cautiously bullish above 1880
- bearish below 1780

Key Levels for RUT:
- cautiously bullish above 700
- bearish below 670

Keene H. Little, CMT
Chartered Market Technician

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