Option Investor
Market Wrap

Shake Out

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Following a strong rally the market will often experience a strong pullback. In a bear market the strong rallies are typically a result of short covering which can make for some very strong buying. Instead of normal buyers waiting for a pullback to get a better entry, thus creating a more orderly stair-stepping higher market, short sellers start to cover their positions at any price once the market starts rallying. Stops are usually market orders and that buying during a rally tends to increase the strength of the rally.

Then you have the wannabe buyers who were waiting for the "dip" to be over so that they can do some buying. They then see the market running away from them and the fear of missing the buying opportunity causes them to start stabbing orders in as fast as they can. This adds to the buying pressure. And then it stops. The short sellers who wanted to take profits off the tables (vs. those holding short through the corrections) finish and the panicked buyers finish and then there's no more buying pressure. The short sellers, with money in their account, start nibbling on shorts again and the new buyers get nervous about buying the rally too late and they jump back out.

Think of bear market rallies as mini-parabolic rallies--they flare up, run out of gas and then coming crashing back down. Often the sharp rallies will be immediately followed by renewed selling that takes the market to new lows. That's the potential from here although I show the potential for some more upside to work through before new lows come. Today's selling was probably a shake-out of the weak longs--those who were late to the buying party. Once those weak longs are shaken out of their positions, leaving the ones who are now holding through the pullback correction (believing we'll see a much higher rally), the market tends to flip around and head back up to new highs for the bounce. That's usually when the new shorts get nervous and start bailing again and new bulls, emboldened by the resumption of the rally, decide to do some buying (determined not to miss the boat again).

The net result of all this, as you can imagine, is a lot of whipsawing in the market as both sides get stopped out of their trades. A corrective bounce is usually a 3-wave affair because of this whipping back and forth and the 2nd rally leg (the c-wave of an a-b-c bounce) is usually the last one before the buying finally peters out for good. Then the shorts attack with a vengeance seeing there are not enough bulls to keep the rally going. As of tonight I think we've only seen the 1st leg up of the correction and today started the pullback but I have to tell you my confidence level for another leg up is very low. If we get a bounce on Friday there should be more downside and the big question for me tonight is whether or not we should expect another rally leg above this week's highs for a rally into at least early August. But even we get a slightly higher rally it should be a good time for bulls to take profits and bears to enter new trades.

Today's strong decline certainly put the fear of the bear back into the market. The VIX, which naturally dropped hard from its peak on July 15th, seems to have found support. As a reminder, the bearish thing about the VIX high on July 15th is that it came nowhere close to its January or March highs even though the S&P 500 dropped to new annual lows. The lack of fear at the new price low should be worrisome for bulls from a contrarian indication. The daily chart shows the VIX had dropped down to its uptrend line from December 2006:

Volatility index, VIX, Daily chart

Since recovering back above the uptrend line in early June the VIX has made five stabs below the line, including yesterday's, since that time. The trend line appears to be significant. Today's big white candle completes a reversal pattern known as the morning star. The big red candle on Tuesday followed by the doji yesterday (the morning star) and then today's big white candle. Whether it will amount to just a correction of the decline in VIX or something more can't be known yet but it is a warning shot across the bow that the reversal from July 15th may have already run its course.

Today's economic reports did not help the market this morning. The jobless claims continue to climb higher and the revisions for past months continue to show higher unemployment (and lower job growth) than previously reported. The good news is that the continuing claims number has dropped so hopefully it's somewhat easier to find jobs for some. Some hard hit neighborhoods, with sharply falling home values, have coinciding high unemployment rates. I'm sure there are many neighbors who appreciate the definitions of recession and depression--a recession is when your neighbor loses his/her job and a depression is when you lose yours. I've been on both sides of that fence.


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Existing home sales (single-family detached and condos) was the other report and that continues to depress people as well. Sales fell -2.6% to a 10-year low while prices are down -6.1% in the past year ($215K median price). Resales are down -15.5% in the past year and down about -33% from the peak in 2005. Meanwhile the number of homes for sale continues to increase (it's the prime selling season) and home inventory stands at an 11.1-month supply. This is the second-highest inventory level since the mid 1980s. And we wonder why consumer sentiment is in the toilet?

Adding insult to injury, the 30-year fixed-rate mortgage is rising, now at 6.63% according to Freddie Mac. Inflation concerns have the banks raising their rates as they worry the Fed will raise rates later this year.

With that let's get to the charts to see what the last week could mean in the bigger picture, starting with the weekly chart of the S&P 500. One comment on tonight's charts--I'm getting a mixed message from the various indices. I'll cover each individually of course and then make some closing remarks at the end for where I think the market is headed next.

S&P 500, SPX, Weekly chart

I'm showing two price scenarios but on a weekly basis they're so close that they're practically on top of each other. Basically I'm showing the market is expected to continue to see lots of selling once the current bounce completes. A 50% retracement of the May-July decline is near 1320 and on the weekly chart the 200-week moving average is at 1321. Therefore, whether the market bounces up to that level from here or after a retest of the July low, it would be a good setup for a short play for the next leg down.

The reason I say it should be a good setup for a short play has to do with where we are in the EW (Elliott Wave pattern) which are the labels on the charts. For those who follow EW, the setup will be for either a c-wave down or more bearishly a 3rd of a 3rd wave down. In an EW count the 3rd wave is usually the strongest move and it's made up its own 5 waves. So the 3rd wave of the 3rd wave is usually a very fast and strong move, typically marked with gaps in the middle of the move. As the market is set up currently, that move could happen as early as August or as late as September. I suspect October is going to be its usual brutal self.

Another thing to notice on this weekly chart, which is shown using the LOG price scale, is the long-term uptrend line from 1992 through the October 2002 low. It's where the decline into the July low found support. To say this trend line is important, having been tested now, is an understatement. A break of it is a break of the bull market uptrend from 1992 (and as shown on the DOW below, the trend line is actually from 1974 and the DOW has already broken it).

S&P 500, SPX, Daily chart

After breaking its downtrend line from the June 5th high there was a quick test of it and then a continuation higher on Tuesday. If it takes a couple of days for another test it would also be a retest of the July low (shown in dark red). That would likely set up another and stronger rally into August so watch for bullish divergences at a retest (if we get it in the next few days) for confirmation of a buying opportunity (for a trade). But as shown in pink, we could get just a pullback and then another rally leg up to the 1320 area. That would be a shorting opportunity.

Key Levels for SPX:
- cautiously bullish above 1291
- bearish below 1235

S&P 500, SPX, 60-min chart

I'm showing one possibility for a move back down for a retest of the July low early next week (dark red). But if SPX finds support around 1235 (62% retracement of the rally off the July 15th low), especially with another test of its broken downtrend line, it should be good for another rally leg up to 1320 (so it would make a nice trade on the long side.

Dow Industrials, INDU, Weekly chart

Like the weekly chart for SPX I'm showing two scenarios for an expected bounce, one being after a retest of the July low (dark red) and the other being another leg higher after the current pullback finishes (pink). The longer-term uptrend line from 1974 through the low in 1990, which is where the October 2002 decline ended, is the bold green line. Where SPX has not broken this uptrend line yet the DOW has clearly broken it. This is a major break. It's a break of the last secular bull market uptrend and says it's over, finit, kaput, done, stick a fork in it and call it good. It takes a rally back above 12300 to say the break was just a head fake (on a monthly basis it would only be one month below the line whereas a close below it in July would be confirmation of the break.

The rally into yesterday's high was rejected at the 200-week moving average (the same one that's at 1321 for SPX) and the 2000 high at 11750, which of course is where the January and March lows found support. A failure here would be a kiss goodbye at support-turned-resistance.

Dow Industrials, INDU, Daily chart

The daily chart shows the short-term bullish scenario of finding support at its broken downtrend line from May, perhaps down around 11100-11200, to be followed by another rally leg up to the 12K area. The dark red price scenario calls for a retest of the July low and then a stronger bounce into August/September.

Key Levels for DOW:
- cautiously bullish above 11700
- bearish below 11140

Dow Industrials, INDU, 60-min chart

The two scenarios on the daily chart are shown up close in the 60-min chart. I show a bounce first tomorrow morning but that's just a guess as of Thursday's close. The market finished near its lows and we've seen many cases this year of reversals the following day. Think of it as short-term capitulation when the buyers run the market up to its high at the close or the sellers dump their stock into the close--they're flushed out. Then the following day reverses the move since the buyers (in a rally) or the sellers (in a decline) have finished and they're out of the way. This is what's meant by flushing out the weak holders.

Nasdaq-100, NDX, Daily chart

While the blue chips, and the small caps, were zoom-climbing the past week, the tech stocks were running a distant fourth place. The price pattern since the July 15th low looks like a corrective sideways consolidation and as such looks like a bearish continuation pattern. We could certainly see a rally leg out of the mess (pink) but it's still a correction. A rally above 1910 would get my bullish attention but until then this is a short waiting to happen.

Key Levels for NDX:
- cautiously bullish above 1910
- bearish below 1790

Russell-2000, RUT, Daily chart

Someone yelled "Fire!" in the theater filled with bears and then allowed them out through only one door. Shorts scrambled to cover and fund managers must be convinced it's a good time to buy (for the expected year-end rally I guess). The combination spiked the high-beta small caps as the buying pressure really spooked the shorts out of their positions. But today's candle is a hard reversal and we have an evening star reversal pattern (just the opposite of the morning star reversal pattern I discussed on the VIX chart). It can even be considered a bearish engulfing candle. Regardless, it looks bearish. The RUT was not able to tag its 200-dma and was not able to hold onto its 50-dma and even closed back below its 100-dma. Small caps can be volatile and the RUT has certainly proven that this month.

Of all the charts tonight I'd have to say the RUT is the most bearish as far as what's next. That sounds odd since it's been so strong. But as strong as the bounce was off the July 15th low, it's only a 3-wave move up. That's a corrective move and the sharp rally fits well as a 2nd wave correction in the larger 3rd wave down. This means the small caps may be starting the 3rd of a 3rd wave down and if true the selling will become intense at times, with the RUT leading the rest of the market to the downside.

That's the bearish setup (dark red). It's also possible we'll see a pullback and then another leg up (shown in light dashed pink) to match the move in the other indices. This one could be a wild pony so be very careful trying to ride it.

Key Levels for RUT:
- cautiously bullish above 726
- bearish below 670

Banking index, BIX, Daily chart

That which was very oversold going into the July low got the strongest bounce in the past week. They also saw the heaviest selling today. The BIX, home builders and airlines all had a good week up until yesterday. Today they got hammered. There are some real emotions running on both sides of the fence with these so trade carefully.

The BIX left a bearish shooting star reversal pattern yesterday at resistance (top of a parallel down-channel and its 50-dma). Today's red candle looks relatively small by comparison to its bigger move but it was down -7.3% today. I've updated the wave count (for those who follow it) for this index and now believe the banks have much further to fall. I was thinking the last low was setting up a longer-term tradable bottom but based on further review of its weekly and monthly charts I think the move down from its early-May high is its 5th wave and the move down from May was only the 1st wave of wave 5. The bounce looks to have completed the 2nd wave correction and now we'll see the 3rd wave down. The pain is not over for the banks, no matter how hard the SEC, Fed and Treasury try to protect their banking buddies.

One soap-box comment (or question) before I move on--why is it that Cox, the SEC chief, thinks it's OK to protect the big investment banks (his trading buddies) from the bad short sellers but the thousands of smaller banks who are in just as much trouble, if not more, get no protection? Not that I want the smaller banks protected (please no). But it seems more than obvious what the SEC is doing. Do the investment bank heads really have that many government officials in their back pockets? Never mind, I think I know the answer.

OK, silly question, I know. Let's move on. The brokers look to be in the same position as the banks:

Brokers index, XBD, Daily chart

After bouncing up to the top of the parallel down-channel in place since the highs of 2007 this index also looks ready for a 3rd wave down. It takes a rally above its May high near 185 to negate the bearish setup.

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

The home builders index almost made it up to its downtrend line from February 2007 but after today's big red one I'm thinking it might not make even that high. That's a bearish engulfing candle if I ever saw one--the past two days have been engulfed. The only question in my mind is whether or not a retest of the July low will hold.

Transportation Index, TRAN, Daily chart

The airlines gave the Transports a big boost this past week but the airline index (XAL) was down -11.1% today. Ouch, and it didn't help the Trannies. Another evening star reversal pattern. It also gave a kiss goodbye at its broken uptrend line from January. There's just nothing bullish in my mind when I look at this chart.

U.S. Dollar, DXY, Daily chart

The US dollar refuses to break down and is either going to rally back up to the top of its flag pattern (which it briefly broke below this month) or it could consolidate sideways into September/October before heading lower again. I show the possibility for a continuation lower (dark red) but that scenario would be negated if the dollar climbs back above 73.16. It's a choppy mess which leaves me guessing where it's headed next.

Oil Fund, USO, Daily chart

As I mentioned last week I think oil has topped, at least for this year. It has broken below a rising wedge pattern starting from the February or March lows and the break points to a relatively quick drop back to the beginning of it. As noted on the chart, that gives us a downside target zone of $70-$80 before seeing a bigger bounce. That equates to $86-$98 for oil's price.

Oil Index, OIX, Daily chart

The oil stock index broke long-term support by its uptrend line from March 2003. The commodity run looks like it might be over (the last bubble to pop). It's due a bounce but I believe it will continue lower into the fall.

Gold Fund, GLD, Daily chart

By dropping below 92 gold has left the bounce off the May low as a corrective 3-wave move. That means it should be completely retraced and the larger 3-wave move down from the March high points to $80 for a downside target. The apex of the previous sideways triangle at the end of last year is near 79 and should provide support if and when GLD gets there. A rally back to a new high would suggest we're into a choppy rally which is typically an ending pattern. However, a new high (above 97.50) would also have the potential for an explosive move to the upside and therefore I'd be a buyer of gold at a new high. Until that happens the larger wave pattern calls for a continuation lower.

Economic reports, summary and Key Trading Levels

Unless the durable goods number comes in disappointingly low, we probably won't see much of a market reaction to the report. A lower than expected new home sales report could further depress the home builder index (already in trouble after today's decline).

In most of tonight's charts show the possibility for the market to get another leg up for the bounce that started off the July 15th low. One reason has to do with time and price. Corrections typically retrace a certain amount of the previous move and take a typical amount of time for that correction. For the blue chips we've seen a minimal 38% price retracement of the decline from May and in less than 38% of the time it took for the May-July decline. More typically, for the type of correction I've been expecting here, we'll see a 50%-62% price correction that takes about 62% of the time for the decline. There's nothing hard and fast about this but the current bounce seems short in both time and price. Therefore I would normally expect today's pullback to be followed by another leg up to a new high (SPX 1320 for example). That kind of 3-wave bounce could even be followed by another strong pullback and another rally leg into late August/early September.

But the price pattern for the RUT and financials, both of which saw a strong rally in the past week, look vulnerable to an immediate decline to new lows, and I mean much lower. I don't see how that could happen without the blue chips following. Therefore I have to warn bulls (again, sorry) that it's possible we've seen all the bounce we're going to get and the selling will start to kick into gear again.

In times of mixed signals I like to look at the techs. And looking at the semiconductors is often a good heads up for what the techs are going to do. Therefore one could say "as go the semis so goes the market". The semiconductor holders (SMH) broke below their July 9th low today and closed below it. The NDX looks sickly in its bounce. Therefore, going with the tie-breaker (the semis) I'd have to say I'm quite bearish this evening and am not confident that we'll see a 2nd leg up for the current bounce. It doesn't mean we won't get it (I actually hope we do as I think it would be a better setup for a short play) but I don't like the odds as of this evening.

For those who follow my live commentary on the Market Monitor I will be updating this view continuously over the next few days as this plays out. Certainly if you're long the market and can't watch it every day be sure you have stop levels identified and placed with your broker. I could be way too bearish this evening and way off the mark (been known to happen, wink) but I'd rather be safe than sorry. Protection of capital rather than return on capital is my #1 recommendation and has been since last year.

But also keep in mind what I stated earlier--a strong move right into the close is often reversed the next day. A rally tomorrow morning would fit the pattern. Whether it will hold or not is a completely different story. If you like the upside potential, and there are a lot of people who do (even other writers for OIN), my only suggestion is monitor your trades carefully and daily, have trailing stops in place and enjoy the ride while it lasts. I could be playing it a lot safer than need be by not participating in the rally (other than day trades). Tomorrow will hopefully provide some more clues and I'll be passing them along in my daily commentary.

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

Key Levels for SPX:
- cautiously bullish above 1291
- bearish below 1235

Key Levels for DOW:
- cautiously bullish above 11700
- bearish below 11140

Key Levels for NDX:
- cautiously bullish above 1910
- bearish below 1790

Key Levels for RUT:
- cautiously bullish above 726
- bearish below 670

Keene H. Little, CMT
Chartered Market Technician

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