Option Investor
Market Wrap

Just Another 200-point Day for the DOW

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I mentioned last week that if you don't like the direction of the market on a particular day to just wait since it will probably reverse the next day. The volatility has certainly returned and 200 to 300-point days for the DOW is becoming just another trading day in the market. These kinds of moves are hard on the bears and the bulls since each feels they can't make any headway. But the short term trend (since the July 15th lows) has been up and the bulls may not be finished frolicking in the pasture.

Speaking of a 300-point rally for the DOW, I just read an interesting statistic (from BiancoResearch.com) that there has never been a 300-point rally in a bull market. Think about that for a second and you realize how powerful short-covering rallies can be and why you don't see them in a bull market. We are in a bear market and the rally of 300+ points on Tuesday was attributed largely to short covering (even Art Cashin on the floor said the same).

Apparently there have been 24 days in which the DOW rallied 300 or more points since 1998. Of the 24 there were 15 days that occurred between 2000 and 2002 (the bear market decline). None occurred between 2002 and 2007 and the other 9 days were during bear phases in the market. That statistic alone should have traders cautious about feeling bullish this market--we're in another correction of the bear market and nothing more.

I use Elliott Wave analysis to help guide me in identifying where we could be in the larger market moves. An impulsive move is made up of 5 waves which then creates a larger degree first wave and the count continues on a larger degree for another 5 wave move (EW analysis is the study of fractal patterns which the stock market consistently produces and is part of the cyclical patterns that many study). In a bear market the 1st wave down is followed by a 2nd wave correction and these corrections typically get traders feeling bullish again after the big 1st wave decline.

After the October-March decline we had a big 2nd wave correction into the May high and most had turned very bullish the market and many were surprised to see new annual lows when the DOW and S&P 500 broke their March lows. Since the July low we've in a smaller 2nd wave bounce and once again many traders are turning bullish. These upward corrections turn many technical indicators bullish and get most leaning towards the bullish side of the boat again. Then the market lets go and traps those bulls. The reason 3rd waves are so strong is because of the "trick" the market plays on those who got sucked in on the 2nd wave correction.

Once the current bounce finishes (which could have a little higher into the middle of August) we will likely see a period of very strong selling (stronger than we saw between last October and January). From an EW perspective that's the highest probability scenario. There are no guarantees in the market (or else we'd be fabulously wealthy) but EW helps improve the odds and that's all we can play. For new subscribers who don't understand the labeling on my charts, those are EW wave counts. The impulsive moves (moves in the direction of the primary trend) are numbered 1 through 5 and the corrections are labeled with letters, with a 3-wave a-b-c count being a typical correction. If you'd like more information on EW analysis I can send you some information to get you acquainted with it. Drop me an email to support at optioninvestor.com and place a request to have it forwarded to me.

With that let's see what Mr. Elliott is saying about the probabilities for where this market may be headed.

S&P 500, SPX, Weekly chart

The weekly chart shows the move down into the March low as wave 1. From there the bounce into May was a 2nd wave correction and since the May high we've started the 3rd wave down. Each impulsive wave will itself be made up of 5 waves (you can count those in the move down from October to the March low). The July low was the 1st wave of wave 3 and the current bounce is another (smaller degree) 2nd wave bounce. This is important because the next move (dark red down arrow) is going to be the 3rd of the 3rd wave. I call these the "screamer" waves since the move will be very fast and the reason is because of all the trapped bulls (trapped by the 2nd wave corrections who believe in a new bull market.


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These 3rd waves are called the "recognition" waves because it's when the majority of traders recognize the market is in trouble. For those who like to play the short side of the market, this is the MOAP setup (Mother of All Puts). The only question for me tonight is whether the smaller 2nd wave (wave (ii) on the chart) has finished or whether we'll get a little higher into next week (opex week). The daily chart shows the two possibilities from here:

S&P 500, SPX, Daily chart

Yesterday's rally reversed again from resistance at the 1292 area (38% retracement of the May-July decline) and left a hanging man doji at that resistance. Today's strong down day may have completed a 3-candle reversal pattern. A break below 1260, the uptrend line from July 15th, would be a heads up that the bounce has finished. The short term possibility (shown in pink) is for a move up to the 1320-1325 area next week to finish the bounce, and then a higher upside target to 1350 by the end of the month, which is shown in the 180-min chart:

Key Levels for SPX:
- cautiously bullish above 1292
- bearish below 1234

S&P 500, SPX, 180-min chart

For a higher correction (pink), there are several possibilities for how it could play out but there are two that I consider higher probability, one shown on the SPX 180-min chart and the other shown on the DOW's 180-min chart below. The pattern on the SPX shows a sideways consolidation in a triangle pattern followed by another rally leg into the end of the month and could get as high as 1349 (62% retracement of the May-July decline).

The dark red depiction says the bounce has finished and today's decline was the start of the "3rd of 3rd" wave down. A break below 1260 would be a heads up but it takes a break below 1234 to confirm we've started the next large decline.

Dow Industrials, INDU, Daily chart

The DOW's daily chart looks very similar to the one for SPX. It too is struggling with its 38% retracement at 11710 and there's higher potential to 11800 if a slightly different upward correction is playing out, shown in more detail on the next chart.

Key Levels for DOW:
- cautiously bullish above 11685
- bearish below 11127

Dow Industrials, INDU, 180-min chart

Instead of a sideways consolidation followed by another rally leg, as shown on the SPX 180-min chart, we could be in a rising wedge pattern to finish the a-b-c bounce off the July 15th low. This possibility requires another leg up into next week and could find a high around 11800 (equivalent to the SPX 1320-1325 area.

Nasdaq-100, NDX, Daily chart

I've been saying for a couple of weeks now that the choppy consolidation in NDX is a strong indication that it will be followed by more selling. The bear-flag pattern that I've drawn on the chart suggests today's high may have been it--today's candle is a bearish shooting star doji at resistance. The only question in my mind is whether we'll see a pullback and one more new high next week or if instead the bounce is finished and now we'll see the next leg down kick into gear (dark red). Both are shown in more detail on the 120-min chart:

Key Levels for NDX:
- cautiously bullish above 1920
- bearish below 1800

Nasdaq-100, NDX, 60-min chart

The bear-flag pattern is shown and I'm also showing two equal legs up from the July 15th low. In an a-b-c correction it's very common to see the a-wave and c-wave equal each other and that level at 1898.75 has been tagged. I would be very careful from here if long the market. A break below 1820 would have me out of my long positions if I were long the market (which I'm not).

Russell-2000, RUT, Daily chart

I showed a rising wedge for the rest of the bounce for the DOW (on its 180-min chart) and a similar pattern for the RUT is shown on its chart, with an upside target of 743. This is just a guess but something to watch for if we see the market rally higher into next week. Otherwise a break below 700, confirmed with a break below 694, would be more immediately bearish.

Key Levels for RUT:
- cautiously bullish above 726
- bearish below 694

Banking index, BIX, Daily chart

I've commented on the parallel down-channel for price action since the March low (using a parallel line to the trend line drawn from the March low to the July low and attaching it to the high in May) and how it's a guide for where price might find resistance. The BIX has tried twice now to break out of this channel but again got rejected today. If it manages to rally higher, shown in pink, I think the upside potential is to the 240 area. Otherwise this index may be ready to start back down again (foiling those who keep trying to buy the bottom in the banks). One reason why I think it could start back down is because of the cleaner pattern on the brokerage index:

Brokerage index, XBD, Daily chart

After the bounce back up to its downtrend line from October 2007 the XBD dropped sharply to its July 28th low. It then bounced again to just shy of the downtrend line yesterday and left a doji (hanging man). Today's big red candle, completely reversing Tuesday's strong rally, completed a 3-candle pattern called the evening star. This pattern at resistance is a strong reversal signal. Will it follow through to the downside? Who knows but it's the kind of signal that considerably increases your odds of being correct if you're on the short side. As labeled, the next move is a 3rd of a 3rd wave down, which will be strong selling if it's correct.

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

The sharp move down from the July 23rd high followed by the choppy sideways/up correction is a recipe for a continuation lower. The bear flag pattern since July 23rd should break down but it might continue to chop its way higher into next week and reach its downtrend line from February 2007. I have been thinking for a long time that the home builders index will finally find strong support at 216 (two equal legs down from its July 2005 high) but now I don't think that level will hold. There's much more pain to be felt by the home builders but it's a question of how much of that pain has been priced in so far.

Transportation Index, TRAN, Daily chart

I could argue both the bullish and bearish case for the Transports and don't see a good setup from here, yet. If the index breaks below its August 4th low at 4875 it will support the more immediately bearish depiction. Otherwise there remains the possibility we'll this index head back up for a retest of its May high.

U.S. Dollar, DXY, Daily chart

I've redrawn the up-channel for price action since the March low since the top of it is where the US dollar stopped today. I have no idea if that will be the extent of the rally for the dollar but that's the potential. A push higher than 74.70 would suggest a rally up to its downtrend line from January 2002, currently near 76.50. Typically commodities head in the opposite direction of the US dollar but today oil decided to follow it, or at least it tried:

Oil Fund, USO, Daily chart

Oil closed up today but gave up some of its earlier gains. Its short-term pattern leaves me guessing a bit as to where it might head in the next week or so but even if it manages to bounce higher, perhaps up to its 50-dma near 107, it should have much lower to go. The downside target zone of $70-$80 ($80-$100 for oil) by September is what I expect to see unless something changes the picture.

Oil Index, OIX, Daily chart

Oil stocks are also a little vague in their pattern, like oil. I see the potential for a whippy market in these stocks over the next month or so before the resumption of its decline in the fall.

Gold Fund, GLD, Daily chart

Playing around with the log price scale and arithmetic scale I noticed that the log scale shows price stopped at the uptrend line from October 2006 (which GLD marginally broke when it ran out sideways through it in June-August of last year). Whether it stops there or continues lower to the $80 area is now the question. Bullishly I see the possibility for GLD to rally back up to the top of a bullish sideways triangle that could play out through most of this year before rallying higher next year. But any further drop in gold, especially with a drop below it May low at 83.57, would confirm we've seen the top in gold and can expect much lower prices into the end of the year.

Economic reports, summary and Key Trading Levels

Today's reports did not have much influence over the market and tomorrow's reports probably will not be market moving either. Today's Pending Home Sales report looks positive for the market but one needs to take into account that these are pending home sales. This number gets modified each month as pending sales are or are not converted to actual sales.

One reader, thanks Denise, provided me with some information about pending sales vs. completed sales and it's not encouraging. Denise is a long-time and successful realtor and said lenders are informing her that as many as 25%-33% of pending home sales may not go through (typically for lack of funding for a variety of reasons). As Denise said, realtors are getting desperate to write contracts (as often happens in depressed areas and during depressing times) and hope that something will stick and get funded. Apparently there are many lending officers quitting simply because they can't get funding, not even for their good clients. As reported by one, "I would say that it is harder now than it was even a few months ago. The credit markets are a complete disaster."

Another lender says the lending guidelines are becoming more restrictive. We've heard this reported many times over the past many months but the point is it's not getting any better even though the Fed has opened the spigot wide open to many more banks in hopes of priming the pump with more cash and easier credit. Supply of credit (cash) is not the problem. It is a demand problem and the Fed can't control demand. If banks are afraid to lend money or people are afraid to borrow more (or buy a house, or a car, or a big piece of furniture) it's not going to help them just because money is cheaper.

These reports from the field show the credit contraction continues and we're a long way from seeing improvement in this area. After the biggest credit bubble in the history of this country we've got some serious unwinding to do. It's going to hurt but it's a necessary cleansing process to flush the waste from the system so that we can get back to healthy growth. In the meantime hunker down and protect your capital and stay prepared for some difficult times ahead.

Most people who came into adulthood since early 1980 have no idea what it's like when the stock market is not in a bull market. There just normal cyclical patterns that we need to get through and learn how to trade in. If you don't like trading the short side (which I think is much harder to do than to trade in a bull market) then paper trade and learn. We will be in a trader's market for many years so learn how to trade both directions and not care which way it goes (easier said than done).

Good luck as we head into opex next week. I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1292
- bearish below 1234

Key Levels for DOW:
- cautiously bullish above 11685
- bearish below 11127

Key Levels for NDX:
- cautiously bullish above 1920
- bearish below 1800

Key Levels for RUT:
- cautiously bullish above 726
- bearish below 694

Keene H. Little, CMT
Chartered Market Technician

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