Option Investor
Market Wrap

Two in a Row

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The market has rallied two days in a row and that means a reversal back down tomorrow. That's a rather bold statement but it's interesting to see the pattern on the daily chart of the S&P 500 (and DOW and NYSE). Since the first bounce up off the July 15th low we've had pullbacks followed by 2-day rallies, Wednesday and Thursday being the fifth occasion. This latest 2-day rally looks very choppy and corrective and that has me thinking it's only a bounce and we'll see continued selling. But watch for this pattern to change as it would at least be indicating some short term strength coming into the market.

Each rally since the January low has shown weaker internal market breadth and the one off the July 15th low is no different. It's a warning that it's very likely just another bear market rally built on hope that all will get better soon. But there is the potential for the market to rally further into September especially since there are many people talking about a weak market starting in August and running into October. When too many expect something it usually doesn't happen. In this particular case I believe we will see some very hard selling over the next two months and the bounce off the July 15th low may already be finished. If so I suspect we'll see some very hard selling start to kick in within the next couple of days.

But there remains the possibility for another leg up in the bounce off the July low to a high in early September. It would certainly be a disappointment to many bears who are banking on a market collapse into October. After flushing them out with another rally leg it would then be ready for a strong decline. If SEC Chairman Cox has his way and limits short selling we could see a brief but strong rally, similar to what we saw in the banking sector after moving them onto the endangered species and protected list. If the short sellers were forced out in something like that the market would then lose the buying power of shorts when it needs it most--after a crash. I strongly suspect a Cox-initiated limitation on short selling would have negative and unintended consequences. But these people usually only learn of these consequences after the fact.

I like to keep an eye on the bond market, even if not trading it, because that market often telegraphs before the stock market what could be coming. It's been a while since I've reviewed the charts of the 10-year yield so I thought I'd take a look at them this evening, starting with a longer term view of the monthly chart since 2000:

10-year Yield, TNX, Monthly chart

After dropping to a low in 2003 near 3.0% TNX then rallied back up into a high near 5.4% in 2007. The pattern of the 2003-2007 rally is a rising wedge and what followed was a typical move--a quick retracement of the wedge when TNX dropped to about 3.3% in January. I show two possibilities from here--the pink wave count calls for a little higher, perhaps up to about 4.6% before tipping back over and the dark red count calls for a resumption of the decline in yields (rally in bonds). At this point I'm leaning towards the dark red count that calls for new low in the yield.

A rally in the bond market would likely be an indication that money in rotating from stocks into the relative security of U.S. Treasuries. As the daily chart shows, TNX needs to rally back above its July high of 4.174% in order to suggest we've got new highs coming (which would mean there are greater concerns about inflation and that would likely have the Fed raising their rates too).

10-year Yield, TNX, Daily chart

Two equal legs down from the June high would take TNX down to 3.62% and the 62% of the March-June rally is at 3.68%. That makes for a good target zone for support if we're to see another rally leg (pink) in TNX. Otherwise a continuation below 3.5% would likely mean new lows are coming and that would be telegraphing greater concern about a slowing economy rather than inflation.

Another signal that comes from the bond market has to do with spreads. We've often heard of the yield curve and that's basically a measure of the spread between the shorter and longer term bond yields. An inverted curve means the longer-dated bonds are yielding less than the shorter-dated bonds and is typically a signal that we're about to enter a recession.

Another example of a spread is the TED spread which Linda has reported on recently in a Traders Corner article and regularly updated on the live Market Monitor. This is the difference between the 3-month U.S. T-bill rate and the 3-month LIBOR (London Inter Bank Offered Rate) and gets its name from the 'T' in T-bill and 'ED' is the ticker symbol for the Eurodollar futures contract. It measures the number of basis points between the T-bill and LIBOR so a 3-month T-bill rate of 1.80 and a 3-month LIBOR rate of 2.91 gives us a TED spread of 1.10. A wider spread means there is greater concern about market risk with traders demanding a higher yielding LIBOR rate.

If the spreads between other bonds and the U.S. Treasury bonds are rising then it's saying there's more concern about the risk of those other bonds against the perceived safety of U.S. Treasury bonds. And that telegraphs to us that there is greater worry about increased risks for investments in general. These spreads tend to move counter to the stock market which makes sense when you think about the bond market telling us there are increased risks in the market and the stock market obviously does not like increased risks. Since 2007 we've seen these spreads forecast a coming market decline. Therefore it pays to watch these interest rate spreads. There is a website called markit.com and they track all kinds of bonds.


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We've heard about and discussed the commercial mortgage-backed securities and how these have essentially blown up in the faces of those who own them. All the write-downs that we hear almost daily from the banks, pension funds, state funds and hedge funds are in large part because of the shrinking value of their mortgage-backed securities (and the alphabet soup of derivatives created from them). As the value of these bonds drops from mark-to-model to mark-to-market the funds have been required to write down the value of their holdings.

Because bond prices and yields are inversely related, as bond prices drop their yields go up. Or viewed the other way around, as investors demand a higher yield to compensate for higher risk it drops the price of the bond. Therefore watching the yield spread between these mortgage-backed securities and Treasury yields tells us when bond holders are becoming more risk averse or more comfortable with the current market risks. And when these bond holders are demanding higher yields we need to pay attention as they're telling us they don't like what they see heading towards us.

Markit tracks these spreads and you can see the spreads for various grades of mortgage-backed securities (CMBX in their nomenclature) at http://tinyurl.com/2hnqkf. What's particularly interesting right now is the fact that the spreads are increasing and have been doing so since before May, the high for the stock market this year. Over the past year each time these spreads have increased while the stock market rallies the bonds have been correct and the stock market soon declines.

Since the low on July 15th the stock market has been rallying (well, at least up until last week) but take a look at the spread on even the "safest" of mortgage-backed bonds, the AAA-rated ones:

Markit CMBX-NA-AAA 5 Index, Daily chart

It may be hard to read the numbers on the left side of the chart but basically the spread has doubled since May, from about 100 basis points (1%) to move than 200 basis points (2%). For reference, these AAA-rated bonds were less than 40 basis points in the first half of 2007. If you check the other lesser-rated bonds you will see that not only are large spreads being demanded but also there's been a spike up in the spreads just in the last week. This is a clear warning that the stock market's rally is very likely just another bear market rally. We will likely see many of them before the stock market finds a lasting bottom (and at much lower levels).

Some other evidence of the weak rally following the July 15th low can be found in the market internals. Each of the rallies since the initial lows in January have become weaker and this is another factor that convinces me that the market is preparing for a swan dive to much lower levels. Whether we're looking at advancing vs. declining volume or advancing vs. declining stocks we see less and less participation in each of these bear market rallies. On top of that we're heading into the weaker period of the year--September and October. The earnings picture has been weakening, we've got uncertainty about the upcoming election, more rumors about failing banks (a big one is coming) and the housing market is not showing any signs of bottoming. Simply stated, it's not a good time to be in the market and many participants know this.

I say many participants know it's not a good time to be in the market but the bullish sentiment is on the rise again. After nine straight weeks of bearish advisors outnumbering bullish advisors (a very short streak when measured against previous bull and bear streaks), the bullish advisors for the week of August 18th jumped up to 40.7% vs. 38.4% bearish advisors. We also see complacency in the VIX. To see this level of complacency while the DOW remains below the January/March lows (and failed a recent retest of those lows last week) is rather disturbing when you think of the number of people who could get hurt during the next decline, which is building up to be a strong one.

I guess a lot of people have faith in Uncle Ben and his printing press (and his investment bank rescue machine). And then there's Hank Paulson and his mortgage nationalization efforts (and helping the failed executives keep their obscene bonuses while allowing the little people beg at the gate). Last but not least there's the SEC's Cox who wants to dissuade the big bad bears from trying to short the market. Without shorts to help start the buying during a decline I can only imagine how much worse it might be. Why am I reminded of the "hear no evil, see no evil, speak no evil" monkeys when I think of this trio?

But there will always be hope in the markets even though in a bear market it's known as the slippery slope of hope. Rather than hope for a market direction let's just stick with the charts for signals as to the direction we should be trading (as traders we shouldn't give a hoot which direction it goes--just give me a direction and preferably a trend).

S&P 500, SPX, Weekly chart

A break below the July 15th low near 1200 would be a confirmed break of the long-term uptrend line from 1990. In the meantime there's nothing that says SPX can't rally up to its downtrend line from last October. In fact two equal legs up from the July 15th low is at 1373, which would be a perfectly normal correction. I'm not saying it will happen but if you're short the market, as I am, you want to respect this possibility, shown in pink.

S&P 500, SPX, Daily chart

I show the same possibility for another rally leg up to 1373 (in pink, matching the weekly chart). Otherwise a drop back below 1261 would be a strong indication that the strong selling has begun and we should see a relatively quick move below 1200. I show the possibility for support at 1170 for another bounce back up to the downtrend line from May but the kind of selling I'm thinking we'll see means it could just blow right through support and head below 1100 very quickly.

Key Levels for SPX:
- cautiously bullish above 1313
- bearish below 1261

S&P 500, SPX, 120-min chart

I show the more bullish possibility in green on the 120-min chart (vs. pink on the daily and weekly charts). If SPX rallies back above 1292 that would considerably improve the probabilities for a stronger rally into early September. Therefore I'm recommending shorts use 1293 for their stop. In the meantime I think short is the place to be.

Dow Industrials, INDU, Daily chart

The DOW has the same setup as SPX. A break back below Wednesday's low would be a strong indication that we'll see strong selling follow. The current bounce off Wednesday's low could have a little more life to it but any higher than 11720 would have me exiting short positions while waiting to see if the stronger rally develops (pink, with an upside target in the 12250-12300 area).

Key Levels for DOW:
- cautiously bullish above 11716
- bearish below 11125

Dow Industrials, INDU, 120-min chart

If we see a little more rally tomorrow, watch the 11550 area where the downtrend line from August 11th intersects the trend line across the two lows on August 8th and 14th tomorrow. It's possible the lower trend line identifies a H&S top in which case a retest of it would be an opportunity to short it as it does a kiss goodbye.

Nasdaq-100, NDX, Daily chart

Last week I had pointed out the Fib projection at 1967 and said it will likely be resistance if it was to be the end of the 3-wave bounce off the July 15th low. The turn back down from it, and now closing below both its 100 and 200-dma's, looks bearish. While it could certainly rally back up to new highs if the blue chips do so, I do not see that as likely at the moment. But certainly you know where your stop needs to be if you're short the techs.

Key Levels for NDX:
- cautiously bullish above 1967
- bearish below 1873

Russell-2000, RUT, Daily chart

The RUT broke support at 737, its uptrend line from July 15th and is back below its downtrend line from October. Bearish, bearish and more bearish. Back above 637 would have me looking for a retest of its high and broken uptrend line. Otherwise short is the place to be on this one.

Key Levels for RUT:
- cautiously bullish above 737
- bearish below 737

Banking index, BIX, Daily chart

The choppiness of the decline since early August has me feeling wary about the banks. I see an equal possibility for a waterfall decline to occur where we see a rapid selloff from here) as well as another rally leg up to the 240 area (for a larger 3-wave bounce off the July low). I show the key levels at 200 to the upside and 163 to the downside--let price lead the way on this one. MACD back below zero has me leaning to the short side.

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

The downtrend line from February 2007 has yet to be broken on a closing basis so that would be the first clue for bulls if they see that happen. But even if the downtrend line is broken I see the possibility for only a brief rally up to the top of a rising wedge pattern before heading back down for new lows. So either directly from here or after a brief rally I think the home builders have not bottomed yet (but could do so with one more leg down).

Transportation Index, TRAN, Daily chart

The Transports tried a few times since mid July to get through its broken uptrend line from January but instead has broken its shorter-term uptrend line from July and today broke its previous low in early August. While the choppy price action means we could still see another rally leg for one more attempt at that stubborn uptrend line from January I don't see that as the higher-probability trade. It did get a nice bounce today after nearly tagging its 200-dma, and left a bullish hammer at that support level, so it could certainly get a higher bounce over the next couple of days. It takes a push above 5211 to say it's going to try again at that broken uptrend line.

U.S. Dollar, DXY, Daily chart

The US dollar spiked above its long-term downtrend line from January 2002 (using Log price scale) and at 77.16 it tagged the level where the 2nd leg up in its rally off the March low achieved 162% of the choppy 1st leg up (to the June high). Right now it has completed a 3-wave bounce and therefore could have ended a correction to its long-term decline. In that case it will head back down now to a new low (dark red). But if the dollar starts to consolidate in a sideways/down type of move it will be a bullish indication that it will be followed by a 5th wave up. That would be the clearest indication that we could get that would say the US dollar has found a low and the trend has changed to up. It will take a couple of weeks and watching price action before we know better which scenario is playing out. If you trade Forex (currencies) or commodities, now is the time to be a little more cautious as we wait for price to tell us what it's going to do next.

Oil Fund, USO, Daily chart

USO found support at its uptrend line from August 2007 (did not quite tag it). It will either correct its decline from July before heading lower again (dark red) or else it will continue rallying to another new high before finding a longer-lasting high. Like the US dollar I'm watching now to see what kind of price action develops from here so as to provide me some clues what's coming next.

Oil Index, OIX, Daily chart

While oil could rally a little more I don't see the same thing for oil stocks. Between the 200-dma and broken uptrend line from March 2003 (Log price scale) coinciding in the 854-859 area, I suspect any additional rally will get turned back from there. The price pattern of the decline from May supports another leg down before finding a tradable bottom.

Gold Fund, GLD, Daily chart

Gold finished a 5-wave decline from its July 15th high and found support at its uptrend line from July 2005. It's a good setup for either a continuation of the rally to a new high (I'm watching the US dollar to see if it provides some clues in that regard), shown in green, or else a bounce to correct the decline from July before heading lower again (dark red). If it heads lower again it will probably head down to at least 60 (600 for gold). There were a lot of people sending me lots of emails saying why I was crazy to think gold would break below 800. It actually happened faster than I thought. If you're a gold bull and hanging on because you have people giving you beaucoup fundamental reasons why gold will rally to $1650 by January 14th, 2011 (or whatever), stick with the charts and not reasons why you think gold will rally. I thought tech stocks would keep rallying in 2000 too. Emotional trading and herd mentality trumps funnymentals every time. Trust me on this.

That being said, I don't know if gold will now rally to a new high. I'm watching price action to help me decide how to trade this next. I am long gold off the low because it's due at least a big bounce back up. But I'm trading gold and have no intention of holding it if the price action says it's only a correction. I'll keep you posted.

Economic reports, summary and Key Trading Levels

There are no scheduled economic reports for tomorrow. Today's reports included the Leading and Coincident Indicators and they continue to look depressing, literally. The following chart shows the history of this index:

Leading and Coincident Indicators chart, courtesy Briefing.com

The pink line is the Leading Indicators index and it dropped sharply in July to -0.7% from 0.0% in June (and worse than the expected -0.3%). It is now approaching the lows seen in 2001. Also, notice the large decline from the peak in 2004. It has done a round trip from the low in 2001 while the market has been holding up. Notice also that the Coincident Indicator index never rose as high as the previous highs in the 1990's. This chart is a picture of weakness that the stock market has not yet priced in. It will.

Only two more summer Fridays to go before we get into September. Between the charts and what I hear people trying to do to prop the market up, I don't discount the possibility that we'll see another rally leg into early September. As mentioned earlier, it would be a move that knocks out a lot of bears and make them afraid to short the market again. It's what the market does.

But I also see price setting up for a nasty decline, one that could literally start any day now. Therefore keep an eye on the exit door if you're still trying to stay in long positions. Once the decline gets started, assuming it will, you will not get another bounce opportunity to get let out of your positions. As the series of 3rd waves starts to unwind to the downside people will recognize that the market is in serious trouble (perhaps with news of a big bank failure and no bailout from Uncle Ben, or something like that).

Once again I'm sorry to be the 'bear'-er of bad news but I feel it's my job to protect traders, not tell them what they want to hear (and I know a good majority of our readers are bullish). Like some family members and friends who think I'm too bearish and who are in this "for the long haul", holding on as their financial advisor tells them to do, I can only advise what I see on the charts and provide my analysis based on broader market and economic factors. Throw in some historical cyclical studies, sprinkle with EW (Elliott Wave) pixie dust, shake the snow loose in my crystal ball and voila! a market forecast. Use it as you wish and certainly make your own financial decisions so that you can sleep at night.

My aunt, who is in her 70's is invested in the stock market and recently asked my opinion. After asking her repeatedly if she really wanted to hear it, since I'm bearish, she insisted. After telling her to sell all her stock holdings and go mostly to cash with some bonds she said her financial advisor recommends she stay invested because "the market always comes back." She told me she doesn't want to talk to me about the market unless I have something good to say about it. It reminds me of the countless stories I heard during the tech bust where people weren't even opening their statements because they didn't want to read the bad news. Unfortunately for them, and the survivors of the 1987 crash, the market did come back (well, not the tech stocks). It has lulled a generation of investors into the false belief that we only have a bull market and that bear markets have been done away with. Don't be one of those people--learn to trade even if it's only to move into and out of stocks every couple of years as the market swings.

We're facing hard financial times ahead, and not just in this country. We're a global market now and we're facing global issues. For those who get into conspiracy theory about government involvement in all kinds of things, including our markets, you might enjoy reading an article making the rounds on the internet from Catherine Austin Fitts, who served as Assistant Secretary of Housing and as Federal Housing Commissioner in the first Bush administration. I can't vouch for her or the accuracy of the story she writes but I must say it's a chilling piece on "The Housing and Economic Recovery Act of 2008". For your reading pleasure: http://tinyurl.com/6nr8z4

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

Key Levels for SPX:
- cautiously bullish above 1313
- bearish below 1261

Key Levels for DOW:
- cautiously bullish above 11716
- bearish below 11125

Key Levels for NDX:
- cautiously bullish above 1967
- bearish below 1873

Key Levels for RUT:
- cautiously bullish above 737
- bearish below 737

Keene H. Little, CMT
Chartered Market Technician

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