Option Investor
Market Wrap

Not Too Big to Fail

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Administrative note: Robert and I (Keene) have switched this week and Robert will take Thursday.

After saving Bear Stearns back in March, which was considered too big and too important to the health of the financial sector to let fail, the Fed and Treasury have essentially said to Lehman Brothers that they're not worthy. They're not worthy of a similar $30B backstop that was given to JP Morgan for taking over Bear Stearns. Consequently the banks that had shown interest in buying Lehman over the weekend instead backed out. Taking over Lehman's unknown quantity of bad investments wasn't going to happen without the Fed/Treasury backing them up.

The Fed/Treasury have boxed themselves into a corner with all the bailouts and assumptions of debt in return for U.S. Treasuries. The bailout of Freddie Mac and Fannie Mae (I like the name given by Bill Fleckenstein to these two as "Franron") has left the U.S. Treasury with very little wiggle room to accommodate more debt (Congress will have to approve a huge increase in the debt ceiling as it is). The nationalization of the mortgage industry will likely result in the assumption of more than $5T (yes that's a 'T') in new debt.

Consequently when the news broke that Lehman would not be bought out by another bank, leaving it no other choice but to file for bankruptcy protection this morning, it sent shivers through the rest of the financial community. Stock futures gapped down Sunday night and steadily dropped lower into Monday morning, resulting in a large gap down opening in the cash market. European markets were down about 4% as well. The concern is the ripple effect caused by the failure of Lehman and its plethora of derivatives and credit swaps. The same concern was the reason given for bailing out Bear Stearns and not letting them declare bankruptcy on Monday, March 17th. That stick-save by the Fed sparked the start of the choppy rally that ran into May. It was thought the Fed can protect us. Now it's turning into "not even the Fed can protect us from ourselves."

Lehman is (was) the fourth largest investment bank and if its failure wasn't enough to scare the investment community then the buyout of Merrill Lynch, the largest brokerage firm, by Bank of America for $44B (less than half its value from a year ago) put an exclamation mark on this weekend's banking news. The purchase price was $29/share which at least is better than the $17.04 closing price on Friday. Its stock gapped up but then sold off for the rest of the day. I think holders of MER stock knew a good chance to sell when they saw it.

But wait, there's more. AIG went to the Fed for a $40B handout, er, I mean loan, to help bridge a gap in funding. The market fears AIG won't last another 2-3 days if they get another downgrade. Supposedly Warren Buffet is talking with AIG about a possible rescue. It's not certain at this time whether the Fed will step in or not to help. The Fed was out today saying they believe the system can withstand the shocks and that there's enough liquidity in the system to handle the crises.

The fear of a Lehman bankruptcy and the impact on the global derivatives market prompted a very rare opening of trading Sunday to allow trading in credit, equity, rates, foreign exchange and commodity derivatives. This speaks volumes to the impact of Lehman's failure. The International Swaps and Derivatives Association (ISDA) estimates the OTC derivatives market, excluding commodities, to be about $455T (yes, that's a 'T' again). While Lehman clearly does not control that amount (they've been rumored to be on the hook for a mere trillion dollars) the problem for the market is that no one knows who controls what. The ripple effect through the system from a bank failure is going to be huge if only because it will lock up the credit market while everyone tries to figure out where all this paper is and who owes who. It's a real mess and for too long no one worried about it because the market kept going up (same with the housing market and all the subprime loans).

The Fed and Treasury strong-armed several banks over the weekend to belly up to the bar with them and pony up some serious cash to help out other banks. There are ten banks that have contributed to a $70B pool of money available for lending. I can just imagine the conversation in that room from the Fed who essentially said "if you want any more money from us then you'll do as we say--pony up." Yes, Daddy. The list of banks includes JP Morgan, Goldman Sachs, Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Merrill Lynch (does that mean BAC ponied up twice?), Morgan Stanley and UBS.

On Sunday the Fed came out saying they feel they've done enough right now. In their statement they said it "feels reasonably confident the various credit facilities it has put in place are up to the task of meeting the liquidity needs of the system." Then in the afternoon a report came out from Merrill Lynch saying they believe the Fed intends to lower its overnight discount rate by 0.5% (instead of the usual 0.25% move) to 1.5%. This would obviously be an effort to make more money available at a cheaper rate to help banks borrow what they need.

While the banks would be helped by this move it's still a problem for the Fed, as I've been saying for well over a year now, because they're pushing on a string. They can make lots of cheaper money available but they can't stimulate demand. If banks don't want to lend money to others (for fear of not getting it back), they're going to sit on their cash. This is all part of the credit contraction that's necessary to correct the massive credit creation over the past decade. Money supply is not the problem right now; it's a credit problem.

Looking to the bond market for clues about what the Fed might do tomorrow at its FOMC meeting, the 10-year yield gapped lower this morning also and then dropped from there. It is now more than 0.7% lower than its July high. By this measure I'd say the Fed has leeway to drop their half point.

U.S. Treasuries are seeing a lot of buying as money rotates from stocks into the "safety" of Treasuries. I use that term loosely now because these Treasury certificates are backed by a worsening balance sheet for the U.S. government. We have become the largest debtor nation and U.S. Treasuries are being swapped out for collateral from these dying banks which is probably next to worthless paper. Be that as it may, with traders running away from stocks and into Treasuries we're seeing yields drop even further.

10-year Yield, TNX, Daily chart

In the last TNX chart I showed (September 4th) I pointed out the Fib level near 36 (3.6%) and said it would likely be support if we're to see the pullback from June finish and start another rally leg. I doubted it would hold because my feeling is that we're going to see yields drop as the economy and banking situation worsens. After consolidating around 3.6% it was definitively broken today and now I think we'll see a drop to 3.28% before another bounce. I'll keep you posted on this chart as changes occur but for now I see a real possibility that TNX will be below the January/March lows by October.

As can be seen in the table at the top of this report, it was a strong down day today. Volume wasn't as strong as we've seen it and that's actually bearish. Very strong volume accompanying selling is usually a good sign of some capitulation and that often means you're nearing a bottom. More normal selling volume can go on for days and days. The selling volume clearly overran buying volume, almost 10 to 1 and it wasn't much different with declining issues swamping advancing issues. New 52-week lows completely dominated new highs, almost 17 to 1. The NYSE, an average that includes many stocks that the big blue chip indexes don't, shows the weaker performance of the broader market than the more narrow-based averages.

So it was clearly not a good day for the bulls today. The DOW was down over 500 points which made it the worst point decline since September 17, 2001 and the worst percentage decline since July 19, 2002. AIG lost $7.09 (-58%) as it struggles to find capital and avoid a downgrade (which will kill the company) and it closed marginally above the important $5 level at $5.09 (and dropped lower to $4.84 in after hours). This stock alone, like Friday, had a large negative impact on the DOW. It has dropped from over $70 a year ago and from $30 at the beginning of August. It's really sad to think about the number of people losing serious amounts of their life savings in companies like these. Well, let's see what damage has been done to the charts, starting with the S&P 500.

S&P 500, SPX, Weekly chart

We've been watching the long-term uptrend line from 1990 where SPX bounced in July. The bounce was very choppy and clearly just a correction to the decline. Today's break of the trend line, confirmed by a break of the July low (which the NYSE had warned was going to happen) is confirming the more bearish wave count (dark red). I continue to show the possibility of another rally leg back up to the downtrend line from October but I seriously doubt the chances for that. Trading is a game of probabilities and at this point the higher probability is for a nasty decline from here. As depicted on the chart, the EW count is set up for a series of 3rd waves to unfold to the downside. This is an extremely bearish setup and calls for a very strong selloff. Using Fib price and time ratios I see the distinct possibility for a selloff to below 1000 in October, bounce and then lower into November.

S&P 500, SPX, Daily chart

SPX 1170 holds some real possibilities for support. As shown on the chart, that's where previous highs and lows in 2000 and 2004-2005 occurred. Also, the 50% retracement of the 2002-2007 bull market rally is at 1172 (shown on the weekly chart). While it's possible we'll see a decent bounce off that level, back up to anywhere from the long-term uptrend line near 1225 to the broken uptrend line from July near 1300. But the bearish wave count calls for hard selling so we might not get much of a bounce at all. Just stay aware of that level and watch for support.


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Key Levels for SPX:
- cautiously bullish above 1255
- bearish below 1211

S&P 500, SPX, 120-min chart

I've drawn a curved blue arrow to simulate a waterfall decline which is what I think we could be entering here. This is the kind of decline that picks up speed on the way down and you can think of it as a parabolic rally in reverse. It tends to lead to a washout (capitulation) and a v-bottom. Where that v-bottom is can only be guessed and it's very dangerous to go bottom fishing in waters like these. But note the bullish divergence that I'm showing on MACD. I've also drawn red trend lines along the highs and lows since the September 5th low and it traces out a small descending wedge. This is only a possibility but I wanted to call your attention to it, especially if you're short and hoping for many more points to the downside. This afternoon it dropped just below the bottom of the wedge but if it's a throw-under finish then we'll see a strong rally out of it. But the bulls must rally this tomorrow and rally it hard--getting back above 1231 (today's high) is a must. Anything less than that should have you shorting all bounces and breakdowns.

Dow Industrials, INDU, Daily chart

It's the same pattern for the DOW as with SPX--the wave pattern is potentially very bearish and calls for heavy selling over the next week. But if the bulls are able to put something together on Tuesday I see the possibility for a good short-covering rally back up to 11750. That would really knock the socks off the bears. If instead the selling continues watch for potential support near 10700, "only" 200 points lower. But again, if the selling picks up speed I doubt 10700 will be even a speed bump. The DOW should easily break below 10K heading into October if 10700 gives way.

Key Levels for DOW:
- cautiously bullish above 11460
- bearish below 11100

Dow Industrials, INDU, 120-min chart

I've drawn a descending wedge pattern for the decline since mid August to show the possibility that we could be nearing a bottom for now which will be followed by a rally leg (the one back up to 11750 shown in pink on the daily chart). Note the bottom of the wedge is currently near 10870 so if we see a little throw-under and then recovery back above stay alert to the possibility that we could rally. Back above 11100 would be a warning to bears and above 11577 would say rally ho. Otherwise a common move is for price to drop below the lower trend line, bounce back up for a test and then continue lower. If you'd like a crisp short entry that's the play you want to watch for.

Nasdaq-100, NDX, Daily chart

Two equal legs down from June is near 1679 and that's also at the bottom of a parallel down-channel from June. The move down from mid August supports the idea that the techs could be ready for a bounce to at least correct the decline from August. In that case a bounce back up to the 1820 area would be typical. Otherwise a continuation lower should have NDX targeting 1500. I don't show it but as I drew in on the DOW's 120-min chart, if price drops below the bottom of the parallel down-channel watch for a bounce back up to test the bottom of it--this is very often an excellent way to nab a short entry.

Key Levels for NDX:
- cautiously bullish above 1820
- bearish below 1775

Nasdaq-100, NDX, 120-min chart

The leg down from mid August is shown on this chart as staying within a relatively tight parallel down-channel. The trend is your friend and it's clearly down. Follow it. Ideally, from an EW (Elliott Wave) perspective, the move down needs to stair step lower before finding a tradable bottom so that's why I say just follow the trend lines for now.

I've mentioned I like to keep an eye on the semis even if I don't trade them. They're very good for providing a heads up for market direction. SMH is flashing some signs at me to expect a tradable bottom soon.

Semiconductor Holders, SMH, Daily chart

The wave count for the move down from mid August and seeing price hit the bottom of its parallel down-channel from May has me alert to the possibility that we're going to see at least a correction of the leg down from August. It's a bullish setup but I don't know if the broader market is going to let any bulls have some fun right now. Just stay aware of this one. If price drops below the bottom of the channel, like I mentioned for the DOW and NDX, watch for a retest of it from underneath and continuation lower from there as more bearish evidence.

Russell-2000, RUT, Daily chart

The RUT had a bad day today and did some catching up to the downside but it too is sporting a potential bullish descending wedge with a slight throw-under at today's close. I'm not seeing supporting evidence to suggest a bounce here but I show it to keep bears from getting complacent. The bearish wave count, like the others, calls for some very strong selling to follow so if you're long and have your fingers crossed that this is just a pullback and nothing more, you could be sliding down that slippery slope of hope. If long I would not want to see Any more selling from here.

Key Levels for RUT:
- cautiously bullish above 724
- bearish below 700

Banking index, BIX, Daily chart

After breaking its uptrend line from July the BIX bounced back up to it and the top of its parallel down-channel from October on Friday and stopped there. Today's big red candle leaves a bearish kiss goodbye at that resistance level. I show the possibility for a move higher to its 200-dma but at this point I'd have to see a move above 204 to believe it. Expect new lows for this index instead.

With Lehman Brothers and Merrill Lynch making the news today it's a good time to check the mortgage broker index:

Brokers index, XBD, Daily chart

Following the little throw-over above its sideways triangle pattern on September 8th price has collapsed back down and stopped at its previous low in July. It might get a little bounce here but then again it might not. It should proceed much lower for another 50% haircut from its recent 160 price before it's ready for another bigger bounce/consolidation around 70-80.

Besides the bad investments crushing the banking industry right now (along with all who own the repackaged loans), the home market continues to struggle. The subprime mortgages are identified as the start of the unwinding of the credit bubble but there are many other kinds of loans that will be equally as challenging for investors over the coming year(s).

Following subprime mortgages, heading up the quality ladder, are Alt-A loans. These are the mortgages made to borrowers who could at least do more than fog a mirror, which was all that was required for a subprime loan (and even that requirement was sometimes waived). Alt-A borrowers at least had a credit score but decided not to enter their income on the application. Estimates for the number of borrowers who exaggerated their income are around 70% and more than half of these people exaggerated their incomes by more than half. These people are now in trouble as their mortgages reset, their incomes are not nearly enough to accommodate the higher payments and their home values are now less than their mortgages. This problem should sound pretty familiar by now.

There are about 3 million homes with Alt-A mortgages totaling over $1T. Compare that to about $855B in subprime loans and you can see where this is leading. Almost half of the Alt-A loans were processed in 2006, the peak of the mortgage business. About a quarter of the loans ($270B) were interest-only or with a low teaser rate with resets scheduled for 3 and 5-year increments. Those resets haven't even begun yet (they'll start next year) and already 16% of Alt-A loans since 2006 are delinquent by at least 60 days.

Wachovia and Washington Mutual were big sellers of Alt-A loans and we all know what's happened with their stock values. These mortgages don't get written down until they are in trouble so we really don't have any idea how much more will need to be written down. I think it's safe to assume we're going to see these banks, and owners of repackaged Alt-A loans (mortgage-backed assets and their derivatives), writing down loans for years to come.

The number of mortgage defaults will continue to rise and the number of foreclosures will therefore continue to flood the market. This will only have a depressive effect on the home resale market for years to come as well. This is a once per hundred-year event we're going through and it's not going to be over when it "normally" would. Some say we'll see the builders start to recover because home starts have dropped below 1M per year. I've been saying for some time, based on my study of previous long-term patterns and history, that we won't see a bottom until home starts are below 800K per year and it could drop as low as 600K this time. We'll get the latest number on Wednesday which is expected to be 950K. There's unfortunately more pain ahead. If you're in the market for a home I highly recommend renting--you can probably get more bang for your buck and not have to worry about a depreciating asset right now.

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

The choppy bounce off the July low makes it a correction to the decline and not the start of a longer-term recovery. A push back above 350 could have the home builders index pushing as high as 400 but I think the more probable path is back down to a new low. The only question for me is whether or not 216 will hold if it gets back down there. Even though there's lots more pain ahead for home builders and the housing market, the home builders could soon reach a longer-lasting bottom where all of the bad news is fully priced in. Maybe.

Transportation Index, TRAN, Daily chart

Nothing new to report on the Transports. I expect it to head back down but need it below 4757 to prove it will happen. If it does, and I believe it will, the break of the uptrend line from January should usher in strong selling.

U.S. Dollar, DXY, Daily chart

After tagging the December 2004 low just above 80 the US dollar has beaten a hasty retreat, as expected. The wave pattern was set up for a pullback to at least correct the leg up from July, or more bearishly start back down to a new low sometime next year. The $77 area should act as support if and when it gets there if we have a bullish price pattern playing out.

Oil Fund, USO, Daily chart

The US dollar dropped hard the past three days (although bounced back up today and left a long-legged doji on the daily chart--indecision) and gold rallied today. Oil should have been right there with oil but instead it sold off some more. Jim has been all over this one and scratching his head as to why oil is selling off despite hurricanes, inventories and now the dollar. Just goes to show how the market moves on emotions and herd mentality more than funnymentals. I see support for USO near 68-69 if it drops a little further where the decline from July will have two equal legs down and it will be at the bottom of a parallel down-channel for the drop from July. It might not stop there as I've depicted but I think the chances are good we'll see a larger bounce to correct the July-September decline.

Oil Index, OIX, Daily chart

I was thinking last week that the oil stocks are ready for a bigger bounce and that's what I'm showing with the dark red wave count. But the bounce so far has me seriously wondering about the possibility. Instead we could see the OIX consolidate over to the top of its down-channel before heading lower again. It's too early to tell but at this point I'd have to say I would not be comfortable on the long side of oil stocks.

Gold Fund, GLD, Daily chart

Gold has bounced back up to its broken uptrend line from July 2005 through the August 2007 low. A drop back down from here would be a bearish kiss goodbye. But the rally off the low on September 11th looks strong and I wouldn't be surprised to see a pullback followed by more rally. It's a bit of a guess for me at the moment right here. The wave count would look better with another low as depicted before a larger bounce. I think gold will work its way down to 60 before setting up a much bigger bounce.

Economic reports, summary and Key Trading Levels

Today's industrial production report was worse than had been expected and that certainly did not help investor mood this morning. Production was down -1.1% in August vs. expectations for a -0.3% decline. It was the worst drop since Hurricane Katrina three years ago. This has industrial production down -1.5% in the past 12 months and -2.0% this calendar year. Manufacturing is certainly in a recession.

Tuesday we get inflation numbers in the CPI data and it's expected to show some moderation from July's numbers. The big report will come from the Fed when they report the FOMC interest rate decision at 2:15 PM. Based on the strong decline in the market today, and the drop in the 10-year yield I think the Merrill Lynch report suggesting the Fed will cut 0.5% off the discount rate is accurate. But even that report did nothing for the market and I suspect an actual cut will not help the market. It's scared and uncertain of what's coming down the pike and it probably thinks the Fed and Treasury made a gallant effort but can't stop the levee from breaking. Everyone now is starting to think about abandoning town before they drown. Not a bad idea if you haven't already done so.

How many times have we seen the market close at its high or low for the day (it closed at its low today) to then be completely reversed the next day? I call them mini-capitulation days as the last of the shorts who can't/won't hold overnight throw in the towel on a rally or the last of the longs bail at the end of the day's decline. With them out of the way the market is free to spin around and reverse course (much to the chagrin of those who bailed at the close). So that's entirely possible for Tuesday--a big rally day to completely reverse (well, take back a big chunk anyway) today's decline. After all it is opex week and stranger things have happened. I certainly see enough price patterns to suggest we could get that reversal even if it starts with a down day that immediately gets reversed (such as they tried today). Just stay aware of the potential for that and by no means should bears be getting complacent here. Don't be shy about taking profits early and often and then get back in by using some of the profits. Steady growth of your account is much better than swinging for home runs.

Having said all that, the wave pattern is set up for a very bearish outcome and I definitely suggest you not look for buying opportunities yet (don't go bottom fishing). We've entered the period of strong surprises to the downside. More selling will beget more selling as more funds and companies are stress tested. Only the fittest will survive this and they'll be great companies to own. You don't need to be part of the stress test.

Good luck this week, keep your cool, don't get stuck in a trade and act like that deer in the headlights (hoping and praying the trading day will end soon) and use more discipline than you normally muster. I'll be back with you a week from Thursday.

Key Levels for SPX:
- cautiously bullish above 1255
- bearish below 1211

Key Levels for DOW:
- cautiously bullish above 11460
- bearish below 11100

Key Levels for NDX:
- cautiously bullish above 1820
- bearish below 1775

Key Levels for RUT:
- cautiously bullish above 724
- bearish below 700

Keene H. Little, CMT
Chartered Market Technician

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