Option Investor
Market Wrap

Today in Review

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As you are probably well aware the markets had a nice bounce today, but not without a little volatility. For instance, the S&P 500 had a 78 point range today. The futures opened higher this morning causing the SPX and NDX to open with an 18 and 37 point gap up, respectively. Both markets sold off from the early highs and fell to lows not seen in years. Specifically, the SPX (chart below) fell to a low of 1133.50 at 1:00 PM ET before bouncing on news that the Brits would suspend all short selling in their markets. The SPX and Dow Jones Industrials pared their losses in 15 minutes after being down 23 and 150, respectively. The Dow had a 600 point range today and closed up 410 points. I dont normally follow the Dow because it doesnt represent the market as well as the SPX. I believe the market was reacting negatively to the fact that Morgan Stanley was in need to find a suitor rather than a partner. It appears that Wachovia and Morgan Stanley are in advanced merger talks. That means that Goldman Sachs and Blackrock may be the only independent investment banks that remain.

Charlie Gasparino of CNBC is credited on breaking the story that Treasury Secretary Henry Paulson is considering setting up a facility to take on the bad debts of various financial institutions. The plan would basically make the US a huge hedge fund that is providing liquidity to banks by taking on the debt and the corresponding margin requirements that curbs their ability to finance new loans. The hope is that the new facility would allow the housing market to advance because it would restore banks ability to lend. In addition, Paulson, with Bernanke as his date, is presenting the idea to House and Senate committees tonight. President Bush would like Congress backing of the idea before more time is spent on the idea. Note that this is still and idea a not the plan. The markets ran on the concept because it is the best solution so far and would possibly protect further companies from going under. It appears as thought the government would rather invest in the assets/loans that are causing the turmoil (read reduced credit ratings on the stocks and increased margin requirements) than continue to provide capital to back up further banking failures. I guess they think it will cost us less this way.

The internal statistics on the NYSE show that there were 2373 advancers and 563 declining issues on over 10 billion shares traded on and off the exchange. The NYA closed up 334.78 points or 4.5%. There were 1041 New 52 week lows and 72 New 52 week highs on the big board. The Arms index closed at 0.51 which shows that there were more advancing issues with higher volumes when compared to those stocks with declining volume. The NASDAQ Composite index closed up 100.78 points or 4.78% on 3.9 billion shares. The COMP had 2195 advancing issues versus 778 declining issues. There were 97 New 52 week highs and 396 New 52 week lows.

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After the bell Oracle (ORCL) reported earnings that were $0.02 above estimates. According to Reuters estimates, excluding special items such as acquisition-related expenses, profit per share was 29 cents, beating the average analyst forecast of 27 cents. Oracle is the worlds third largest software developer. The adjusted operating margin was 40%, up 3.5% from a year ago. The only negative in the report was that there was a 12% drop in business management software sale. ORCL is bid up to $19.86 in after hours trading after closing the regular session at $18.75.

The Indexes

S&P 500

For tonight I plan on covering the SPX and NDX and their respective support and resistance levels. I am going to spend a little time on the CBOE Volatility Index ($VIX) and discuss the capitulation theory. Finally, I want to give me take on the whole credit crisis and point fingers.

As the chart above shows, ever since the SPX failed to break above the 1305 resistance on September 1st the market has been on a free fall. There have been a couple of attempts to stage a recovery but the declining 21 day exponential moving average (EMA) maintained its dominance. Even todays 50 point advance couldnt break above the 8 day EMA which is currently at 1213.5. Option expiration weeks are generally volatile anyway without all of the investment banks going out of business. As mentioned above the reason that the markets advanced so much into the close was that the media reported that the Treasury is proposing a new solution to take on the bad debt of financial institutions. The RSI on the SPX chart above has re-emerged from oversold territory. In addition, the Slow Stochastics crossed above its moving average. The upper Bollinger band is consolidating while the lower Bollinger band continues to decline. The spread between the upper and lower bands represent to existence of greater volatility. Should the market advance tomorrow, the 21 day EMA (1238) will provide the primary resistance level that the SPX needs to move above. With the 8 day EMA less than the 21 day EMA the trend is still a confirmed downtrend. Therefore, short at tests of resistance and cover at extreme lows. If we do get a run up to the 21 day EMA tomorrow and you short the SPX, set a stop loss if the SPX continues upward above the 9/12 high of 1255 or just closes above the 21 day EMA. The downtrend would revert if the 8 day EMA crosses above the 21 day EMA.

The SPX chart above shows the simple 50, 89, and 200 day moving averages (SMA) over the last few months. It also shows the Fibonacci retracement levels from the previous low of 1200 to the recent high of 1313. As you can see the SPX declined almost to the 161.8% extension level and then found support. The 50 day SMA is at 1260 and will almost coincide with the price resistance at 1255 mentioned earlier. The negative is that ADX, generally a trend indicator, is above 20 while the trend is downward. Money Flow is low but not at extreme lows. There wasnt even a tick up in the money flow indicator after todays huge run up. All three moving averages are on a downtrend. While I believe the market capitulated today (more on that with the VIX) the move occurred on a report of a plan of action that isnt approved by Congress. So we may see some consolidation before running to test the previous highs in August and the 89 day SMA at 1298.

I wrote the Contrarian this morning so the moving averages arent as fresh as those in the above chart. However, the VIX broke out to an intraday high of 42.16 which is a level not seen since 2001. I am sure you have heard the saying One day does not a trend make. The same is true with volatility. It is entirely possible for the VIX to try to run up and retest. A failure to break above the new high would confirm a bottom was set today. Trading the VIX spikes is difficult to do if you arent able to close out the position on a break above the recent high. Those breakouts signal that there is still more market volatility to come and the position should be closed. For instance todays initial gap higher in the SPX brought the VIX down. But by 11:15 AM the VIX had broken above the 36.39 close which therefore suggested more market downside was due. Once the market declined and bounced, the VIX had to confirm the bounce by breaking back below 36.39. By the close, the RSI and Stochastics on the VIX also declined below the overbought territory. The VIX closed down 3.12 at 33.10. However, the 10 day moving average did not decline which was needed to confirm a positive portfolio bias. See below for the Contrarian from earlier.

NASDAQ 100 (NDX)

The NDX broke down to an intra day low of 1606.30 before bouncing up 64.97 to 1697.42. The NDX had a 98 point range today and at its low was below the 161.8& extension level before bouncing to close just below the 127.2% extension level of 1698.04. The ADX moved up to 31.18 even though the NDX bounced today, but not higher than Wednesdays high. ADXs advance confirms the downtrend until the ADX declines. Money Flow is low but not at an extreme level like I would prefer before taking bounce trade. The bounce may extend up to the recent high on 9/12 at 1775. The 50 day SMA is at 1840 while the 89 and 200 day SMAs are at the 1887 level. The moving averages require a sustained advance that would occur on positive fundamental news.

As mentioned before, the high today didnt break above yesterdays high. The 8 day EMA at 1720 should provide the next level of resistance for the NDX. With the 8 day EMA below the 21 day EMA, the trend is down. While a break above the 8 day EMA would provide a short term long trade, a run up to the 21 day EMA would be a short trade. In either circumstance, risk management must be defined prior to entry. Risk management really depends upon the user. But a long at a break above the 8 day EMA should be closed on a break below yesterdays high, for example. A short trade at the 21 day EMA may be stopped at a break and close above the 9/12 highs and/or the 21 day EMA.

Gold Futures

Gold began the week in an oversold state and was quickly snatched up as one of the only safe alternatives. Another safe money play has been the US Treasury bond and 10 year note. The TNX declined to 3.25 yesterday as fears arose. Clients fearing that their money isnt safe in the money markets or the brokerage firm requested being invested in the T-Bills. I had difficulty buying Treasury notes today because other traders and institutions grabbed them faster than I could. What is amazing is that there is no yield. Gold opened a little higher and traded flat until the markets sold off into mid day. At its peak, Gold ran to 925 before selling off to a low of 836 as traders took profits and closed the commodity at 848. I suppose there isnt as much need for safety if the government is going to save the world. The shiny assets are usually bought as an inflation hedge or a safe money alternative. Hard assets are thought of as the foundation of currency and in the case that the financial world comes to an end would revert to being the main currency for exchange of goods and services. Since traditional asset allocation hasnt worked during this bear market gold and silver and the Treasury long bond are where cash runs to when the equity market appear glum.

Last night at dinner with my wife and kids, mom and dad, my mom asked me why the market was down so much and what happened to AIG and Freddie Mac and Fannie Mae. I started to explain in great detail until I got the look from my wife and then proceeded to explain what I about to go through. Of course this is my opinion. My quick assessment of who is to blame goes all the way back to 1999. I will try to keep this non-partisan. The Glass-Steagall Act of 1933 put in place the separation of bank and brokerage to avoid the problems that caused the Great Depression and 1929 stock market crash as well as establish the FDIC. For those of you that dont know, over leverage from cheap money being borrowed by everyone put the market in a vulnerable state. Back then the transfer of information was very slow and transparency didnt exist. The crash occurred from similar reasons that the current markets are declining, credit quality and earnings. But the SEC Act of 1933 and 1934 set to do is provide consequences for market manipulation. In addition, there wasnt the level of supervision and regulation we have today. Much of todays rules are based upon the SECs desire to establish a regulatory foundation that would provide orderly markets for decades to come. In 1999 the rule that kept banks and brokerages was repealed. As investors pushed exchanges to reduce spreads to pennies or less from sixteenths, the margins that the brokerages and specialists reduced to nearly nothing. The first reaction to tighter spreads was for Wall Street research firms keep high ratings on companies too long while the companies paid for analyst coverage. Spitzer took that profit source away. Then as the economy sank into 2001 and through 2003, brokerages with the new found ability to lend like banks took on leveraged investments such as Mortgage Backed Securities and their derivatives, CMOs and CDOs (Collateralized Mortgage Obligation and Collateralized Debt Obligation, respectively) while cheap money was plentiful. Overexposure to these investments as Greenspan began to raise rates to curb inflation from increasing home prices that occurred from too much cheap money reduced the performance of the underlying assets. For instance, many of these CMOs may have been floor bonds. A Freddie Mac floor bond pays interest as long as the Fed Funds stays below the target floor rate, in many cases 4%. So when rates moved past 4%, these bonds ceased paying interest and principal in some cases and became Non-performing bonds. Non-performing bonds decrease in value and the balance sheets of the brokerages carrying these investments did as well. But the manipulation The Fed didnt take into account that their incessant rate increases were starting to break the foundation of the credit market. While the inflation was occurring in 2005 2007 brokerages were being forced to liquidate these non-performing CMOs as Bloomberg and Bear Stearns pricing models differed from the newly adopted Reuters standard. Then Bernanke took office and decided to take an academic approach to running the worlds largest economy. He too read the government employment, CPI and PPI data as inflationary and continued to increase rates into mid 2007. He continued Greenspans rate increases to curb home prices from increasing anymore. Back to CMOs, the benefit of these investments is from buying at a discount and receiving the principal at par in an accelerated pay down that occurs when mortgage holders pay down their balance from prepayment, sales and refinancing, death and divorce. The SECs COX decided it was a good idea to repeal the up tick rule in July 2007. The markets decline and increased volatility in August 2007 was the direct impact from that decision. Admittedly, I lost a substantial amount of money because the market didnt react to the extreme levels in volatility as it had in 1996 - 2002. The unknown reaction is why I get out of a long SPX trade when the VIX spikes above the recent level. Without the up tick and an orderly market, the VIX could run up to 100 or more. One of the main reasons for the 1933 and 1934 Acts were to provide an orderly marketplace that didnt enable market manipulation. Repealing the up tick rule for shorts gave investors the ability to push the market down without any recourse and taken normal order from the markets. Now we have short sellers borrowing across brokerages and selling short until a stock is so worthless it cant raise capital to continue operation (Read AIG and LEH). My opinion is that the government had to bail out AIG because they caused the environment that created the problem. That is why Cox should be fired, as Senator McCain suggested on Thursday. Therefore, the one at fault for this mess stems from who ever decided it was a good idea to repeal the Glass-Steagall Act. Then I would blame the Feds inability to recognize their policys effects on the securities created and managed by the same government. Then I would blame the SEC for creating the environment that the Acts set to avoid. If information wasnt so transparent and the markets werent this liquid another crash would occur. So if the SEC reads this, make it necessary for the security to up tick and only allow shorts against existing long margin positions at the same brokerage firm (i.e. Short on up tick only and short against the box). Short selling provides liquidity and opportunity. And opportunity is another word for capitalism. So dont get rid of short selling, just fix the rule.
 

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