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Market Wrap

Bailout Bounce

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The market was an expectant parent today. Like any nervous parent anxiously awaiting the birth of their child the market became happier as the time neared for the birth of the bailout. As the news was coming out today indicating a deal was very close to being brokered the market became more enthusiastic about the prospects that just maybe this whole mess can be put behind us. But as the talks progressed there was concern about how well the labor process was proceeding. Then fear about what the baby might look like started creeping into the market. It looks like it's a...it's a...actually we don't know what it is. But it became clearer by the end of the day that the market might not get the beautiful baby that they thought they deserved and the market lost a lot of its earlier gains. Buy the rumor, sell the news?

We all know the market anxiously awaits resolution of the bailout plan, knows there will be some version of the plan but is very nervous that it won't be enough (will there ever be enough for the Wall Street babies who can't stomach losses and want the taxpayers to bail them out?). It still astounds me that the very people who did not see this coming, and kept assuring us it would not get worse, are now the ones we're supposed to entrust with a $700B donation from the taxpayers. What's really scary is that I know they'll be back for at least double that.

At any rate, before jumping into my regular charts I wanted to discuss a little more about credit spreads. On Tuesday I showed the chart of the TED spread (the spread between 3-month T-bills and Libor). As this spread widens it reflects how comfortable (or not) banks are with risk. The more worried they are about lending the higher the return they want on their loans to other banks. As I had mentioned Tuesday, up until August 2007 the spread typically ran about 1 point (1% more than the 3-month T-bill rate). Here's the updated chart as of today:

TED spread, courtesy bloomberg.com

After peaking at 3.13 last Thursday it dropped but I had mentioned possible support at previous highs from last December and March. You can see that the TED spread has bounced back up this week, and this after all the bailout talk. What this is telling us is the banks are not impressed. The government intends to bail out the banks and relieve them of their toxic mortgage securities as a way to improve the liquidity in the market and grease the skids of the credit machine. The purpose is to get banks more willing to lend again since a healthy credit market is extremely important to the functioning of our economy. For example, many companies are very dependent on short term loans for their operations and when those loans are due to roll over, money is not available and the company is forced to curtail operations or find other avenues for getting money. (Notice GE announced today they will stop their stock buyback plan).

But, and this is a big but, the banks are not reflecting the hope that the Fed, Treasury and Congress have in helping free up the credit market to operate again. So the big question is what happens if we relieve the banks of their toxic debt but it doesn't help the credit market? It will truly be the last bullet fired in an effort to slay this monster. If the bullet doesn't faze this monster then the credit market will remain frozen, the taxpayer will have become the proud owner of a dying asset and there will be no more money to bail out anyone else. The TED spread is telling me this is what is going to happen.


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The reason for this goes back to what I've been saying for well over a year now--the bear market is caused by fear and a complete reversal of the credit expansion we've had for the past decade. The government, by definition a decision maker by committee, is always the last one to act and it's always well after the trend is firmly entrenched. In other words they're too late. The trend towards becoming risk averse will have to play out and my only hope is that we don't commit too many taxpayer dollars to fighting this (since it will only go down a black hole).

The credit spreads therefore measure banks' fear about lending. You can lead a horse to water (you can increase liquidity and cash) but you can't force him to drink (you can't force a bank to lend or a borrower to borrow). I've shown this chart before that shows the credit spread inversely (the wider the spread the lower the curve) against the S&P 500:

Credit Spread between Moody's Corp. Bond Indices BAA and 30-year T-note, Daily chart, courtesy Elliott Wave International

Note that any time the credit spread widened (curve dropped lower) the stock market followed. The S&P 500 bounce off the July low to the August high was not matched by a bounce in the credit spread. Both have dropped lower since. Now we see the stock market is again bouncing off the September low but the credit spreads continue to widen (seen in the TED spread and the chart above). As a betting person it would be better to make your bet in the direction of the credit spread--the market should drop lower again.

There hasn't been much of a change since my newsletter on Tuesday because the market has essentially been on hold. Even a good chunk of today's morning rally was given back by the end of the day, especially in the banks.

S&P 500, SPX, Weekly chart

Unless SPX can rally above today's high the weekly candle will close below the long-term uptrend line from 1990. This could be a significant sell signal. Back below 1172 would be a bearish heads up and below 1162 would strongly suggest we'll see SPX down to 1077 by early October.

S&P 500, SPX, Daily chart

As bearish as the signals are for the market I know to never discount what this market can accomplish to the upside when it gets excited about something. If the market feels exuberant about a bailout plan it could easily accomplish a rally up to the downtrend line from October 2007, currently near 1350. I think it would be a world class short play setup but I'm not holding my breath for that (nor should you if you're holding long and hoping for a bigger bounce to exit some positions). I think the higher probability scenario continues to be the dark red one calling for a strong selloff into November. However, a rally above 1250 would be a bullish heads up that we are probably headed higher as per the pink scenario.

Key Levels for SPX:
- cautiously bullish above 1250 and bullish above 1360
- bearish below 1180

S&P 500, SPX, 120-min chart

The key levels to watch tomorrow are 1250 to the upside and 1188 to the downside. I would play the direction of the break of either. As for downside potential the bearish wave count calls for a very strong selloff. I've been saying this for a few weeks now (it's amazing how long the market is holding up) but when it goes (assuming it will), there's going to be panic in the air. The Fed and Treasury are now out of bullets and I'm sure they'll try more things but eventually the market just needs to do its thing and wring out the excesses, waste, fraud and abuse.

Dow Industrials, INDU, Daily chart

The downtrend line from May and last week's high makes the 11500 area doubly important now so a break above it should see the DOW head at least for 12141 where there's a Fib projection for the pink A-B-C bounce off the July low. It's also where the 200-dma will be located in another couple of weeks.

Key Levels for DOW:
- cautiously bullish above 11500 and bullish above 12230
- bearish below 10700

Dow Industrials, INDU, 120-min chart

The DOW's pattern is very similar to SPX and has the same key levels to watch--the downtrend line from September 2nd near 11330 and yesterday's low. If the market rallies tomorrow above today's high look for at least a run up to the key level. A break below yesterday's low should see strong selling follow.

Nasdaq-100, NDX, Daily chart

Of all the indices I've felt that the NDX has a good chance for rallying a little higher, to give us a 3-wave bounce off the September low. As depicted in pink that would have NDX rallying up to about 1830 (above 1774 would confirm that scenario). Otherwise, like the others, a break below yesterday's low would be bearish.

Key Levels for NDX:
- cautiously bullish above 1774 and bullish above 1895
- bearish below 1645

Nasdaq-100, NDX, 120-min chart

After breaking its downtrend line from September 2nd last week, NDX came down for a successful retest. That's another reason to feel bullish about this index. Therefore a rally tomorrow back above today's high should have you looking to buy the dips and see if it can make it up to the 1813-1833 area. But back below 1645, confirmed with a break below 1606 should have you looking for short entries and the drop should be significant.

Russell-2000, RUT, Weekly chart

I'm sticking with the weekly chart of the RUT until something starts to make more sense on the daily chart. Price action has been too choppy to allow me to make a confident call on its pattern. The pink wave count is just an idea that I foresee playing out if the market can maintain bullishness into the end of the year. While I have my doubts about that scenario I'll let price action dictate, not personal opinion. It takes a break below 678 to break its longer-term uptrend line. After three touches this year a weekly close below that trend line would be significant.

Key Levels for RUT:
- cautiously bullish above 768
- bearish below 678

Banking index, BIX, Daily chart

Tuesday's chart showed the BIX more "squished" to show the down-channels so tonight I'm showing it a little closer to help see it a little more clearly. For example, today's candle is bearish in that almost the entire rally today was given up. The bailout is intended to help the banks but investors look to be taking advantage of rallies to sell instead. And now with shorts out of the way any selling that takes hold in this sector could be even more painful (no one to buy it at the bottom of a selloff).

Brokers index, XBD, Daily chart

Like the BIX I had shown a squished chart on Tuesday. This index has followed its down-channel for the past year and last week's rally up to the top of the channel, followed by the strong selloff from there is important. There's very little doubt in my mind which way this index is headed next--down.

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

Lots of choppy price action bounded by a parallel up-channel from July. I feel strongly that this will break down; it's just a matter from where.

Transportation Index, TRAN, Daily chart

With little fanfare and nary a mention by the talking heads the transportation stocks are breaking down. Today is the 2nd close below its uptrend line from January and one could even say today's rally was a failed retest of that trend line. Back below yesterday's low would be a strongly bearish statement.

U.S. Dollar, DXY, Monthly chart

Tuesday's newsletter showed the daily chart and the bounce off the March low looks huge. Going to a monthly chart shows that it's actually fairly minor. The dark red wave count calls for another decline to a new low (Fib projection at 67.52) but at this point I'd say there's an equal probability that we'll see the dollar turn back up and make a new high (above resistance at the December 2004 low at 80.39) or a retest of the high. In either case that would be an impulsive rally off the March low and it would tell us the bottom is in for at least the next year (green).

Oil Fund, USO, Daily chart

Depending on what the US dollar does could have a big impact on the commodities. If the pullback from July was only a correction to the longer-term rally we'll probably see a rally back up from here (green). Getting back above 92 would be a heads up that we'll see a run back up in oil. If we see a choppy pullback into October we could then get another rally leg into November before seeing oil head for new annual lows (dark red).

Oil Index, OIX, Daily chart

The bounce off the September low looks a little small in both time and price to be a correction of the May-September decline but if the stock market sells off strongly I can certainly envision these stocks going down with the ship. Otherwise, like oil, I see the potential for a down-up sequence (dark red) to finish a correction before heading lower again.

Gold Fund, GLD, Daily chart

There's a good possibility that gold has finished its bounce to correct the decline from July. However, it takes a drop back below 76 to confirm that likelihood. In the meantime it a push back up could do a retest of the September high before pulling back or head higher from here (breaking above 93 would be bullish).

Economic reports, summary and Key Trading Levels

Final GDP and the Michigan Sentiment could move the market if the number is a big surprise but I don't expect that to happen. I think the market is so hung up on the bailout plan that it's not even looking at anything else. This is one nervous market and it's very afraid Congress is not going to give Paulson the money he wants. It could end up being a sell first ask questions later if the market gets a sense that the plan is not going to accomplish much. Certainly the credit spreads are telling us exactly that.

Keep a close eye on those spreads. Bloomberg reports it (delayed) and I would not trade off the intraday moves and not even the daily moves. But watch it for divergence like a showed in the charts at the beginning of the newsletter--this market is telling us not to trust the upside in the stock market. I continue to warn others about downside surprises. Yes we get very strong short-covering rallies (to become less as the SEC adds more and more companies to the no-short list) but notice they're getting reversed faster and faster. The market is telling us something so it behooves us to listen.

I know many are leaning bullish the stock market. I get plenty of emails telling me why. I could of course be completely wrong in my market assessment, and I'll be the first one to switch sides once the market tells me to (with a break of key levels to the upside). But cyclical studies, historical patterns, a deeply troubled credit market and a bearish EW (Elliott Wave) pattern are just a few of the pieces to this jigsaw puzzle that's giving me a very bearish outlook for the market.

As long as the SEC doesn't take away all possibilities to play the short side of the market, learn to play that direction but play it very carefully and with much less money than you would use on the long side. It's more of a trading environment rather than investing (long and short) and will be this way for years to come.

And speaking of the SEC and their daily additions to the no-short list, can anyone explain to me why IBM was added to the list? I'd accuse someone of a payoff or fraud but I know we have people in the highest places in government that have only our best interests at heart (cough). But the way this market is making us feel about those in charge, putting IBM on the no-short list just prompts more and more people to question the integrity of the system. And as more people become distrustful (part of the bear market cycle), the more inclined they'll be to simply pull the plug, sell their stock holdings and go away. That's what bear markets do--they create an environment where people become disgusted with the system and never want to own stocks again. The 2000-2002 decline didn't even come close to accomplishing this. There is unfortunately more pain ahead for the market.

But we're traders, right? We want to trade both directions and make money both ways. Give me a trend and I can make money. Other than my long-term investments I don't care which way the market moves. Hopefully we're helping you become a better trader so that you don't depend on a long-term bull market. It'll be back but it might take a few years. So learn with us, paper trade and practice, practice, practice. You'll have plenty of time to use real money--the market is always here.

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

Key Levels for SPX:
- cautiously bullish above 1250 and bullish above 1360
- bearish below 1180

Key Levels for DOW:
- cautiously bullish above 11500 and bullish above 12230
- bearish below 10700

Key Levels for NDX:
- cautiously bullish above 1774 and bullish above 1895
- bearish below 1645

Key Levels for RUT:
- cautiously bullish above 768
- bearish below 678

Keene H. Little, CMT
Chartered Market Technician

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