Option Investor
Market Wrap

Have We Bottomed?

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As I watched todays trading action I tried to make sense of the volatility and get a handle on the answer to the most asked question of me Have We Bottomed? The best way to answer that question is to pose one to you, the reader and option trader. Did the market capitulate today? Has Main Street thrown in the towel and cashed out of the market? Have you taken your money out of the banks? Normally, I would point to the CBOE Volatility Index ($VIX) and point to the $VIX hitting 48.40, a level not seen since 2001. But with the up tick rule still out of the picture, the market can decline further and with more conviction than in the past. I realize that the financials are off limit, but do you really think that the Smart Money has been waiting for October 2nd to get short the financials? They are selling anything with a pulse in order to push the markets to the brink. By selling short oil and the energy complex, for example, the markets have been in a freefall and have pulled the Financial Sector along for the ride. By carefully selecting the proper sectors that have the most influence on the general markets (sector weightings), large institutions can affectively push the markets around and trigger other institutions to initiate sell programs. Is this market manipulation? Not in my book. If I had billions to trade, I would do the same exact thing. The Cascade trade is an effective tool for institutional investors. In normal markets where large investment banks have investment capital for proposition trades, a company like Morgan Stanley could downgrade a company like Apple Inc., as they did today, to possibly buy or cover a short a highly correlated competitor at a much lower price or force the NDX below a short strike price in order to save a large short NDX Call prop trade. I realize it all sounds like conspiracy theory but there are legal methods to move the markets. In todays market place, I wouldnt be surprised if a large Prime Brokerage client of Morgan Stanley requested the timing of the AAPL downgrade to coincide with the cross currents of the Bail Out package.
Todays internals may have pointed to signs of capitulation. On the NYSE, there were only 53 advancing issues and 2842 declining issues. That means that only 2% of NYSE stocks advanced today. There were only 17 New 52-Week Highs versus 1,055 New 52-Week lows on 2.6 Billion shares traded. However, the ARMs Index or TRIN was only 0.52 which suggests more selling. Usually, we look for the TRIN to spike above 2.0 to initiate an overnight long signal.

Today on the NASDAQ, there were 424 advancing issues versus 2,563 declining issues. There were 22 New 52 Week highs versus 685 New 52 Week lows. The NASDAQ had about 2.8 Billion shares traded today. Money came into the treasury market as the return of ones money became more important than the return on ones money. The TNX (10-Year Treasury Yield Index) dropped 1.95 to 3.62%. As the chart below shows, the TNX posted yields as low as 3.25% two weeks ago and has since run up as the bailout plan was unveiled. The TNX may fill in the gap over the next few days as foreign money looking for a safer haven is converted into dollars. Buying treasuries pushes the yields down. Foreign money can be tracked by seeing the relation between various currency pairs.

I am sure everyone is getting blasted with emails from friends on either side of the political spectrum about who is at fault for the problem and who is at fault for not solving it before it ever became an issue. It will be difficult, but I will try to recap todays events without indicating my political bias. In addition, I want to cover the story from a different angle than what you have already seen on TV or read. If you were paying attention on Sunday, the news sources announced that the Emergency Economic Stabilization Act was drafted and most likely to be voted on Monday. While the market got what it had anticipated the initial reaction this morning was to sell off today. One of my friends was dumbfounded because the market was down and the expectation was for it to bounce on the news. I clarified that the market moved in anticipation of the plan and the smart money decided to sell into the false strength and wait for the Act to actually pass the vote. Since the Act didnt pass (228 nay to 205 yes) for whatever reason and whoevers fault, the S&P 500 went from being down about 45 points at 1:30 PM EST to down 90 points by 1:46 PM. The SPX tried to run back to only down 60 or so but could hold onto any strength. Throughout the day the Dow Jones Industrials found more relative strength than the SPX because it wasnt so affected by the NASDAQs weakness. The Dow Jones Industrials ($DJI) only has two technology companies; Intel (INTC) and Microsoft (MSFT). As the Internals above show, the SPX closed down 106.85 at todays low of 1106.42. The Dow Jones fell 777.68 to 10365.45, also the $DJIs low. Since the NASDAQ 100 (NDX) and Russell 2000 (RUT) also closed at their daily lows, it appears that the selling climaxed at the close and drew the indices to close at their lows of the day. After the vote, the Republican Minority was the first to point out the faults of the Majority and not the faults of the plan itself. Since I live on Main Street and interpret Smart Money tendencies, I along with most of you reading this, have a bias for this plan to go through. After the Republicans were finished House Majority Leader Pelosi spoke about bi-partisan ship and not giving up on providing a solution. The back and forth action of blaming continued as Senator Osama rallied his audience against the Republican Administration and House. He commented on how the current administration provided an environment for Wall Street and Banks to take advantage of the American people and put the country at risk. Senator McCain spoke about how now is not a time to point out fault; it is a time to create a solution. A week ago, Warren Buffett was interviewed on CNBCs Morning Call. He basically stated that the general plan was a good plan and that he wished he had $700 billion to finance the plan. He also indicated that something needed to happen fast. So far, the clogging of credit pales in comparison to the House and Senates reaction to the problem. They spent valuable time trying to determine who and the why rather than relying the opinions of professional money managers like Paulson, Bernanke, and Pimcos Bill Gross. As indicated by the October Fed Funds Futures (currently at 98.38), my guess is that Bernanke will be forced to lower the Fed Funds and Discount Rates a minimum of 0.25% rather soon (100 98.38 = 1.62%). There is an assumed 100% chance of a 25bp and about a 50% chance of a 50bp rate reduction by October expiration (30 days from now). Finally, I kept waiting for gold to rally more than it did. The futures contract closed 14.9 higher at 909.30 after hitting a high of 920.10. Usually gold is the place where safe money goes when the end of days is upon us. I keep hearing people talk about how the US is going to go into a depression. Main Street is worried about the economy and their money but is apparently telling their representatives to vote against the Act because they dont want to bail out the fat cats on Wall Street. At this rate of consolidation there wont be a Wall Street as it is today. There will be a few big banks that control the world: JP Morgan, Citigroup, and Bank of America.


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Other Important Factors

As mentioned earlier, AAPL was downgraded to equal-weight from overweight by Morgan Stanley. Morgan Stanley said slowing demand and margin risk isn't priced in and PC unit growth is decelerating. The remaining source of growth is increasingly in the sub-$1,000 market where Apple does not play. Also, earnings per share growth will decelerate "meaningfully" from June quarterly levels due to tough comparisons and investments in iPhone growth.

Wachovia sold its banking operations at fire-sale prices to Citigoup (C) who confirms agreement-in-principle to acquire WB's banking operations in an FDIC-assisted transaction. C will be raising $10 billion and cutting its dividend to $0.16. C will pay Wachovia (still WB) $2.16 billon in stock and assume $53 billion in senior and subordinated debt. The transaction will result in C acquiring more the $700 billion of Wachovias banking subsidiaries assets and related liabilities. The FDIC has agreed to provide loss protection in connection with $312 billion of mortgage related and other assets while C is responsible for the first $30 billion. Citi is also responsible for the next $12 billion in losses up to a maximum of $4 billion per year for the next three years. Citi has also agreed to issue to the FDIC preferred stock and warrants with a combined value of ~$12 billion. The FDIC has agreed to be responsible for any further losses on this portfolio. There were reports that several European financial institutions had to be bailed out and concerns that the changes made to the financial relief plan over the weekend would limit financial firm participation.

Tomorrows Factors

The Chicago PMI will be released tomorrow morning. The market expects a decline in the Purchasing Managers index to 54 from 57.9. Consumer Confidence is also expected to decline to 55 from 56.9. The end of the week is loaded with employment data which could be the catalyst for the Fed to act more quickly. However, lower rates may not matter since banks arent lending to anyone, especially each other. The TED Spread, which is the difference between what banks charge each other for 3-month dollar loans (3-month Libor) and what the U.S. government pays (3-month T-bill) -- rose 63 basis points to 3.55%.

The EPS cycle is about to start in about 2 weeks. We will have many more companies to discuss then.

The Indices

As mentioned earlier, the various indices I follow all closed at their respective lows of the day. It would be of no surprise to me to see the markets gap higher and the fall lower intraday; mainly because there wont be a resolution to the Economic Stimulus Act until Thursday, at the earliest. Lets first discuss the S&P 500 (SPX) support and resistance. Last week I wrote that a trader should short rally attempts until it doesnt work anymore. Last Thursday and Fridays run up was inspiring of a bottoming process in that the market opened lower and closed higher. The usual action was to open higher and close lower or open lower and close even lower. None of that matters now. Todays failure to find any support and subsequently break through all previously established support has greatly altered the picture of the market.

The chart above shows that the RSI is in oversold territory again. But the Slow Stochastics has yet to follow through to indicate downside momentum. Fridays high did close above the 8 day exponential moving average (EMA) but it failed to break above the 21 day moving average. Todays close was lower that the lower Bollinger band (1132.39). My Bollinger bands may appear different than yours because I use the 21 day EMA as the base moving average. As with most canned Bollinger bands, the upper and lower bands are calculated according to 2 standard deviations of the center line.

The SPX hasnt been at these levels since 2004. As the chart above shows, the 100% retracement from the 2004 breakout low is at 1060.71. We could see a move down to those levels as the market figures out how to price in the governments lack of action. Historically, when Money Flow is at these levels (21.877) on the weekly chart, the market is near a low. Long term moving averages are so far out of play that they dont even deserve mention. These are circumstances when old fashioned support and resistance and pivot points are useful.

As mentioned last week, the 50 day moving average provided the SPX with substantial resistance. The mention of the plan wasnt enough to move the market that much. A plan is an idea and not the action or result. Even though the plan will be adopted as an Act latter this week, the entire results of the plan of action wont be revealed for years. Right now there isnt support until 1060 and the next resistance level is last weeks low at 1133. The trend is still down. That means the best trade is to short at tests of resistance and cover at extreme lows or signs of capitulation.

Speaking of capitulation, looking at the VIX chart over the last ten years I have noticed that each time the VIX spiked to about 48 50 the market established a bottom soon after. Sentiment is dim and portfolio managers are willing to pay anything for protection right now. We never want to be asked why we didnt have some sort of hedge or a way to participate on the downside of the market so some traders actually buy puts at the low. Today the VIX peaked at 48.40 which lines up to past highs not seen since 2001. I drew a yellow line to depict the high level and another to depict the low that the VIX ran up from. The difference or amplitude of the VIX is fairly consistent in each market top scenario as indicated by the low VIX. The lower yellow line is marked at around 17.50 from April 2001. The VIX ran to a high of 48.46 in July 2001. While we dont know if todays high is the high the low is 15.82 from around May 1st.


I could get lazy and mention that the NDX chart appears very similar in shape as the SPX chart but that wouldnt be very nice. The NDX had been in a relative range throughout the year until September 1st when a few of the NASDAQ components reported weakened outlooks. Once the 1750 support level was broken the NDX has been in virtual freefall. The daily chart has the Slow Stochastics ticking down today while the Stochastics moving average (blue line) is also curling over. This provides potential downward momentum and room for the NDX to drop further until the Stochastics reaches oversold territory. However, the RSI is already oversold. Normally, we look for the RSI to close above 30 to trade the long side of an oversold bounce. Otherwise we would be trying to catch a falling knife.

Since there isnt much support in the near term I had to draw a weekly chart to see where the NDX had previously found price support. The NDX hasnt been this low since 2005 when it almost came down to its 200 day moving average. This time is different since there isnt a moving average that poses any significance within sight. At some point institutions and mutual funds will have to abandon their rules to trade only above the 200 day moving average pr some other lethargic indicator. Our next support level is 50 points lower at 1446. The weekly Money Flow Index is curling upward which may indicate that a bottom may be developing. A bottom doesnt mean that the trend is changing; it just means that there is a decent probability counter trend trading opportunity that is developing. Trade the bounce and cover and reverse at resistance. Trading can be very simple if you make it so. Trade patient!

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