Option Investor
Market Wrap

There's Blood in the Streets

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They say (ever wonder who "they" are?) it's a good time to be brave and start buying stocks when everyone else is puking their stocks (to use the stock market vernacular) and blood is running in the streets. I could be wrong but the streets are looking pretty red about now. Feeling brave? Well, there's brave and there's bravado. When I was flying in the Navy I was told of the saying (usually along with a picture of an airplane stuck in a tree), "There are old pilots and there are bold pilots, but there are no old bold pilots." One could use the same sentence and replace "traders" for "pilots".

This is one wicked market and it's clearly got people running very scared right now. Emotions are running very high and price swings of 400-500 DOW points, and more, are becoming almost common place right now. The VIX is finally registering real fear:

Volatility Index, VIX, Monthly chart

I had to go to a monthly chart to find the previous high that has not been exceeded and it was back in 1998 during the LTCM (Long Term Capital Management) hedge fund blow-up and the ensuing financial crisis. It's amazing how a relatively few fund managers can really screw things up. The problem now is that it's not one fund blowing up, it's thousands. And it's not just taking down a few banks, it's taking down the global banking system. It's truly frightening what's happening in our financial markets these days. When I started warning over a year ago that the credit market would collapse at a mind-numbingly fast speed, and therefore was ready for this, I must admit that I sit here in shock and awe how quickly things are unraveling.

At any rate, VIX has shot up to almost the 1998 level and I fully expect to see that level of 60.63 well exceeded. We've got a long way to go before we finish October but it will be interesting to see where the month closes. The closing high in August 1998 was 48.33 and in September 2002 is closed at 44.57 (the high in September 2001 was 57.31 and in July 2002 the high was 56.74). The high so far this month is 58.24, recorded yesterday. Today the market dropped to a new low but I guess as long as the DOW doesn't lose 800 points in a day ("only" dropped 508 points) it's not as frightening.

I learned a little tidbit at the end of the day that's worth mentioning (I like numbers and am fascinated by where and how we find them correlating). The DOW lost 508.32 points on Black Monday back in October 1987. Today's decline was 508.39. Back then it was a -22% decline whereas today it was at -5% decline. Just for reference, a -22% decline from last Wednesday's high at DOW 10831 (October 1st, following the strong rally last Tuesday on hopes the bailout would somehow be good for the market) would be a loss of 2383 points and drop the DOW down to 8448. Just another 1000 points to go...

The financial difficulties we find ourselves in are very much a global problem now. The currency markets are reflecting the seismic shift in the markets and people are scrambling to get out of positions. The euro is collapsing against the yen as people scramble to get out of their yen-carry trades, selling euro-denominated assets and buying back the borrowed yen. In the weekend newsletter I had mentioned that there's no place to hide--all asset classes are deflating and deflating rapidly now.


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Deflation is to be expected in a credit collapse. When credit is created it's created out of nothing. The Fed creates money out of nothing (which is why it's called fiat money instead of gold-backed or silver-backed) and then they give it to the banks for insertion into the monetary system. The banks have been required to hold less than 10% on the books and can lend out the rest. Each bank they lend it to does the same thing and pretty soon the Fed money that was created from electrons has created an enormous increase in money that isn't real. It's credit and credit is not money and has no value. The only way it has value is if more and more is created behind it. Sounds like a Ponzi scheme if you ask me. So when the credit market collapses all that created money gets sucked up back into electron-land. It's not anywhere. It's not sitting in someone's account waiting to be invested, it's gone, poof!

So the collapsing credit market takes everything of value, which was created by demand from too much money being created from nothing (credit) and squashes it back down. The Fed is furiously pumping liquidity back into the market, as are all Central Banks now, and trying all kinds of creative ways to do so (including now buying unsecured and asset-backed commercial paper). But the collapse of the credit market is like a black hole and it just siphons out money, never to be seen again. People are selling whatever assets they have to raise capital and that depresses the value of just about all asset classes.

Many bearish hedge funds aren't even making money this year because they've been playing the pair trade of shorting the financials (until Cox slapped their hands for playing that game) and going long the commodities. In previous times when the stock market sank it was a good time to get into commodities. Gold bulls talk about this all the time. But this time it's different and it's because we have the super-sized credit expansion over the past decade being followed by a super-sized credit contraction. The last time it was this bad was following the huge credit expansion of the 1920s (but this time we dwarfed that credit expansion period). What will follow will unfortunately be very similar. It's why I've been saying we'll be dealing with a bad case of deflation very shortly. The fast drop in commodity prices was the last bubble to be pricked.

I want to stick primarily with weekly charts tonight because frankly we've got so many near-term support levels giving way. We need to look back into 1998-2004 to see where price-level support is located. I'll also point out some Fib levels of interest and then at the end of the newsletter I'll briefly touch on the Gann Square of Nine chart because it also does a good job at identify important price levels.

S&P 500, SPX, Weekly chart

SPX broke below 1000 which is an important number. It's only a minor break so far but it has broken below its long-term uptrend line from 1990 through the 2002 low and as I'll point out on the Gann chart at the end of the newsletter, 1005 is also an important level. The week's closing price is the important close so we'll have to see how it does by Friday.

S&P 500, SPX, Daily chart

I've pointed out the importance of the break below both parallel down-channels, from October 2007 and the other from the high in May. When price breaks out of a channel, either out the top of an up-channel or below the bottom of a down-channel, it is almost always followed by an acceleration of the trend, down in this case. The decline from May is following a waterfall declining pattern and that portends a lot more selling to come.

But nothing goes in a straight line and the market should get some decent size bounces on its way down. So we look for support and places to try a long play if you dare (it's way too early to be thinking about picking a bottom) or at least support levels to take profits if you're playing the short side. There's a short term Fib extension of the previous bounce located at 990, a Fib projection at 974 (based on 2nd leg of the move down from August being 162% of the 1st leg down) and then a lower Fib projection at 925 (2nd leg equal to 162% of the 1st leg down from May). As I'll show on the Gann chart later, 974 is also an important level on that chart.

Key Levels for SPX:
- cautiously bullish above 1110
- bearish below 1077

S&P 500, SPX, 60-min chart

I had mentioned in the weekend newsletter that the market was set up for a crash and it appears to be in progress. With the Fed, Treasury, Tom, Dick, Larry, Moe and Curly doing everything they can to plug the dike's leaks, the decline is being held back but clearly there are systemic problems that the market is just now starting to grasp (it's why the 3rd wave down is so strong and is called the "recognition" wave). I'm showing a stair-stepping lower as it "unwinds" the EW count and completes more the smaller 3rd waves that will ultimately complete the 3rd wave in the move down from October. It's got many more to go and I'm only showing a partial count here.

The challenge, for traders, is figuring out when we can expect a bigger bounce and therefore when it's prudent for short players to hold for more downside and when it's better to take your money off the table and not let the market rally against you. I have not recommended long plays for a while now and I continue to recommend you shy away from counter-trend long plays right now. If you're an experienced day trader then you already know what you're doing (right?) but if you can't stay glued to the screen to watch the progress of a bounce I think it's too risk to by looking at doing any buying. Let this market puke its insides out and then step back in and look for the babies thrown out with the bath water.

Dow Industrials, INDU, Weekly chart

On the DOW's weekly chart I'm showing there's a decent chance we could see the market find its footing for at least a bounce (pink) or consolidation (dark red) as the DOW has reached its long-term uptrend line from the 1974, 1990 and 2002 lows. To say this uptrend line is an important one is a gross understatement. Cracking it would declare the 1982-2000 bull market officially over. Slightly lower, near 9130, is the uptrend line from 1982 and then a Fib projection at 9001 followed by a Fib projection at 8131. I have no doubt whatsoever that the lower level will be broken. The only question is how quickly.

Key Levels for DOW:
- cautiously bullish above 11400
- bearish below 10400

Nasdaq-100, NDX, Weekly chart

The NDX weekly chart shows the break below channel and Fib support near 1485. The next potential support level is the 2004 level near 1302 and then a Fib projection at 1132 (2nd leg equals 162% of the 1st leg down from October 2007).

Key Levels for NDX:
- cautiously bullish above 1600
- bearish below 1480
A chart I haven't shown for probably a year is the relative strength of the Nasdaq vs. the S&P 500. The tech stocks, as a measure of market willingness to take on risk, or not, will usually lead us to the upside and downside. The pattern that has played out in the relative strength chart is very telling:

Nasdaq vs. S&P 500 Relative Strength, Weekly chart

After leading the market to the downside from 2000 to 2002 the Nasdaq started leading the market back to the upside (the "price" moving up says the Nasdaq is outperforming to the upside). But the sideways triangle pattern is very telling and the fact that it completed the required a-b-c-d-e pattern with a typical slight throw-over in August 2008 says it did a classic pattern and finish. If this were a stock I'd be all over this and short in a big way. This is a highly reliable pattern and says the tech stocks will be weaker than SPX well into 2009. It doesn't mean they both can't rally but if they do rally then tech stocks will be weaker than the broader market. Use this kind of study in helping you determine which sector you want to get into, or out of, when you're ready to play the bigger swings in the market or certain sectors.

An example would be to look at a RS chart of the commodity related stock index (CRX) vs. SPX and you will see it peaked in June of this year. It's been on a crash course since and it's telling you that commodities, those stocks that everyone was hyping earlier this year, are outpacing the broader market to the downside right now. Same for the emerging market index. It's a very good tool to use.

Russell-2000, RUT, Weekly chart

The RUT's weekly chart shows it has broken below the bottom of its parallel down-channel from last October but is nearing potential Fib support at 551 (two equal legs down from October. If it does find support there it would only be good for a small bounce (pink) because the EW count is not finished. It needs a 4th and 5th wave to go before it will find a more meaningful low. As shown, the next lower Fib projection is down to 419.

Key Levels for RUT:
- cautiously bullish above 643
- bearish below 580

NYSE, NYA, Weekly chart

The weekly NYSE chart shows a waterfall decline and what typically happens if price falls out the bottom of a parallel down-channel. It has now broken below the bottom of a steeper down-channel and sliced right through its 50% retracement of the 2002-2007 rally (after a quick bounce off it on the September 18-19 rally) and today it dropped below the 62% retracement at 6544. This is one weak market.

Banking index, BIX, Daily chart

I'm sticking with the daily chart of the BIX because it's actually holding up better than the rest of the market at the moment. This is to be expected--it will bottom first and even start rallying before the broader market. But it too should have some work to do on the downside before finding its bottom.

It's the same with the brokerage index--it's got lower to go but it's proceeding lower in a more orderly fashion, if that's possible:

Broker index, Daily chart

I'm looking for XBD to drop to the bottom of its down-channel before another significant bounce.

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

Back to a weekly chart to show where the home builder index has been and where it could be headed. I think this index is very close to finishing its decline. Look how well it's holding up compared to the carnage around it. There's just not much more to sell. I think we'll see it slightly undercut its 2001 low (taking it nearly back to its origin of 125 in 2000). I could be fooled by more weakness than that but it's just not a sector that interests me and I'll probably stop covering it soon (post it if something different happens). It's dead money.

Transportation Index, TRAN, Daily chart

The weekly chart of the transports shows some real damage occurring. The break of the year's low, and the 2006 low, now has the average heading for the 1999 and 2005 highs near 3800. That should certainly be good for at least a bounce, one that could take it back up to the 4300-4400 area and play out for at least a month.

U.S. Dollar, DXY, Daily chart

My US dollar chart is missing data from October 1st through the 6th but has a print today at 81.521. The Fib projection at 81.74 be capping this move up and the wave count looks good for completion of the 5-wave move from March (with confirming negative divergence between the 3rd and 5th waves). We should see a multi-month pullback in the dollar before it rallies strongly next year.

Oil Fund, USO, Daily chart

USO could still find support just under $70 but if it doesn't I think it will drop below $60 and then stair-step lower from there. Demand destruction (along with credit) is deflating the price of most commodities, especially ones that are industrial related.

Instead of just showing the chart for oil stocks I'm going to start showing the chart for the commodities related index:

Commodities Index, CRX, Weekly chart

As I had mentioned over the weekend, the breaking of multiple uptrend lines tells us emphatically that the 2003-2008 rally has finished. It has retraced nearly two thirds of that 5-year rally in 3 months. That's a crash. The 2006 lows and the 62% retracement, both near 517, could be good for at least a bounce.

Gold Fund, GLD, Daily chart

Gold as a commodity is under intense selling pressure. Gold as a safe-haven hedge is under accumulation (and being sent off to Swiss banks). I could argue equally strongly at this point for a continued selloff or a rally to new highs. No new trade recommendations here but a break of either September's high of October's low should be a heads up for a trade in that direction.

Economic reports, summary and Key Trading Levels

Economic reports will not have much of an impact this week. Tomorrow's reports include pending home sales and crude inventories.

Before finishing I wanted to just quickly review a tool that some use. A Gann Square of Nine chart is basically a spiral that starts with 1 in the center and then spirals out from there, as far as you care to go. I built one in a spreadsheet and you can't read anything on the chart below because I had to squish it to fit here but it looks like this:

Gann Square of Nine chart

The circle is divided up into 5-degree sections so as to be able to identify where in the circle you are. Along the outside of the circle are written the days of the year (slightly off because there are 365 days but only 360 degrees in a circle). The purpose of the chart is to identify numbers that are on the same degree vector (or 90, 180 or 270 degrees away) but at a different level of the spiral. A number is said to be squared to another if it's along the same vector.

Looking at just the top left section shows the 2002 low for SPX at 768 and 2007 high at 1576. Notice that they are on the same degree but 6 levels apart:

Gann Square of Nine chart, partial with SPX 768 and 1576

One of the reasons I was pounding the table back in October 2007 that the market was topping, and that it was time to get out of your stock holdings (because of the expectation for a very nasty bear market decline to follow), was because of this Gann chart (in addition to price hitting the top of its up-channel with bearish divergence and was hitting both a Fib time and price window).

It was even more significant because it was related to 540 degrees (which relates to a cube with 6 faces and 6 times 90 degrees equals 540 degrees) since 1576 is 6 levels from 768, or 4 times 1-1/2 times (540 degrees) around the circle. Sounds like a bunch of gobbledygook but it's also related to Fibonacci and the natural order of the universe. It measures synchronicity which affects us (solar and lunar cycles, etc.). Anyway, it works.

So yesterday on the Market Monitor I was calling for potential support at 1005 because it squares out to the 768 and 1576 level. Yesterday's low was 1008 so close enough. But today that level broke. It may hold on a weekly closing basis so we'll have to wait and see what happens by Friday but using this chart to find the next potential support level I go 90 degrees around and find what number we come up with:

Gann Square of Nine chart, 90 degrees from 1005

I highlighted 973 which is 90 degrees from 1005. If you go back and look at the daily SPX chart near the top of the newsletter you'll see that there's a Fib projection at 974 where the 2nd leg of the move down from August will equal 162% of the 1st leg. That's pretty good correlation and that's a long-winded way of saying I think we'll find support at that level should it drop to there tomorrow, or whenever (we might get another bounce first before heading down to that level. I'll be watching carefully to see if a counter-trend long play is warranted or not.

This is one tough market so continue to exercise much greater care than you normally would. Good luck and I'll be back with you on Thursday and try to set up the final day of a wild week.

Key Levels for SPX:
- cautiously bullish above 1110
- bearish below 1077

Key Levels for DOW:
- cautiously bullish above 11400
- bearish below 10400

Key Levels for NDX:
- cautiously bullish above 1600
- bearish below 1480

Key Levels for RUT:
- cautiously bullish above 643
- bearish below 580

Keene H. Little, CMT
Chartered Market Technician

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