Option Investor
Market Wrap

A Year in Review

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It's hard to believe that a year ago today the S&P 500 made its last all-time closing high (1565.15). On October 11th it made its final all-time intraday high of 1576.09. What a difference a year makes. In that time the S&P 500 has shed points 655 points (-42%) of the 807-point 2002-2007 rally, or almost 83%. 83% of a 5-year rally gone in a year. Welcome to a bear market. The big question on everyone's mind now is how bad it will get. The fear among many is palpable and we're hearing all kinds of comparisons to the 1929 crash and Great Depression.

I want to do a relatively quick review of the past year because this business requires us to do so every now and then. We must learn where we did well and where we fell down. This game we play requires constant learning and tweaking of what we do. The moment we feel comfortable with what we're doing is the moment the market slaps us upside the head by making a move we did not expect nor were we prepared for. This is a game of constant what-ifs that we go through in our heads and on the charts.

I wish I could give you all good news about an expected miraculous recovery that's right around the bend after a day of capitulation. While we could see a nice v-bottom recovery it will likely only be a dead cat bounce. And I don't think the market is quite ready for the v-bottom although we might see one tomorrow for at least a brief bounce. A bounce might even last a few weeks (although I don't see that setting up yet). I've never minced words with you and I won't start now. I received plenty of hate mail for being so bearish as we approached October 2007. Certainly my friends and family often patted me on the head and said, "You're a nice boy. You should get out in the sun more often." I'm now being inundated with requests for help with what they should do with their demolished accounts. So I'm going to continue giving you the most honest market analysis I know how. It's not always right, and more often wrong, but I give you potential scenarios with key levels and that's what I'll keep doing. You must analyze the markets unemotionally and without bias. That's much easier said than done and literally takes years of practice. I still struggle with it every day, especially during big moves like this.

In the "what else is the government doing to save us" department, they've been busy bees in the Fed and Treasury this week. But like the nursery rhyme, all the King's horses and all the King's men couldn't put Humpty together again. Confirming that the global economy is inexorably linked (refuting the idea that you can "diversify" by investing in overseas markets) yesterday saw a coordinated effort to lower interest rates in central banks. The Federal Reserve, European Central Bank, Bank of England, and the central banks of Canada and Switzerland all cut rates by .5%. The Bank of Japan endorsed the move but did not cut their rate (it's kind of hard to cut your rate when it's at .5%). Even China joined in by cutting their key interest rate and lowering bank reserve requirements, all in an effort to free up more cash to enable the banks to lend (whether they'll lend it out is another matter). The Fed's rate is now 1.5% while the ECB rate is 3.75%.

The coordinated rate cut was of course done as part of their effort to lower the costs of borrowing money and is a further effort to unclog the credit system. One measure of their success is the TED spread that's been discussed several times. It is unfortunately continuing to climb and closed today at another all-time high of 4.23. After dipping slightly following the Fed's and Treasury's actions this week, from 3.87 last Friday to 3.56 points on Tuesday, it has been climbing steadily higher the past two days. It's sending exactly the opposite message the Fed and Treasury, and other central banks, had hoped to see from their bailout efforts.

As for the coordinated rate cut yesterday, the other reason for the coordination (and I suspect the real reason) is because the countries are trying to prevent a race to inflate one currency over the other which would entice money to leave other countries and make the credit crunch even worse in that country. Currencies generally move very slowly against each other but this week some have seen their biggest moves in a very long time. The U.S. dollar, even though the U.S. is currently in a weak position, has seen a strong rally while the euro is crashing, particularly against the yen.

We've all heard of the yen-carry trade over the past few years. We've been told that it was pretty much unwound and no longer a factor in the markets. Those who have been saying that might have to amend their statements. This was a trade created by borrowing yen at a very low interest rate and investing it elsewhere where the return easily paid for the borrowing costs. It was taking margin trades to a whole new level (more credit creation added to the fuel and which is now experiencing deleveraging).

The investments with this borrowed yen were going into euro-denominated assets and particularly into commodity assets so Canadian and Australian currencies were the beneficiaries. But now with the European countries in more dire straits than even the U.S. (their banks were using 50:1 leverage whereas U.S. banks were "conservatively" using 30:1 and 40:1) and commodities crashing to earth, those who were using borrowed yen, on margin, to make these investments are now selling those assets to pay back their yen loan and apparently can't do it fast enough.

The selling of assets in other currencies and paying back the yen loans is causing the value of the yen to rise, even though Japan is not doing well at all, and that's forcing faster liquidation of the yen-carry trades. So we've got normal deleveraging of the credit expansion and now on top of that we've got deleveraging of the yen-carry trades. One look at the euro and Australian dollar vs. the yen shows what's happening to the weaker currencies:

Euro vs. Yen, Daily chart

Australian Dollar vs. Yen, Daily chart

This can be viewed as nothing short of a crash in these two currencies vs. the yen. This has only added to the selling pressure in global markets, as if we needed any more selling pressure. In periods like this you have to throw fundamentals out the window and you have to throw oversold indicators out the window. Panic selling, which is really what we have, feeds on itself and normal technical indicators become worth diddly. Even a strong rally following this kind of selling will likely be just a dead cat bounce so you can't be in a rush to buy up some "deals". Be the second mouse that gets the cheese on a retest.

The Fed and Treasury, and the foreign central banks have made numerous attempts to jump start the markets. Their hope has been that by relieving the banks and insurance companies (and auto companies, and cookie companies, and homeowners, and dog owners) of their bad debts, combined with massive liquidity injections and now a rate reduction, they would be able to encourage more lending to help relieve the credit crunch. God bless them for trying but this is a problem that's too big for even them to handle. And while I understand the necessity to try the things they've been trying (and complaining that they're pouring MY money down a black hole) I'll continue to explain the problem with the analogy of leading a horse to water but being unable to make him drink. Or stated another way by Jeff Macke "you can make markets jump but you can't make them fly". Everyone is afraid and fear stops lending and borrowing, no matter how much money is in the system. It's not cash or credit availability that's the problem, it's a demand problem and demand has vanished.


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I must admit I'm scrambling today to write tonight's newsletter. The market has sliced through key support levels like a hot knife through soft butter. I've got to update support levels and price projections on almost all of my charts. Frankly, even as bearish as I've been (I've got the hate emails to prove it), I did not think the market would come down this quickly. I know I've warned repeatedly about a market crash, including a strong warning in last weekend's newsletter, but it's not until you see one unfolding before your eyes that you experience the wonder of it all. It's got me scrambling to find new support levels and potential price paths from here. I am going to stick with weekly charts tonight, with an occasional daily or intraday chart to show something specific, because we need to keep our eye on longer term support and resistance levels now. The decline has become too large to stick with the daily charts--a straight line down with no other references doesnt help much.

I had wanted to review where we've been in the past year, hence the title of tonight's report as a year in review. Back on October 10, 2007 I included the following chart in that night's newsletter:

S&P 500, SPX, Weekly chart, October 10, 2007

Between the parallel up-channel, bearish divergences at the October high, Fibs and the Gann level of 1576 (discussed in the Tuesday newsletter if you ever get it--supposedly that problem will be fixed by tonight) I started to pound the table that it was time to get out of the market, take your bullish profits and tuck them away for safe keeping. It was a sweet setup.

If we take that chart and look at it as a monthly chart I can show where the uptrend line from 1990 came from:

S&P 500, SPX, Monthly chart, 1990-2007

This is a chart using the log price scale because of the huge run-up from 1990 to the 2002 high. Needless to say the green uptrend line is an important one.

Now we look at the same chart updated through today's close:

S&P 500, SPX, Monthly chart, 1990-2008

SPX chopped lower from October through August and while the decline from October to January felt pretty steep at the time I think we'd all agree it has now been dwarfed. Once that long-term uptrend line broke in September the selling has intensified. This is a crash leg down. At this point the 2002 low doesn't look very far away, something that seemed so inconceivable even a month ago.

On August 1st I made a projection on a weekly chart for how I thought the rest of the bear market leg down would unfold into 2009:

S&P 500, SPX, Weekly chart, 2005-2011

I remember thinking at the time, and checking my work repeatedly, that I was being too bearish. I make my projections based on typical EW relationships, both in time and price, and yet it seemed price was coming down too quickly. As it turns out I was being too conservative. I knew it was going to be a very difficult time for the market to hold up in the credit deleveraging I saw coming, but I must admit to being surprised by this chart.

Getting in a little closer to the above chart and changing the price scale to arithmetic shows where we are and I've updated the price projection for I think we're going now:

S&P 500, SPX, Weekly chart, updated projection

The EW count needs a relatively small bounce, which probably will stay well below 1000 now, and then a continuation lower to complete a 5-wave move down from the August high near 1313. As I label the move down from August, it's the 3rd of a 3rd wave, the one I kept saying would be the recognition wave. It's the strongest move within the EW 5-wave impulse and clearly it's living up to its reputation.

The market may not be quite ready to bounce as shown since the short-term pattern looks like it needs to work its way a little lower before the slightly bigger bounce is ready (to where it's labeled (iv) on the chart). After the next low, towards the end of the year, labeled wave 3, we should get a slightly larger bounce into early 2009 before a final low in the last half of 2009 (maybe another October low). From there we should see the market reenter another cyclical bull market that corrects the leg down from October 2007 in the secular bear market that we've been in since the 2000 high.

The key levels are not as useful now because the market would have to rally so strongly to break the downtrend that they're somewhat meaningless at the moment, but here they are for SPX:

Key Levels for SPX:
- cautiously bullish above 1110
- bearish below 1005

S&P 500, SPX, 60-min chart

I cleaned up the 60-min chart and am now showing EW labels are price projections because frankly they're somewhat of a guess here. Keep it simple--the trend is your friend and it's clearly down. Stay short inside the channel, get flat or try a long with a break above the channel. Any questions?

Dow Industrials, INDU, Weekly chart

I thought surely we'll see support between 9100 and 9400 but the DOW didn't even look back as it sliced right through that area. There are some potential support levels around 8400 and then 8100 but I think only for a bounce before continuing lower into November before finding a tradeable bottom and rally into the new year.

Key Levels for DOW:
- cautiously bullish above 9600
- bearish below 9000

Nasdaq-100, NDX, Weekly chart

I think NDX will drop slightly lower, perhaps after a small bounce in the morning, before bouncing back up to the 1300 area and then drop lower into next week. At this point I see opex week as being a down week which could be exacerbated by opex hedging and settlements. I don't foresee much of a bounce in the techs until it drops down to the 1000 area by the end of the year. And then maybe a bigger rally into 2009.

Key Levels for NDX:
- cautiously bullish above 1600
- bearish below 1500

Russell-2000, RUT, Weekly chart

After holding relatively well compared to other indices the RUT has simply let go. Like NDX I expect a small bounce soon but basically this index should stair-step lower into November before we get a bigger bounce into 2009.

Key Levels for RUT:
- cautiously bullish above 600
- bearish below 580

Banking index, BIX, Daily chart

The banking index broke its September low which confirms the bounce off that low as being just a correction. Most of the selling has already pummeled this index so I'm watching to see if the decline forms a steep descending wedge (choppy decline) rather than a steep decline back down to the bottom of its parallel down-channel.

The index that's still taking a beating is the brokers:

Brokerage index, XBD, Daily chart

I have little doubt that we'll see this index tag the bottom of its parallel down-channel. It might bounce before it gets there but it's clearly got room to fall.

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

After breaking below its bear flag pattern the home builders index has dropped sharply. In the longer term EW count I have this one in its final 5th wave so there shouldn't be much left to the downside. But that's relatively speaking. From a high of 1100+ back in 2005, another 100-150 points off this index is minor. However, when considering a drop from over 350 in September to a possible low around 100-150 by the time it's done, that's still another 50% haircut (and then some).

Transportation Index, TRAN, Daily chart

The transports look like the small caps here. After holding up relatively well this index has come crashing down, including right through potential support at the 2005 highs. The next level of support are the 2005 lows near 3380. I recently read of a DOW Theory newsletter writer saying we now have a DOW Theory buy signal. Whatever. He's obviously using his own version of DOW Theory. The master of this theory, Richard Russell, says we have more pain ahead of us.

U.S. Dollar, DXY, Daily chart

QCharts is not reporting the data on the U.S. dollar (I'm obstinately still using version 5.1 which no longer receives some of the data that they've moved over to servers that are feeding only version 6.0. So this chart is from stockcharts.com and I haven't been able to label it. But basically you can see a 5-wave move up from March and that means the trend is now to the upside. After a 5-wave move it gets corrected so the dollar should be ready for a multi-month pullback to correct the rally off the March low, perhaps back to 76. Then the dollar should rally strongly again next year.

Oil Fund, USO, Daily chart

USO has made it to the bottom of the support zone I pointed out back in July. Now the question is whether it will bounce (pink) or just keep on truckin' in the southbound lane. The commodities related index looks like it could find support here so perhaps oil will also bounce off support.

Commodities related Index, CRX, Daily chart

The 2003-2008 rally in commodities is officially over and the decline since May has now retraced 62% of the bull market rally. Time for a bounce? One would normally think so but these are not normal times.

Gold Fund, GLD, Daily chart

Gold looks bullish to me. It fits in with commodities but notice how well it has held up compared to the commodities index. Gold is a safe haven and people are rushing into gold out of fear of the unknown and fear of inflation due to all the efforts of central banks and governments to reinflate the economy. The thinking is that once the economy starts to rebound we will have a huge inflationary problem. I argue that we'll be dealing with deflation and not inflation and that argument supports a decline in all assets, gold included. So a drop below 72.26 would confirm gold is joining the bear party.

But until a break below 72.26 this chart looks bullish. The 3-wave pullback from March is corrective and would therefore point higher. What might happen is we'll see another leg down for gold that creates a larger 3-wave pullback and a drop to about 60 can be expected in that case. It still points higher for gold so the question is whether it will rally higher from here or not until another leg down as part of a larger pullback.

Economic reports, summary and Key Trading Levels

Economic reports have been light all week and tomorrow is no exception. This market has much bigger things it's worried about than these reports.

The numbers in the first table at the top of this newsletter are starting to show signs of capitulation. Volume is up, down volume is nearing a 90% down vs. up volume and new lows are completely swamping new highs. What does that mean for us? Nothing. It just means the selling is strong. But as opposed to day after day of normal volume in the selling, much stronger volume starts to speak "volumes" about what's happening and clearly people are now panicking and wanting out of their positions at any price. My personal phone calls and emails can attest to this. Most financial advisors' names are now mud, but they keep doing what they do best--"just stay the course, the market always comes back, you need to think long term, this is a great buying opportunity, etc." They only know one direction and one speed.

But hey, everyone needs to make a living. I just don't like it when they argue with me about what I want to do with my money (or someone on whose behalf I'm calling). They argue as if it's their money. I suppose they feel they're being paid to offer advise but my problem with them has been that too many family members and friends feel they can't tell them what to do, or don't feel they have enough knowledge about making their own decisions. We all need to educate ourselves in things we consider important and unfortunately it takes a bear market to remind us that managing our money is important enough to learn more about. So I hardly blame financial advisors for the quandary that most investors find themselves in.

I work with a really good financial advisor who manages my parents' IRA account. I called him in May to have him move some money out of a money market account into a bear fund. He has disagreed with me all the way through the bear market and we banter back and forth a lot. He was very polite during my phone call and merely said, "OK, but just remember, this is your inheritance we're talking about." It was his polite way of telling me he thought I was being an idiot to move the money. Needless to say that fund is doing quite well this year. But I can at least argue from a position of strength--knowledge of the market and having a good handle on what you want makes all the difference. Unfortunately the vast majority of Americans spend far less time learning about what they're invested in than the time they spend in front of the TV learning about the next American Idol (and that crowd seems intent on voting for our next president the same way).

But I digress. This is a very emotional time for everyone, whether you're heavily invested or not. We worry about what this means for the economy, our jobs, our food supplies, war, who the next president will be and will he do a good job. It's this fear that causes bear markets, not the other way around. The market is merely a reflection of social mood and it's doing a damn fine job. Many blame bear markets on corporate corruption, greed, day traders, and a slew of other factors. But what they fail to recognize is that all those factors created the bull market before it and no one complained, even when they knew about it. It's when we get hit with a bear market that people look around and look for things to blame. We need to look in the mirror and check what our emotions are doing to us.

So sit back, take a deep breath, do some yoga exercises and learn to relax. Don't get caught up in the hype and hysterics surrounding you. Don't feed on it or into it. This too shall pass. It's a cycle we're in and it will run its course. The market will recover and we're going to have a longer-term investment opportunity again. It may be six months or a year down the road and there could be some more pain ahead for you personally or for your close friends and family. Be there for support and seek out support. The main thing we can do to help is be as positive as we can and continue to keep our heads up and look ahead for better times that are coming. And if you're experiencing some financial pain or job loss, it's not the end of the world. I've been there and I can tell you it's stressful. But we survive and we become wiser because of those experiences. Wisdom comes from painful experiences so learn from this use the experience to do better next time.

Futures just spiked down as I wrap this up (8:30 PM EST) but I haven't seen any news yet, other than Japan's Nikkei is down -7%. Art Cashin said he'd like to see a down open, some real capitulation and then strong recovery (v-bottom). Maybe he'll get his wish Friday morning. Good luck in this wild market and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1110
- bearish below 1005

Key Levels for DOW:
- cautiously bullish above 9600
- bearish below 9000

Key Levels for NDX:
- cautiously bullish above 1600
- bearish below 1500

Key Levels for RUT:
- cautiously bullish above 600
- bearish below 580

Keene H. Little, CMT
Chartered Market Technician

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