Option Investor
Market Wrap

Market Wrap

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I am sure many of you know that the various markets were up substantially today. The question is whether the economy is out of the woods and can now establish a sustainable bounce up to resistance. The efforts that the Federal Reserve, U.S. Treasury and current administration have started probably wont be fully acknowledged for months to come. However, the goal for the Federal Reserves everything including the kitchen sink policy was to provide liquidity into the system and regain the perception that the banking system is better off than everyone feared. Positive perception is the key to the viability of the economy and markets. From my perspective, the markets all moved higher on the promise from the Federal Reserve and other central banks throughout the world would provide as much liquidity as needed in short term funding. The hope is that banks will feel comfortable lending to one another again as well as lending to consumers.

Another kick in the markets pants came from the news that Morgan Stanley (MS) and Mitsubishi UFJ Financial Group (MUFG) would be renegotiating their deal. Last Friday the market feared that the risk of lowered credit ratings of MS would kill the deal and that MS would be the next stock to fail. By 9:40 the news came out and confirmed the closing of a $9 billion or 21% investment in MS. MUFG acquired $7.8 billion in perpetual non-cumulative convertible preferred stock at a 10% dividend and a conversion price of $25.25. In addition, MUFG also acquired $1.2 billion of perpetual non-cumulative NON-convertible preferred stock at a 10% dividend. MS gained $8.42 to close at $18.10.

Abbott Laboratories (ABT) announced a $5billion share repurchase program. ABT closed up $4.76 at $54.21.

There was some speculation of a merger between Chrysler and General Motors (GM), but GMs board gave the idea a cool reception, according to the WSJ. Another Dow Jones component, General Electric (GE), declined $0.50 to $21.00 even though it is one of the few companies to still hold an AAA credit rating.

The most followed commodities, Crude Oil and Gold, moved up $4.14 to $81.84 and moved down $22.10 to $834.50, respectively. Last week gold wasnt trading at levels normally associated with catastrophic chaos like we have been experiencing. It was my assumption, even before the media reported that institutional investors were selling their long positions in gold to raise margin capital. On Friday, they even sold off Chicago Mercantile Exchange (CME). A lot of professionals were spotting the short term bottom for Crude at $85. Crude declined to about $75 on Friday for the same reason as Gold did. However, gold declined today as the concerns for the end of the world subsided a bit. With golds volatility, I dont believe it is the safe haven many gold bugs believe it to be. If another depression occurred, do you think that the U.S. currency would lose all of its value? And would gold replace paper as the currency? I think wheat, rice and water would be the best currency in the worst case scenario. But there isnt anything to worry about now that the markets are on their way back up, right?

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Lets look at todays internals to see if the move higher was as impressive on the inside as it appears from the outside. On the NYSE there were 3,316 advancing issues versus 205 decliners on over 3 billion shares traded. However, there were only 2 new 52 week highs and 125 new 52 weeks lows. The NASDAQ composite had slightly less advancers percentage wise but still managed to post an exceptional broad market rally. There were 2,574 advancing issues versus 429 declining issues on 2.8 billion shares. There were many more new 52 week lows than new 52 week highs with 133 and 2, respectively. With most of the sectors recovering from a freefall, there arent many stocks near highs to improve the 52 week highs. Weak sectors today include homebuilders and miners. Not all of the financials had a stellar day either. CME Group (CME), US Bank (USB) and Wells Fargo (WFC) spent most of the day in the red while Morgan Stanley (MS) and Goldman Sachs (GS).

The Indices

S&P 500 (SPX)

The SPX advanced upward 104.13 points or 11.58% to 1,003.35. Banks and the Bond markets were closed today for the Columbus holiday. Since the banks were closed today, none of them could report that they were closing due to liquidity issues or credit rating declines. I still wonder how Moodys and S&P ratings companies can still operate without some sort of SEC probe into why the companies maintained their AAA rating on the Mortgage Backed Securities (MBS) and Collateralized Mortgage/Debt Obligations (CMOs/CDOs). Now these same ratings companies are reducing the ratings on the companies that hold MBSs, CMOs and CDOs as investments because the realized credit worthiness doesnt garner an AAA rating. Perhaps an announcement of a probe into Moodys Standard and Poors rating practices will assure a continued market advance. My assumption is that investors will regain confidence once these companies can no longer reduce the ratings on troubled bank stocks. The lowered ratings almost put Morgan Stanley out of business last week.

The above chart represents the SPX over the last five days. The top dashed line shows Friday October 3rds close at 1099.33. The lower dashed line is from last Tuesdays close. As you can see, todays 104 point move up only regained Wednesday, Thursday and Fridays losses and needs another 96 points to reach the closing low on October 3rd. Last Fridays run up in the last hour showed us how fast the market can move when it wants to. I think that the close on Friday reflected the mutual fund redemption requests that had come in throughout the day. I was instructed to sell some funds in the morning by a couple that were so troubled about their portfolio losses over the week that they were waiting for me at my office to give personal instruction. What was peculiar was that the wife seemed fine but the husband was concerned. In fact, the wife mentioned that her decision to sell would be the reason for the market to go up. And up it did. I told a couple of clients that I didnt like to add to the problem and that the market was near a bottom. My advice was and still is to sell into the strength of a bounce.

For instance, sell at the initial test of the resistance. The 21 DMA was initially the main resistance right after the 8 day crossed below the 21 day EMA. In the SPXs case, the 8 day exponential moving average (EMA) has been the dynamic declining resistance. The SPX closed just below the 8 day EMA, which closed at 1,005.84 today. Usually we would either short the test at resistance. But this bounce seems to have velocity. The RSI and Slow Stochastics have both re-emerged out of oversold territory. Fridays close managed to close above the lower Bollinger band. Last week, I outlined the support at 960 from the breakout gap in 2002. That same level appeared to be the resistance intraday until the buying came in after 3:00 PM. Last Monday, the SPX tried to bounce intraday but ended up failing to break through the 8 day EMA the following morning. Tuesday closed down sharply just below 1000. The SPX has returned above 1,000 after declining to a low of 839.80 on Friday. I believe the next resistance will be found at last Tuesdays high, 1072 and/or the 21 day EMA. Since I get to write tomorrow, I will have to revisit these charts to see if anything else develops.

The SPX moving average chart, as I refer to it, finally saw the Money Flow Index (MFI) dip below 30. I would prefer the MFI dip below 20 to mark an absolute selling climax. Even with todays move higher, the ADX managed to close slightly higher. But that is a lagging indicator. Since I use a 14 bar ADX, by the time the ADX signals that the trend downward has subsided, the market will have tested the resistance level and retraced. The 50 day simple moving average (SMA), currently at 1208, could be reached in two days like todays advance. According to the Fibonacci retracement calculations, the 38.2% retracement level (1069) is near last Tuesdays high. The 50% retracement is near the low established on the fake out low on 9/19. I believe the SPX still has about 70 points prior to establishing new sell signals. I want to show you all one last chart view of my prediction of how this market recovery will appear.

The chart above is of the SPX the March 2001 highs into the bear market lows of 2002. I believe the market recovery will be more of a U or W shape rather than a V shape. U shapes have more of a consolidation period before beginning to advance higher. Dont forget that one day does not a trend make. Even though the S&P futures are up 25 points as I write this, the market hasnt erased last weeks turmoil. Sell into rallies until that strategy no longer works. I have defined some areas of resistance that one can reduce upside exposure or increase Negative deltas. But breaks of these resistance levels should be cause shorts to be quickly covered. Dont try to be a hero and sell short the next leg down if there isnt going to be a leg. I could be wrong on the shape of the recovery.

NASDAQ 100 (NDX)

The NASDAQ 100 is another one of my favorite indices. As with the SPX, the NDX closed above the lower Bollinger band after piercing it intraday. The NDX showed relative strength on Friday while the NASDAQ Composite posted a gain. The problem with the NDX is that is tends to gap higher and lower all the time. And that requires the market to move into these gaps. For instance, todays gap higher set a gap at 1317.48 that needs to be filled. However, the NDX looks pretty good for a run up higher to fill in the gap down from 10/3 at 1,469. The 21 day EMA is at 1,509 and declining. So the 21 day EMA may provide some short term resistance as early as tomorrow. The Naz futures are currently up 30 points which would put the open at 1469.50. The gap higher would also create a new gap that would then need to be filled. Therefore, the ebb and flow of consolidation is born. While the NDX appears to only have a short distance to travel before reaching resistance, the RSI and Slow Stochastics show that there is plenty of room for the oscillators to travel before becoming overbought. Basically, the NDX has some momentum built up in it and could blow through the 21 day EMA just to get retail traders over zealous about the assumed new uptrend and then bam!... the market sells off sharply hitting newly creates stops along the way to fill in the new gaps.

As mentioned earlier, the gap is asking to be filled (identified on the above chart by the purple line). I like the fact that the MFI dipped below 20 on the NDX chart. That shows that there was a massive amount of selling. In addition, the ADX actually posted a slightly lower level today which indicated that the previous trend (down) is subsiding. While the 50 day SMA is almost too far away to mention, it is at 1733 and declining along with the 89 and 200 day SMAs. I mention this because this decline has done a great deal of damage to the chart. While the science of the chart is just the numbers, the art of the chart isnt pretty if you are a bull. I believe that the indices will consolidate within a volatile range (small up trends followed by sharp declines) which brings the moving averages lower. They need to be lower for the NDX to break above the 50, 89 and 200 day SMAs. I refer back to 2002. It took about a year for the moving averages to come into the price.

The VIX

While I am on the subject of volatility, the VIX was coveted by many as the premier fear gauge. The VIX is the CBOE Volatility Index or the constant implied volatility measurement of SPX options. It provides real time reference to traders willingness to pay extreme insurance premiums at usually the worst times; when there isnt any need to insure. Historically, the VIX trades within a range of 18 32 with the occasional spike up to 48 50. The media jumps on board the contrarian train when the VIX moves above 30 by having so called experts on to define what the indicator is suggesting. A while ago, I began to use the 10 and 20 day SMAs as a way to filter the noise and identify the bias of the indicator. Sure, I can sell the market when the VIX is low and buy when the VIX is high. But determining the shift in investor sentiments momentum is best done with the moving averages. Trading the spikes would have cost a lot of capital in the recent VIX advance. It should be noted that there were plenty of opportunities to buy the spikes and cover at tests of the 10 day SMA. Breaks below the 10 day SMA would support maintaining the long position until the 20 day SMA came into play. That leads me to the current reading. The VIX declined 14.96 to 54.99 today. The 10 day SMA is at 52.17 and the recent low is at 52.54 (I dont count the bad tick lows). Therefore, if the VIX cant break below the 10 day SMA or the recent lows, the trade is to add negative Deltas buy buying puts or selling calls or selling the long underlying position. For instance, your portfolio consists mainly of SPY and you sell call options above, at or below the strike depending on the portfolios bias. If you are now somewhat bearish short term, you would sell in the money calls to hedge the underlying SPY position. Or you could establish a negatively biased short Iron Condor (Call spread and Put spread sold simultaneously). I happen to think that the VIX is finally going to break below the 10 day SMA and test the 20 day SMA. That decline should cause the 10 day SMA to curl over which will make me switch the bias to Positive from Negative. I will send out The Contrarian tomorrow night which will cover Contrarians perspective of the Put/Call and the VIX indicators.

EPS Scheduled Announcements

Since there arent any economic reports until Wednesday I will cover them tomorrow. However, as the month of October sets in there are more and more high profile companies reporting earnings. For instance, we will be watching Dow Jones components JNJ and INTC tomorrow. Pepsi reports tomorrow as well. Other interesting volatility plays include DNA, LLTC and ADTN. I look forward to covering tomorrows action for you. Have a good night and good trading tomorrow.


 

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