Option Investor
Market Wrap


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Trying to figure out where to trade the long side and the short side of this market reminds me of the game where you have to whack the mole as it pops its head out of the ground. It of course disappears and then suddenly pops out another hole.

Take a look at the numbers in the above table and see if you could figure out whether today was bullish or bearish. First thing you see of course is that the indices were in the green. Well, the blue chips were in the green. The techs and small caps couldn't find enough interest. Bullish the blue chips, bearish the rest. Volume was very heavy today so that's good on an up day, right? But down volume beat up volume and declining issues beat out advancing issues almost 2:1. So that's bearish, right? New 52-week lows continue to swamp new highs and that's bearish. Gold was down while oil was up so more mixed signals. All in all I'd say the mole won the day today.

After the low on October 10th I have repeatedly warned traders that we could enter a frustrating period of a couple of weeks where price chops sideways as it consolidates a bit before heading lower again. The trouble for those of us trying to trade the market is that the "chop" includes swings in the DOW of several hundred points and still not be particularly meaningful. A move of several hundred DOW points in the span of less than an hour has become standard practice for this market. And as soon as it rallies (pops its head out of the ground) and you try to join the rally it immediately ducks down and heads underground again only to pop back up at a different place, without you on board.

The overnight action in equity futures is not giving us any clues either. Last night futures rallied fairly strongly but then by the morning it had all been given up. The market then rallied after a brief dip and the DOW was up +250. It then gave up 550 points and was down -200 for the day before rallying 480 points in the final hour to close +172 for the day. Just another day in the market. What's amazing is that on the 60-min chart it looks like relatively small moves today. On the daily chart it's in the noise category and left a small candle.

So once again, if you're feeling at all frustrated in figuring out this market you are not alone. I don't listen to CNBC but I saw Jeff posted at the end of the day that Maria Bartiromo said, "This market is completely whacked". She doesn't impress me much but that was probably one of the brighter observations I've heard her make. As I'll review in tonight's charts, we could still be in a large consolidation pattern (4th wave correction for those following the EW (Elliott Wave) count in the move down) and these are probably the most frustrating to figure out real time. It's when the trend resumes out of it (down in this case) that it will become more recognizable as to what kind of consolidation pattern we had (bear flag, triangle, pennant, rectangle, etc.).

It doesn't seem very long ago that I was using daily charts for the bigger picture and 60-min charts to see what could happen over the next few days. Well, the weekly chart is the new daily chart and the daily has replaced the 60-min. The moves in this market have become so large that we have to take a bigger picture view of it just to try to make some sense of the moves. So onto the weekly and daily charts:

S&P 500, SPX, Weekly chart

Price has been consolidating just underneath the level of the price highs and lows from 2001 and 2002 (near 950) and its longer-term uptrend line from 1990. I believe the S&P will stay below that uptrend line throughout 2009. The pattern is set up for another leg down and I'm trying to figure out a downside target but won't have a good bead on it until it starts down again. For now I believe we'll see the October 2002 low at 768 either hold or be marginally broken. Some analysts I respect are calling for a crash from here but I don't see evidence of that in the EW pattern.

As pointed out last week, there is a potential turn week the last week of October (a Fibonacci 55 weeks from the October 2007 high) so that bears watching if we're getting a low into next week. From the next low we should get a bounce into the new year before breaking down again and giving us a longer-term bottom, good for perhaps 12-18 months, but it will likely be just a lot of consolidation rather than a strong cyclical bull market.

S&P 500, SPX, Daily chart

Price has essentially been consolidating since the October 10th low in what may be a descending triangle (declining highs, flat bottom). Out of this pattern should be another leg down to the 700-768 area, labeled wave 5. Because we're in a 4th wave correction it remains very difficult to determine where exactly we are within the correction. It's why I've stressed it's a time to be very careful and trade lightly. These 4th wave corrections are probably one of the primary reasons traders give back the profits made during the previous strong move (down in this case).

One idea that I don't show but that occurred to me as I was studying all the charts for tonight is the possibility for a small descending wedge to form from the October 14th high (labeled as wave 4 on the chart). That would suggest another up-down sequence to a minor new low (might not even reach 768) before starting the year-end rally. I'll cover that possibility in more detail next week if it looks like it could be playing out.


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Key Levels for SPX:
- cautiously bullish above 1063 and bullish above 1200
- bearish below 840

I don't consider the DOW to be as good a proxy for the broader market right now. I see too much evidence of manipulation and interference in its pattern as compared to the others. I will therefore show weekly charts for the DOW to give a sense for some levels to watch but I'm not using it as part of my current daily analysis.

Dow Industrials, INDU, Weekly chart

The DOW has the same pattern as SPX and the new leg down could have the DOW tagging its October 2002 low at 7197 at the same time SPX is tagging its 768 low. Then a bounce into the end of the year (may not amount to much) before a longer-lasting low in the first quarter of 2009.

Key Levels for DOW:
- cautiously bullish above 9800 and bullish above 10500
- bearish below 7880

Nasdaq-100, NDX, Weekly chart

If SPX and DOW manage to drop down their October 2002 lows then I expect NDX will make it down to the lows last seen in 1998 and March 2003 near 940. Because NDX topped out a couple weeks after the DOW and SPX last October its potential turn date by the Fibonacci 55-week turn window is during the week of November 16th. But as depicted, I think it will only be good for a bounce into the new year before turning back down into a longer-lasting low early next year.

Nasdaq-100, NDX, Daily chart

I show the possibility for a big leg up (pink) to the top of its down-channel before turning back down. I have no idea what could spark that kind of rally but if it happens it would be a very good short play setup. Otherwise we should see NDX either continue consolidating in more of a sideways pattern before heading lower again or as mentioned briefly for SPX we could see it chop its way lower in a descending wedge patter over the next couple of weeks.

Key Levels for NDX:
- cautiously bullish above 1520
- bearish below 1368

Russell-2000, RUT, Weekly chart

There's little to add for the RUT's weekly chart--it looks like the others and we should see it head lower before it will be ready for a bigger bounce, in time if not also price.

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

Broker index, XBD, Daily chart

With the Fed cutting interest rates and flooding the market with liquidity while the Treasury buys up stock in the financial industry you'd think it would help the brokerage houses but so far nothing. The XBD index remains inside its longer-term down-channel from October 2007. Back then it had peaked out just shy of 269. I think by the time it finds a longer-lasting bottom it will have lost over 80% of its value. But hey, the good news is I think this is close to finding that bottom. The bad news is that it might mean another 40% haircut from its current price.

The Fed is probably not done cutting interest rates and it's interesting to see where rates have come from and where they could be heading, looking at the monthly chart of the 10-year yield:

10-year Yield, TNX, Monthly chart, 1994-2008

From a high of just over 8% back in 1994 the 10-year yield has dropped to about 3.5% and could be headed for 1.6% by the end of next year if I've got the right pattern and it follows its long-term down-channel. The Fib projection for the leg down from the 2007 high is to about 1.6% and that crosses the bottom of its down-channel at the end of January 2010. That's clearly somewhat speculative at this point but if true then buying in the Treasuries will still be strong through next year (and a good place to park your money for now).

With the yield headed lower during this 14-year span, which means prices have rallied, you can well understand why investors in Treasuries have outperformed investors in the stock market. Some individual stocks have clearly been the exception but if you've been in index funds you would have been better to be in a Treasury fund.

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

The home builders may be due for a bounce if the little parallel down-channel holds. It's also testing the 2001 low. But I don't think we've seen the final low for this index yet.

The Transports are now in synch with the broader market and therefore its chart isn't telling us anything I haven't already covered. I'll skip its chart tonight in the interest of time.

Commodity Related index, CRX, Monthly chart

The commodity stocks have simply been crushed. I had mentioned over a year ago that when the selling hits it will hit everything. That which was created through the magic of credit creation is thus destroyed by the inevitable credit implosion. Add in a parabolic rally and the "last bubble" and the result seen in this monthly chart should come as no surprise. But by the number of hedge funds that are in serious trouble, because of their blind faith in the idea that commodities had to keep climbing because of the supply-demand curve, I'd say this market has trapped more than a few bulls. I suspect we'll see a complete retracement of the 2003-2008 rally before the decline finds at least a tradable bottom.

As far as commodities go, gold is also considered a safe haven and has held up better (the same cannot be said for oil).

Gold Fund, GLD, Weekly chart

The type of pattern that I see unfolding in gold tells me it will drop lower but not in a straight line. In fact we could be nearing the point where we'll see a big rally in gold before it heads for new lows again. The stock market has been wild but the gold market has been wicked for traders. Both sides are getting whacked but the gold bulls stand by their conviction that one must own gold for the hard times that are coming. I don't argue their logic but I think it will be cheaper to pick up next year.

Oil Fund, USO, Weekly chart

Oil has now retraced more than 78.6% of the rally off the 2007 low at 42.56. That's usually the last line of defense and exceeding that typically means a complete retracement. I'm sure once we get there we'll see more stupid people heading out to buy their favorite land yacht, thinking the oil crisis is over and cheap gas prices have returned for good. It will be a relatively short-term event and they'll get nailed again as the longer-term oil shortage problem kicks back in. But that may not be for a couple of years until we get through the recession (I won't say the 'D' word).

Economic reports, Summary and Key Trading Levels

It's been an extremely light week for economic reports. Today's was the unemployment report which showed an increase in the jobless claims (no surprise) to 478K. This was higher than the expected 465K and slightly higher than last week's 463K. Tomorrow's lone report is Existing Home Sales and is expected to be 4.95M which would be a slight improvement over last week's 4.91M.

Earnings keep coming in hot and heavy and for the most part have been even more disappointing than downwardly revised expectations. It has helped keep the market depressed. But Mr. Softee, MSFT, announced after the bell that they saw a slight gain in 1st quarter profits and sales were better than had been expected. Their stock jumped initially in after-hours trading but then pulled back close to their closing price by the end of after-hours trading. Nasdaq-100 futures went slightly negative after the close.

<u>Roubini Sees Crisis Worsening, Hurting Emerging Markets</u>
Nuriel Roubini has been one of the economists with a more accurate assessment of the credit crisis and its implications on our economy. While he was hopeful about a year ago that we would see the Federal Reserve succeed in helping to solve the credit crunch, he has now turned rather bearish about the prospects for a recovery soon. In fact he's thinking we could see a real breakdown in the financial system (as if it hasn't already happened) and consequently in the stock market. You can listen to his talk (47 minutes including a question and answer period) at the Bloomberg site: http://tinyurl.com/5ulz3w

From the sounds of Roubini's talk he's thinking we could see a true panic-driven market crash from here (which of course begs the question--what the heck have we seen so far?). I'm projecting another leg down for the market for what I think will be a tradable bottom in November (maybe earlier if it happens quickly from here). The potential is for SPX to drop down to about 700 although the October 2002 low near 768 certainly could act as strong support. From the 1044 high on October 14th, a drop down to 700 would be another 33% decline and could certainly qualify for the crash leg that Roubini is forecasting.

I did not listen to Greenspan's testimony before Congress today (which is usually just a circus show) but I understand he was taking some responsibility for what's happening today (how could he not?). He is apparently in a state of "shocked disbelief" about the credit crisis that is unfolding. It's proof to me that people like Greenspan are book smart and common-sense dumb. The "financial engineering" he was so proud of in the early 2000s was very dangerous, and not just in retrospect. There were many, including Buffett, pointing to the huge systemic risk.

All it needed was a Minsky moment and the whole house of cards is collapsing. Greenspan will go down in history as one of the worst, certainly reckless, central bankers we've had. Unfortunately the guidance of the banking system on his watch is what will now cause huge pain for ordinary Americans (and others world wide as they too were playing with the same foolish highly-leveraged investment vehicles). For example, Iceland's government investments became one big highly leveraged hedge fund and are now in dire straits.

I was reading in one of Jeff Cooper's articles recently that Universal Economics identified four previous periods of "financial engineering" in U.S. history. Why we let financial institutions create new ways to lose money is beyond me. The following chart of asset-backed securities shows the extent of the credit creation process:

Asset-Backed Securities Outstanding, data courtesy Securities Industry and Financial Markets Association

The total number is derived from automobile loans, credit card receivables, equipment leases, home equity loans, student loans and loans for building homes. This does not include mortgage-backed securities which has caused round one of the credit collapse. From that list we can expect to see trouble in all of them. Most people who are studying this problem identify construction loans as the next shoe to drop as far as defaults and that could cause a very serious commercial paper credit freeze (worse than it is now).

Universal Economics reported that the average decline for the stock market after each of the previous four periods of financial engineering (which is just another way of saying excessive credit creation) was -45%. But that was the average. The credit expansion this time around completely blew away previous periods. We've seen nothing like what we experienced leading up to the high in 2007. I fully expect the unwinding process to take the stock market well below a 45% decline. It of course won't be a straight line down and it will take some time. It's a matter of how quickly we unwind the credit expansion that will help determine how long it takes before we're back to a stronger footing to launch the next bull market (which will come).

We've been reporting recently what the TED spread has been doing and the good news this week is that it has dropped from a high of 4.64 points on October 10th to a closing level of 2.57 today. This measures the spread between the 3-month LIBOR index and the 3-month Treasuries which are being assisted by global central banks at the moment and may not be truly reflective of the state of the credit market, particularly for the commercial market. Unfortunately the spread between commercial paper and Treasuries continues to widen which tells us all the work the
Fed and Treasury have done (and money they've spent and will spend) hasn't done diddly for the commercial market. Things are Not getting better out there and there's very little the governments can do at this point.

Graphically this commercial market credit spread can be seen in the following chart (the spread is charted inversely so the wider the spread the lower the curve):

Spread between Moody's Corporate Bond Indices BAA and 30-year T-Note, courtesy Elliott Wave International

I've shown this chart before and pointed out that a stock market rally while this credit spread continued to widen was always followed by a continuation of the stock market decline. I see nothing on this chart that tells me I should be looking for a bottom and a buying opportunity. Nothing.

I think the best advice for now, for longer-term investors, is not to do like we're hearing so many doing right now--picking a bottom. Even diehard bears are scurrying in to pick up bargains. If you're a masterful stock picker and can buy with the confidence that not only are you in the right sector but also the right stock and at the right time then by all means have at it. But when talking about the indexes I think we've got new lows coming and then there could be an opportunity for a 1 to 2-month bounce into early 2009 before another leg down to new lows again.

If you want to trade the bounce off the next low it could offer up some nice returns (even as much as a 50% gain off the low). If you're looking for a longer-term investment I think the bargains today will be even better bargains by the end of the 1st quarter of 2009. As Jeff
Cooper recently said, "When there is deafening silence at the bottom, then it will be time to start some buying." In other words, when you no longer hear that this is a bottom and it's a good time to buy, then you'll know we're there.

It will get better but give this market some time to find a longer-lasting bottom. The 2nd mouse gets the cheese--whatever low we find it will be tested weeks to months from that low. That's when we'll look for a longer-term bottom. Be safe and good luck. I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1063 and bullish above 1200
- bearish below 840

Key Levels for DOW:
- cautiously bullish above 9800 and bullish above 10500
- bearish below 7880

Key Levels for NDX:
- cautiously bullish above 1520
- bearish below 1368

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

Keene H. Little, CMT
Chartered Market Technician

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