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Market Wrap

Fed Funds to the Rescue

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The title of today's newsletter is a little play on words. This week the Federal Reserve dropped the Fed funds rate by .5% to 1.0% and wants to see the market hold up while mutual funds have been making an effort to paint the tape for month/quarter/fiscal year-end. The combination has been a one-two punch to the bears this week.

As for what the Fed is doing to our financial system, I came across a cute quote, "Zero score and seven years ago, Fed Father Greenspan brought forth, upon this continent, a new era of easy credit, conceived in lunacy, and dedicated to the proposition that all paper monies were ultimately combustible." And now the Fed funds rate is back to 1%.

That quote is from Joel Bowman at agorafinancial.com. Greenspan had dropped the Fed funds rate to 1% and injected lots of faux money into the system back in the early 2000s and since it worked so well the first time, leading to the greatest credit bubble in all of history, Bernanke seems to feel a 2nd round of cheap credit and massive liquidity injections will do the trick again. I'm reminded of the analogy of a drug user coming off a high and not wanting to come down so he injects himself with an even larger drug dose than what got him high the first time. We all know how well that works out in the end. Are we doing the same thing to ourselves?

Back in June 2003, just after Greenspan made the final cut in the Fed funds rate to 1% the DOW closed near 8990. Yesterday after getting the rate back down to 1% the DOW closed near 8990. Does the market have a memory? It was a nice little round trip there--up above 14K and back to 9K, 5 years later. The first time the DOW hit 9K was April 1998. Ten years and we're back to the starting line but at 1%, massive debt and money creation out the wazoo. The Fed is rapidly running out of ammunition but like the good American he is, and remembering the story of the Alamo, he's going to go down fighting. Or is it Custer's last stand? No matter, both work.

It's been a strange week. After dribbling along at the October lows for 1-1/2 days the market suddenly bolted to the upside Tuesday afternoon. Did the idea of a drug injection wake our poor overdosed market? And more importantly will the little spike up hold this time? The price pattern leaves much to be desired in trying to figure it out but the last time the market was tagging its 20-dma (September 19th) it was followed by a wicked selloff. Yesterday and today it's finding resistance at the 20-dma.

The crazy whippy price action looks so much like a big 4th wave correction within the move down from May that I think we could be stuck in this for another few weeks. It's an idea that I've been considering for the market (basically one large sideways consolidation from the October 10th low through November to work off the severely oversold conditions) and as this whacky price pattern continues I'm thinking more and more we're going to be stuck with this a while longer.

The 907-point rally in the DOW on Tuesday, low to high, was one of the strongest on record. Just another one in a string of huge moves in the last month. Here is a little tidbit from Todd Harrison at Minyanville.com that you may want to remember as it relates to bear market rallies: there have been 36 times over the last 80 years (37 now after Tuesday's rally) when SPX rallied more than 6% in a single session. Thirty-two (32) of the 36 occurred between 1929 and 1933. Two of those >6% sessions were October 13th and 28th, also in a bear market. The other times were also during bear markets. The point is, strong rallies like that happen in bear markets, not bull markets. There's nothing like a short-covering rally for strength, but they don't stick.

When looking at the most recent strong rallies this month--October 13th, October 20th and October 28th--we see a bearish development:

NYSE vs. Advance-Decline Line, Daily chart:

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As noted on the chart, each of the strong rallies is getting weaker and weaker when looking at the internal market breadth for each day, such as the advance-decline line. Even Tuesday's very strong point move could not equal the strong move up from the October 10th low or even the October 20th rally which was not as many points. Stronger point move on weaker breadth is a warning sign. It's a warning that buyers are becoming weaker even if the major indexes are showing large point gains. The market can certainly press higher but we have a warning here that it's very likely the bear-market bounce variety rather than the start of something more bullish.

With the Fed dropping their rate to 1% and more credit being made available to anyone who wants it (only requirement is that they can fog a mirror) we're all watching to see if it starts to have a positive impact on credit spreads. As reported last week, the TED spread (difference between the 3-month LIBOR, or interbank rate, and the 3-month Treasury) dropped initially from a high of 4.64 on October 10th to a low of 2.53 on October 22nd, a week ago last Wednesday. Since then it's been creeping back up and today finished at 2.82. It's not continuing lower in spite of what all the central banks of the world are doing. That's not a particularly good sign.

TED Spread, data and chart courtesy Bloomberg.com

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I've drawn a line across the high from back in December 2007 and you can see the drop in the TED spread hasn't even come down that far. In fact it's only retraced about 50% of the climb off the lows in June. Is this a correction or the start of larger decrease in the spread?

Worse, the commercial credit market continues to remain frozen. The updated chart of the spread between the Moody's Corp. Bond Indices BAA and the 30-year Treasury yield has shown virtually no improvement:

Moody's Corp. Bond Indices BAA vs. 30-year Treasury yield, courtesy Elliott Wave International

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After big rate reductions (1% this month) and massive liquidity injections we've got no change in the corporate spreads. Nada, zero, zilch. This has to be worrying the Fed. There's so much money in the banking system right now that the big banks feel they can still hand out billions in bonuses (they've set it aside for year-end) and use the rest to buy up other banks. But they're not lending it out. Welcome to a credit freeze that the Fed and Treasury are powerless to stop. They just haven't recognized that fact yet. But we taxpayers are now going to pay those huge bonuses for failed leadership in the banking industry. On top of that, word is out that Hanky Panky Paulson paid double for stock and warrants for bank stocks than what Warren Buffett paid. He has handed out $125B so far and essentially gifted the banks, including to his Goldman Sachs, from the taxpayers, roughly $62B so far. And that's being handed out as bonuses. Grrr...

With all the talk of so much cash/credit for bailing out the banks, mortgage holders and just about anyone else who feels they need debt relief, you knew it would only be a matter of time before the states came calling. I don't know if he's the first but NY governor David Patterson has apparently hit up Uncle Sam for a loan. He feels the federal government must provide states with "immediate fiscal relief for deficit". It seems everyone has their hand out begging for money. One can only imagine the unimaginably huge debt we're saddling future generations with. Unless of course the government simply devalues the dollar at some point after monetizing the debt.

We've got one more day to get through the week, end of month, end of quarter and for some, end of fiscal year. We had an FOMC announcement where the Fed used one more of their precious bullets and I'm sure "they" did not want to see a market selloff on that (what a waste of a bullet in that case). Add in funds doing their paint-the-tape thing to make their books look somewhat presentable to their gullible clients and we've had the perfect excuse for lots of market buying. They've managed to hold prices up but as shown above, market breadth is giving away what's really happening underneath the hood. Lots of clanging and squeaking going on in there. So let's see if the charts are telling us much these days.

S&P 500, SPX, Weekly chart
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The consolidation we're seeing since the October 10th low, albeit with large price swings, continues to fit as a 4th wave correction. While the price swings feel huge at the moment, you can see that relatively speaking they're rather small. The only question in my mind as I look at this chart is when the next leg down starts, not if. SPX could find support at the October 2002 low at 768 or, as depicted, drop below it. There's an important Gann level at 661 if 768 gives way (assuming of course the market drops further).

It may seem unreasonable for SPX to drop all the way down to its 1994 low by early next year and I'll admit that seems like an awfully long way down (cuts the market in half again from where it is). But it seemed unreasonable to me at the time when I projected back in January that we'd see a drop down to 768 by the end of the year. The rest of the EW (Elliott Wave) count needs to finish and the projection that I'm showing is based on typical wave relationships in both time and price).

As I mentioned, how and when price makes a new low is the bigger question in my mind. I've mentioned more than once since the October 10th low that we'll be entering a 4th wave correction. If ever there was a time you don't want to trade the market it's in a 4th wave. They are the whippiest and choppiest time you'll see. The price action since October 10th is just convincing me more every day that we're in a 4th. EW corrections can be any one of 11 different types and it's a challenge figuring them out real time. That's why it's usually best to wait until the move out of it gets started (down in this case) before entering new trades.

It's a bit messy looking but the daily chart shows what I think are the higher probability wave counts in and out of the 4th wave correction:

S&P 500, SPX, Daily chart
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It's possible that we'll see a continuation of this week's rally into next week and top out around 1050 (light dashed line). That would create a typical A-B-C bounce off the October 10th low. I consider that possibility to be less probable than the others but would become a top count if SPX rallies much above 1000.

The other possibility, of the three scenarios I'm presenting, is for the market to sell off hard next week (dark red). As long as SPX stays below the high on October 20th (985.44) the sharp selloff idea remains a valid possibility. But I'm beginning to think that is a less likely possibility.

The pink count shows a large sideways triangle forming, a very common pattern for a 4th wave correction. These are probably the whippiest of all the corrections, full of reversals and reversals of reversals. It fits. It also says we're going to be stuck in this pattern through November. I of course have no idea if this will play out but it's my latest thinking and I'll be updating it every day (on the Market Monitor) and every week here until we get resolution. These are great to trade once it's finished. It's an a-b-c-d-e wave count inside the triangle and once you figure you're into wave-e (where pink wave 4 label is at the end of November) you enter your trade (short in this case) and ride the 5th wave down. In the meantime those are treacherous waters inside that pattern. Enter at your own risk.

Key Levels for SPX:
- cautiously bullish above 986 and more bullish above 1060
- bearish below 824

Dow Industrials, INDU, Weekly chart
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The DOW's weekly chart looks just like SPX. It should be in a 4th wave correction in the 5-wave move down from May and once it completes we should see a 5th wave down into either November or as late as December (depending on long the 4th wave takes). That would complete the one larger degree 3rd wave for the move down from October. That means the new low would be followed by another, and larger, 4th wave correction into next year before a final low in the spring of 2009. As noted on the SPX chart, but not mentioned, the low next year should set up a cyclical bull market that lasts at least a year, possibly longer.

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

Nasdaq-100, NDX, Weekly chart
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Different index, same picture--a 4th wave correction since October 10th should be followed by another leg down, which could find support at the 1998 and 2003 lows near 940. I'm showing a Fibonacci 55 weeks from its October 2007 high. That marks a potential turn week. Whether it will be a high (or the end of the 4th wave correction) or a low can only be known as we approach the date. This week was a similar 55-week turn window for SPX and DOW but at this point it's hard to say it will be a turn window.

One thing I will say about the potential turn window for SPX and DOW--sometimes these turn windows turn into acceleration windows. So if you go back to the SPX daily chart where I showed the possibility for a fast decline from the current bounce (dark red), that would fit as an acceleration of the move out of its turn window (which is this week). I would not want to be long the market right now, even if we instead just go sideways for another few weeks.

Nasdaq-100, NDX, Daily chart
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The NDX pattern since the October 10th low does not look quite the same as the one for SPX and DOW. So instead of a sideways move over the next few weeks this raises the possibility for either a little more rally up to the top of its down-channel (near 1450) before heading lower again, or dropping hard from here. As long as NDX stays below 1368 the more immediately bearish scenario (dark red) remains a possibility. It would be particularly bearish because of the short term 1-2, 1-2 wave count to the downside since the October 14th high and it would point to another strong decline that likely breaks the 940 level.

The RUT looks similar to NDX in that it made lower lows in October and continues to look potentially more bearish. If we suddenly start to sell off hard I suspect the RUT will be leading the way.

Key Levels for NDX:
- cautiously bullish above 1500
- bearish below 1368

Key Levels for RUT:
- cautiously bullish above 553
- bearish below 442

Broker index, XBD, Daily chart
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The broker index had me thinking it might not be far from a bottom. It (and the banks) should bottom before the broader index and once it shows signs of that then we'll have a better heads up for watching a bottom in the broader averages (could be months apart). I like the down-channel for XBD and think we'll see it run down the bottom of it and potentially make a tradable bottom by the end of the year (perhaps at the same time the broader market is making its wave-3 bottom).

U.S. Home Construction Index, DJUSHB, Weekly chart
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The home builders are bouncing off their 2001 low and the bottom of small parallel down-channel from the May high. Ideally we'll see an up-down sequence to finish its decline next year with the broader averages. It shouldn't be much lower now before the selling is done in this sector.

Commodity Related index, CRX, Monthly chart
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The commodity index has made a very steep drop from its June high and I think, like the stock market, it's forming a 4th wave correction off the 78.6% retracement of its rally from its 2002 low (201.78). There's a good chance it will do a complete retracement of that rally by early next year if not sooner.

Oil Fund, USO, Daily chart
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Oil has been beating the commodity index to the downside. It too should be ready for a bounce/consolidation before proceeding lower. It might find support in the $45 area before getting a much bigger bounce back up ($70 maybe $80).

Gold Fund, GLD, Weekly chart
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After finding support at the bottom of a parallel down-channel last week gold is getting a bounce. We could see it make it back up to the $80 area before heading back down again. The pattern supports an eventual drop to the $55-$60 area by early next year (it will probably bottom with the stock market).

Economic reports, summary and Key Trading Levels
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The U.S. economy shrunk by a -0.3% annualized rate in the third quarter, primarily because consumer spending slowed dramatically. As we know, consumer spending is about 70% of our GDP (pretty sad to think we have to spend our way to wealth now). Domestic sales fell -1.8%, the largest decline in 17 years and consumer spending fell -3.1%, the first decline in 17 years and the biggest drop in 28 years. Business investments fell -1.0% while investments in homes fell for the 11th straight quarter.

A picture is worth a 1000 words and the one for consumer spending isn't pretty: [Image 16]

You can see consumer spending actually peaked back in 2000 and the whole stock market rally from 2002-2007 was really built on hope that everything was better. The only thing that was better, if you can call it that, was the huge run up in credit which inflated all assets. A look underneath the hood was telling us the economy itself was not doing that well, led by a weakening consumer. It's all coming home to roost now and we need to flush the system of the waste (otherwise known as financially engineered by-products).

Friday morning's economic reports have the potential to move the market. If there are any negative surprises, all the stock that mutual funds have been picking up for their end of month/quarter/year reports could get dumped in a hurry if the state of the economy continues to spook them.

Summarizing tonight's charts, we're in a correction of the strong decline from September but I do not see any evidence suggesting we've put in a bottom. The correction that we've been in since October 10th could end at any time or it could extend sideways for another few weeks. I would not want to be long the market considering the fact that the wave pattern clearly calls for more downside work to be done and this is being confirmed by lack of market breadth even as we see large point gains.

The kind of correction we're in, a 4th wave, kills traders. Any money they made during the previous strong move (3rd wave down in this case) is often given back to the market with whippy price moves and stops getting hit left and right. The large price swings require wide stops and they're getting hit anyway. Death by a 1000 paper cuts. I made the recommendation three weeks ago to stay out of the market until this correction finishes and I can't comfortably say it's finished yet. As shown on the SPX daily chart, we could see this sideways chop continue through November. Know when to trade and more importantly know when not to trade. I learned long ago to not trade 4th waves. I'll nibble at the edges and I've added to my short position at the highs of the swings but even those have been relatively small additions. I prefer to bet heavier once I have a good idea that the correction is finishing or has finished. No evidence of that yet.

Because of the risk that remains in this market, with downside surprises right around the corner and an EW pattern that shouts for more downside, long is simply not the place to be yet. After the next low we'll have a good trading opportunity to pay the long side into early next year. Flat or short--those are my only two suggestions. But be careful if you're short by owning some long November puts. If we go sideways into Thanksgiving you can kiss those puts goodbye. That would even do some damage to December puts, especially if they're OTM. Decide on a drop-dead date or price to pull the plug if we haven't dropped yet.

In the "what could surprise this market" category, I recently read that a very large bank in Japan, Norinchukin, is heavily exposed to the derivative mess and it could take them down. Who cares you say? Well, it turns out Goldman Sachs has been reliant on funding from Norinchukin. Goldman has been rumored recently to be courting Citigroup about a merger. Is Goldman too big to fail? Could they break the Treasury bank? Just asking.

It's a rough market out there. Trade carefully and good luck. I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 986 and more bullish above 1060
- bearish below 824

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

Key Levels for NDX:
- cautiously bullish above 1500
- bearish below 1368

Key Levels for RUT:
- cautiously bullish above 553
- bearish below 442

Keene H. Little, CMT
Chartered Market Technician

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