Option Investor
Market Wrap

Waterfall Decline

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If you look at the decline from November 4th you can see the decline start off slowly and then bend over into a stronger decline. It looks like a waterfall and indicates we're into the capitulation phase of the selling. Many are starting to think there's no bottom--just the opposite of where this market was back in October 2007 when I heard many many comments about nothing but blue sky above us. Now there seems to be nothing but a swirling cesspool below us. The hard part for traders is trying to figure out where and when the capitulation will end so that you don't get your fingers cut cleanly off by trying to buy it in an attempt to catch the inevitable short-covering squeeze as the market comes bounding out of the low.

The important point to keep in mind now, as we attempt to identify the bottom of this move is that the 2nd mouse gets the cheese. The first mouse gets his head caught in the trap and the 2nd mouse gets to come along and take the cheese out of the trap. Assuming we get a v-bottom reversal one of these days, they rarely stick. The market almost always comes back for a retest. It could be days, weeks or months but the initial bounce will likely fail and selling will take it back down for a retest of the low.

If you're a short-term trader you'll say "that's OK, I want to catch the bottom and trade it up, reverse and trade it back down and then reverse again at the test of the low and ride it back up". That's clearly what we are going to try to do. Investors (longer-term traders) can afford to not rush things in trying to catch the bottom. They can instead wait for the retest. Identifying which kind of trader you are will help determine how you want to trade the current decline and coming rally.

I had thought on Tuesday that the market was making a bottom. There was a very good fractal pattern between the March low and this week's low and it was a good setup to finish the leg down from May. I exited my short positions (with a little seller's remorse yesterday and today) and nibbled on some longer-term long plays. At each potential support level I'll nibble on a couple more. I'm using January call options for the anticipated sharp move back up and it's just a trade (hence January and not further out--but I don't like front month, which will be December in another day, because of the time decay). I suspect the next bounce into the new year will be very choppy and will require trading in and out relatively quickly.

But clearly I'm a little early in anticipating the bottom. I liked the setup earlier in the week but that setup was broken. Now I'm back into the hunt for where the bottom might be. I want to get right into tonight's charts before I run out of time (I had a lot of problems with QCharts today and so got behind in getting charts updated). So let's just jump right in and review what we've got.

S&P 500, SPX, Weekly chart
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SPX didn't even slow down as it passed through 768 today, the October 2002 low. It didn't close much below that level but it closed below it. This could be a big deal if we don't see an immediate reversal on Friday (leaving a head-fake break). We should be close to a bottom though, whether here or after a small bounce and slightly lower again as shown on the daily chart below. The EW (Elliott Wave) pattern calls for a correction of the leg down from May (wave (4) on the chart) and then a final low next year before setting up a bigger rally

S&P 500, SPX, Daily chart
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There is a bullish divergence at the new low as compared to the October 10th low and I expect it to hold. In the wave count for the move down from May, we're into the 5th wave and 5th waves very commonly show weaker market breadth than the previous 3rd wave (which was the October 10th low). There are a couple of different ways to count the 5th wave and the dark red count suggests we're putting in a bottom here and now (and start the rally into February). The pink count, which I'm starting to favor more, calls for a relatively small bounce and then a final low in early December. As noted in the bold note on the chart, I consider the short side of the market the riskier side. While there is certainly the potential for more downside the risk now is for a strong short-covering rally to start something bigger to the upside. Therefore if you're unable to watch the market all day and exit short plays quickly you could come home and find you gave up a lot of profit or worse, lost money.

Key Levels for SPX:
- cautiously bullish above 917
- risky being bearish

Dow Industrials, INDU, Weekly chart
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One thing you'll notice about the weekly charts this week is how they're all in synch. I quickly reviewed many sectors this afternoon and the patterns are almost all the same. This is good because it shows all sectors getting hit and we're seeing a washout. The rally coming out of this decline has the potential to be strong initially (before settling into a choppy sideways/up kind of correction/consolidation into February).

The DOW could make it down to its March 2003 low at 7416 before bouncing, or even down to its 2002 low at 7197. It might bounce a little into next week before making the new low. In any case I think the DOW is likely to find support at one of those levels if not slightly above them.

Dow Industrials, INDU, Daily chart
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The DOW stopped at the bottom of a small parallel down-channel from the November 4th high and "only" about 140 points above its March 2003 high. A quick jab down on Friday could tag that level where the bottom of the down-channel crosses. As depicted I think we'll either get a relatively small bounce back up/over to the top of the channel before heading lower for a final low this year or we'll soon start the rally into February.

Key Levels for DOW:
- cautiously bullish above 8923
- risky being bearish

Nasdaq-100, NDX, Weekly chart
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Friday marks the end of the 55th week from the October 2007high for NDX. Whether that will mean anything for this index will only be known in hindsight. This index did a remarkable job following Fibonacci time cycles on the way up into that October 2007 high so I'm watching this one closely. If the market sinks a little lower then we'll probably see NDX at least test its March 2003 low near 940.

Nasdaq-100, NDX, Daily chart
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For the 5-wave decline from May I've labeled the end of the 4th wave correction as the November 4th high (a-b-c consolidation off the October 10th low). From November 4th it's a bit sloppy but I can now count a 5-wave move down which should be the completion of the 5th wave. It did a slight throw-under below the trend line along the lows from October 10th and the oscillators show bullish divergence. It's a good setup for a bigger bounce, either back up to the top of its down-channel near 1300 before heading back down again, or a bounce into February from here. I would not want to be short here.

Key Levels for NDX:
- cautiously bullish above 1300
- risky being bearish

Every once in a while I'll bring in the semiconductor chart if it's helping confirm a potential turn. I think the weekly chart is confirming that potential:

Semiconductor Holders, SMH, Weekly chart
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The wave count for the move down from July 2007 is clean and therefore a great example of where we are. The important part of the count is the move down from May (labeled as wave 2) which I'm showing as a 5-wave move down, labeled as waves (i) through (v) to complete the larger-degree 3rd wave. It's very common for the 5th wave to equal the 1st wave and that's the projection I'm showing at 14.50. Again, only in hindsight will we know whether or not that's an important level but I like the setup here for the end of the move. If the market bounces a little and heads for one more new low I suspect SMH will do the same thing. But this is a good buy setup and certainly a place I consider the short side as the risky side.

Russell-2000, RUT, Daily chart
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The RUT looks bearish by breaking below the parallel down-channel for price action since the October 10th low. If it immediately reverses back up on Friday it will look like just a throw-under. I've got only one EW count on this one as it would look best with a small bounce and then another new low into the end of the month/beginning of December. This one may be a good indication of what the broader market is going to do as well. If it follows the red path I think it would make an outstanding long play setup into next year, one I actually hope we'll see.

Key Levels for RUT:
- cautiously bullish above 500
- risky being bearish

Banking index, BIX, Daily chart
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Since the 3-wave move down into the October 10th low I've believed the banks are going to head lower in a descending wedge pattern. Descending wedges in a decline (ascending wedges in a rally) often mark the end of the move as it chops its way in the direction of the trend but losing momentum, which can be seen in the oscillators. The move down from November 4th is another 3-wave move and will achieve equality in the two legs down at 106.20, so just a little lower than Thursday's closing price. It doesn't have to get down to that level but it would be a good setup for a bounce, especially since it would be off the mid line of the larger parallel down-channel from October 2007 (dotted line).

Whether from here or slightly lower it should bounce into December before dropping to a final low by the end of December. That might coincide with a test of the lows in the broader market. I expect banks to make their final low a few months ahead of the broader market which I expect to see next April/May so that fits well. The banks should be a good long play off that final low as it should rally fairly quickly back to the top of the wedge which is up near 237. It would be a nice double. But not yet--it's too early to be thinking long the banks.

Treasury yields dropped hard today as money scurried into government bonds. The monthly chart shows the big move this month, mostly from this week:

30-year Yield, TYX, Monthly chart [Image 11]

The 30-year bond rose over 4 points during regular trading hours and then another 3+ points during after-hours--one of the largest moves I can recall seeing. To say money has been racing out of stocks and into the safety of U.S. Treasuries is an understatement. The longer-term pattern of TYX shows the steep drop this month, most of which was this week and the bulk of that was today's move. Not much below today's closing price is the bottom of a parallel down-channel from the June 2007 high, currently near 3.6%. There is a downside Fib target for the current leg down at 3.46% so that gives a downside target zone for rates over the next couple of weeks. The larger down-channel shows a downside target potential near 3%.

So the good news for those who need to borrow is that rates are coming down. The bad news is people can't find money to borrow, certainly not like the glory days when it wasn't even required that you be able to fog a mirror to qualify. Unfortunately mortgage rates are not dropping like Treasuries and nor are credit spreads shrinking much. The LIBOR rate has returned to the 2% area which is not nearly as good as the sub-1% rate last year but better than the 4+% rate last month. But rates between banks may have improved with the central banks backstopping every risk they can think of but the spread between less secure bonds and Treasuries continues to stay very wide and suggests the credit market is still frozen solid.

The commodities markets continue to get hammered hard. Oil broke an important uptrend line from 1998:

Oil contract, CL continuous, Monthly chart
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It's hard to read the years on this monthly chart but the uptrend line from 1998 has now been broken and that's obviously very bearish as it says the uptrend is complete and that the current decline is only the first leg in what will become either a large sideways consolidation or part of what will become a larger 3-wave pullback. But as I noted on the chart, oftentimes you will see the same price action above or below a channel. In this case oil rallied briefly above the top of the channel in July. The commonly used phrase for the market is "as above, so below" or vice versa. Therefore it's possible we're only seeing a throw-under that will soon be reversed and oil will then rally higher for the next 2+ years. The wave count calls for a renewed rally and you can trade oil with USO which also has options. There is additional downside risk for oil to drop to $40 and if it drops below $37 it would negate the bullish wave count. So it might be a tad early on the long play but I think it's close to rallying. It will probably rally with the stock market.

Gold has held up much better than most other commodities. It's considered a safe-haven investment so it's no surprise it has held up. But if people have been running to gold out of fear we could see money leave it if the stock market starts to rally some and we start hearing "the bottom is in, the bottom is in, BUY Mortimer, BUY!" The wave pattern also calls for more downside in gold before finding a tradable bottom:

Gold contract, GC continuous, Weekly chart
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The broadening wedge pattern says the pullback is probably just a correction and not the start of some massive selloff that we'll see. However, the downside projection for gold remains the $600 area and could work its way lower over the next few months as the stock market bounces. If and when it gets down near $600 I think it will be a good opportunity to buy some for your investment portfolio to hedge against a possible inflation problem created by the Fed (after we deal with a deflationary environment which will also pressure gold prices).

One more point on deflation before wrapping this up, there are many who are calling for hyperinflation because of the huge run-up in the money supply this year. While hyperinflation could be a problem in another year or two we first need to get through a deflationary period, which is evident in the drop in prices of nearly everything now--that is the definition of deflation. This is an interesting chart of the change in Base Money supply:

Percent Change in Base Money Supply [Image 14]

The first comment about this chart has to do with the spike up at the right side of the chart. That's the fastest growth in money supply over the past century. That's just mind boggling. Then as noted on the chart, the previous time this pattern has played out was the time leading up to the Great Depression. I look for fractals all the time in the stock market (that's what EW analysis is all about) and here's one in the money supply growth. There's a reason so many are now comparing other signs in the economy to the 1930s.

Economic reports, summary and Key Trading Levels

There are no significant economic reports on Friday and today's reports continued the negative news we've been hearing about the economy. The initial unemployment claims continue to ramp higher and most economists seem to be getting on board with an estimate of 8-9% unemployment next year. This does not measure those who have dropped off because their unemployment insurance ran out or those who call themselves consultants while finding other work or those who are underemployed (e.g., working a part time job or two while seeking full time employment). In other words the number is worse than what is being reported. I suspect our homeless population is going to increase dramatically--remember to help wherever and however you can. There but for the grace of God go I...

Leading indicators are heading down fast and the Philly Fed index is diving to new lows, as shown in the following chart:

Philadelphia Fed Index through November, 2008 [Image 15]

You can easily see the sharp drop in Prices Paid but it's a little harder to see the sharp drop in the dark blue line which is Manufacturing Activity. It has now dropped slightly below the low seen in 2001 and very likely it's not finished declining. The prices paid for goods are dropping at the fastest rate seen on this chart, back to 1992. It's another sign of deflation. While we think it's nice to pay less for what we want/need (like energy, food, appliances, etc.), the significant thing about deflation is the insidious nature of it and why the Fed is powerless to stop it.

As people (consumers, businesses, etc.) hunker down to wait out the storm, they see prices are coming down and start to think about waiting for things they need. This causes all kinds of businesses to slow down and lay off more people. People become afraid and buy even less and it becomes a vicious cycle. The Fed can't change social mood buy stuffing the channels with more money. The amount of money created by the Federal Reserve banking system has been huge this year and yet it hasn't helped the credit market one bit. We flush hundreds of billions of dollars down the toilet (AIG, Fannie Mae/Freddie Mac, investment banks, defunct car companies) and it's not helping. We pay to prop up bad business models, losing the money in the process, while good companies with good business models go starving for credit. We have it bass ackwards when it comes to what we should be doing in times of financial stress. We counseled Japan not to do exactly what we're now doing.

This is what happens in a credit collapse and the only thing mind boggling about it is why people like Greenspan, Bernanke and the supposedly bright investment bankers couldn't see it coming. Or perhaps many of them did and just wanted their piece of it before it all fell apart. Now we're into the part of the cycle that will be painful to go through but very necessary to cleanse the system. If the Fed/Treasury/Congress would stop trying to prop up bad business models and put the money to better use then we might be able to turn the mood around and get people excited about new growth potential. Alas it's not the way these social mood swings work. We will work through a deflationary process in the meantime (which takes down the value of all assets) before we start the healing process all over again.

I came across a good list of 10 things the people in charge should remember they cannot do:

You cannot bring about prosperity by discouraging thrift.
You cannot strengthen the weak by weakening the strong.
You cannot help little men by tearing down big men.
You cannot lift the wage earner by pulling down the wage payer.
You cannot help the poor by destroying the rich.
You cannot establish sound security on borrowed money.
You cannot further the brotherhood of man by inciting class hatred.
You cannot keep out of trouble by spending more than you earn.
You cannot build character and courage by destroying men's initiative and independence.
And you cannot help men permanently by doing for them what they can and should do for themselves.

This is a list that was first published in 1916 as "The Ten Cannots" and credited to Rev. J. H. Becker who gained attention as a motivational speaker. Some things never change.

This down cycle too shall pass and the cycle will swing back up. Understanding where we are in the cycle, and price pattern, can help us navigate the treacherous waters ahead. Look for a bounce soon and then we'll see if it's going to lead to another low for the year in early December or a bigger bounce into February before we have to worry about another leg down. Trade carefully here--it's a tough spot to enter new trades.

Good luck and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 917
- risky being bearish

Key Levels for DOW:
- cautiously bullish above 8923
- risky being bearish

Key Levels for NDX:
- cautiously bullish above 1300
- risky being bearish

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

Keene H. Little, CMT
Chartered Market Technician

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