Option Investor
Market Wrap

Return on Your Mattress

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Market Stats
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You know people are afraid of getting their money back when they invest in T-bills at the equivalent rate of stuffing it under a mattress. In an effort to loosen up the gridlock in credit land the Fed has been attempting to get banks to lend more money and to entice people to borrow more. By lowering interest rates (which the Fed is expected to do again next week, cutting the rate from 1% to 0.5%) the Fed is hoping people will take a few more risks again and start borrowing/spending. Their effort has resulted in mortgage rates dropping but then I have to wonder why a bank would be willing to lend money out at 5.5% if they weren't willing to do it at 6.5% and 7.5%.

Battling the Fed's efforts, credit spreads remain wide and people are saving instead of spending. Saving is a good thing for individuals and for the country (it makes money available for lending for mortgages, business loans, etc.) but in the short term it's hurting our economy which is so dependent on consumer spending now (somehow we need to continue spending our way to wealth). And now people are showing they're interested in saving their money in risk-free investments. Unfortunately risk-free means interest-free as in zero, nada, zilch return on your money.

The Treasury sold $32B in 1-month T-bills at a yield of 0%. The Fed wants people to borrow and spend more but the flight from risk continues. Corporate credit spreads are wider than ever and people are flocking to 0% returns on Treasuries rather than invest in 10%+ corporate bonds. Most people are now saying "been there, done that and lost my T-shirt".

The 3-month T-bills are not much better, returning near zero--0.01%, while the 2-year and 10-year notes are yielding 0.85% and 2.65%, respectively. Investors bid more than four times the available Treasuries for sale. If this doesn't tell us how much things have changed from a year ago, nothing will. Preservation of capital has clearly taken over concerns about return on capital. The mattress rules!

As Treasury yields drop (to negative rates if you consider inflation at the moment) it is also a sign that the bond market is afraid of deflation and not inflation. Even a 0% return in a deflationary environment will give you a positive return (the same as hiding your money under the mattress or in a lock box buried in the back yard (just don't let Fido see you burying it). As asset prices deflate the value of cash increases (takes fewer dollars to buy the same asset. The insidious nature of deflation is that people and businesses begin putting off purchases as they wait for prices to drop further.

There is a lot of speculation that the Fed will force the longer-dated Treasuries lower if deflation is taking hold next year. Lower rates of course means higher bond prices and we've seen prices begin that familiar (by now) parabolic climb. Many are speculating that bonds are the last bubble to pop so investing in bonds is clearly a bit risky right now. If prices were to pop and come crashing back down that would of course spike yields back up and that would indicate we've got a hyper-inflationary problem on our hands instead of deflationary. It's going to be a delicate balancing act by the Fed over the next year. Just keep your eye on the bonds.

In the meantime a review of a long-term chart of the 30-year yield shows bonds might not have much more rally in them before reversing:

30-year Yield, TYX, Monthly chart (1993-2008 [Image 2]

The 30-year yield has dropped to the bottom of a parallel down-channel near 3.0%. Slightly lower is a Fib projection at 2.87% for two equal legs down from the high in January 2000. The wave pattern would look best with a bounce, maybe back up to around 3.4%-3.6% over the next several months and then a new low (to create a 5-wave move down from the June 2007 high). But the bottom line is that bonds could be setting up soon for a much larger reversal. The flip side is that a break below 2.8% would signal a more concerted effort on the Fed's part to drive longer-dated yields lower in a stepped-up effort to fight deflation. That would not be good for the stock market.

I mentioned credit spreads above and this is a measure of the market's willingness to take on risk. The world's central banks have made a concerted effort to get inter-bank lending kick started again. They were successful when looking at the TED spread (difference between the LIBOR and 3-month Treasuries) where the spread dropped from high of 4.64 points on October 10th to a low of 1.75 points on November 11th. But they've since bounced back up to about 2.18 points which is where the previous spike highs in 2007 and 2008 were located. So what was resistance may have turned into support for the TED spread, arguably for the most heavily supported banks.

But corporate lending is still sucking wind. In fact they're starting to suck on a vacuum. Moody's Baa-rated bonds continue to demand an increasingly higher premium above Treasuries, as reflected in the following chart (credit spread line is shown inverted):

Credit Spreads, Moody's Baa index vs. 30-year T-Note, courtesy Elliott Wave International, updated through December 1, 2008
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By showing the widening credit spread inverted you can see the correlation to the stock market. I've shown this chart in the past, usually when the stock market was bouncing while the credit-spread line kept dropping (widening). We have a similar situation today with the stock market bouncing off the November 21st low while credit spreads continue to widen. This says the credit market remains frozen and is getting worse, not better. Can a 20-25% stock market rally be trusted in the face of this? Only time will tell since it's always possible (even if unlikely) that the stock market is out ahead of the bond market in sniffing out the bottom. This is a red flag and tells the bulls to be careful about charging at it--could be a sharp sword right behind it.

The price pattern of the stock market leaves much to be desired as far as figuring out where it's going short term. I have no doubt we'll get a multi-month bounce/consolidation, whether from here or after a new low this month, but I also have no doubt we'll get another low relatively early next year. Then I'll get excited about the upside potential but not yet. There are plenty of opportunities to play the long side in this market but since it's a counter-trend move (in my opinion) it requires close tabs on your trades and be ready to pull the plug quickly with small profits. It's by no means a buy-and-hold market.

We'll review several weekly and daily charts to try and maintain a bigger picture view of what could be playing out. I apologize in advance for messy charts--an attempt to show a few different price scenarios on the same chart tends to make it look confusing. I'll identify the key levels to focus on and hopefully keep you out of the chop zone.

S&P 500, SPX, Weekly chart
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The leg down from May 2008 has probably completed (although as I'll show later on the NDX and RUT charts, there remains the possibility for an end-of-year Santa Claus decline instead of rally). That leg down should be the 3rd wave for the move down from October 2007 and that means we've entered a 4th wave correction. Anyone who knows anything about 4th wave corrections in an EW pattern just let out a huge groan. That's because 4th wave corrections are ugly to trade, full of whipsaw moves, frustrates the heck out of both sides and typically results in brokers making money and traders going broke.

The dark red price depiction shows a sideways triangle for the correction (very typical 4th wave pattern) but that's just a guess at this point. It calls for price to whip up and down into about February and then a low for the year around May. The pink count shows a higher rally--perhaps up to about 1050--before dropping to a new low within the first quarter of 2009. For either case I think the top of the parallel down-channel could get tagged and be resistance.

The daily chart zooms in closer to look at the recent lows and how price could play out over the next few months:

S&P 500, SPX, Daily chart
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The multiple trend lines and patterns make this chart confusing so I'll go through each scenario. The current bounce has broken through the potential inverse H&S neckline (blue line), currently near 880. If SPX pulls back to that line on Tuesday and holds above it we could see the rally push up towards a Fib target of 973 (it first has to get through tough resistance near 950). The pink count shows the potential for price to slide down towards the uptrend line from November 21st, currently near 850 (shown more clearly on the 60-min chart below), before heading higher into the end of the month (for a nice Santa Claus rally). Barely visible is the dashed line showing a drop from here to a new annual low by the end of the month (for a Grinch decline). This would follow the scenario shown more clearly on the NDX and RUT charts below. It would also be a cleaner finish to the decline and a very good setup for the long side into the new year.

Key Levels for SPX:
- cautiously bullish above 900
- cautiously bearish below 818
(either side is only for a quick trade)

S&P 500, SPX, 60-min chart
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A slight difference on the 60-min chart vs. the daily chart is the pink scenario which on this 60-min chart shows a deeper retracement to a Fib projection near 789. A break below 845 would suggest a minimum drop to that level. Otherwise if SPX holds above 870 (Monday's gap up would be closed at 877.81) and starts to rally again we should see a move up to at least 950 if not to the 973 price projection (for two equal legs up from November 21st and the top of a parallel up-channel for the bounce off that low).

For the DOW I decided to change the wave count from an impulsive 5-wave move down, as shown on the SPX charts, to a corrective count. For the short term it doesn't really matter but it could help provide for another downside target for the next leg down once the current bounce/consolidation finishes.

Dow Industrials, INDU, Weekly chart
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The DOW has the same general form as the decline for SPX and has the same parallel down-channel. The correction that we're in, assuming it will continue for at least another month, should work off the oversold conditions in the market. While I'm expecting a 4th wave correction on the SPX chart I'm showing a b-wave correction for the DOW. They are both very difficult patterns to trade and I urge caution on the part of traders--this is the time you should become extremely picky about your entry points with strict stop-loss control and price targets for exits.

The difference in the wave counts between SPX and the DOW is the downside projection for the next leg down early next year. The DOW's wave count points lower (but not tremendously) and right now I'm showing a projection down to the 6000 area for a low for the year.

Dow Industrials, INDU, Daily chart
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For the DOW I'm showing the October 10th low was the end of the leg down from May. Since that time we've been getting a lot of corrective price action and therefore a sideways triangle (my top choice for the wave count) has been playing out since October. The current leg up should finish in the 9500-9700 area (probably at the lower end of that range) and then head back down as it continues to build out the triangle pattern. If the DOW breaks down below 8118 it would be more immediately bearish and the probability for a new annual low by the end of the month would increase. The DOW climbed above its 50-dma yesterday and today but was unable to hold either time. Now we watch closely to see what kind of pullback we get and whether another assault on the 50-dma will lead to a move higher.

A break above 9700 would suggest we could see a rally as high as 10300-10400 (Fib projection and downtrend line from May). The pink count also would mean we could have a very nasty January otherwise the bears will have to wait until February. For several reasons I'm beginning to lean towards the wave count on the DOW vs. SPX but as I mentioned earlier, it doesn't really matter yet.

Key Levels for DOW:
- cautiously bullish above 9000
- cautiously bearish below 8100

Nasdaq-100, NDX, Daily chart
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NDX tagged the top of its parallel down-channel today at the same time it almost reached its 50-dma near 1261. I don't show a continuation higher from here for NDX but a rally above 1270 would be a break of resistance and could lead to challenge of the November 4th high near 1382. But assuming for the moment that the bounce has finished, we could pull back and stay inside a developing sideways triangle pattern (dark red, like that shown for the DOW and SPX) or drop to a new annual low before the end of the month (pink). At this point I consider the new low as having an equal chance to the consolidation pattern. If we do get the new low it will be a great setup to get long for a run higher into January.

Key Levels for NDX:
- cautiously bullish above 1270
- cautiously bearish below 1096

Russell-2000, RUT, Daily chart
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Similar to the NDX pattern I see the likelihood that we'll see price either consolidate sideways into January before heading lower again or heading lower from here (or possibly after a minor push higher to a projection at 517). For now I see the key levels of importance at 423 to the downside and 520 to the upside. In between could be a real choppy ride whereas outside those levels we could have a runner.

Key Levels for RUT:
- cautiously bullish above 520
- cautiously bearish below 423

I'll update my usual sector charts on Thursday but I wanted to show the banks' chart because of the possibility we might see a turn before Thursday.

Banking index, BIX, Daily chart
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Like the DOW the BIX also ran into its 50-dma yesterday and today but has been unable to hold it. Only slightly higher, at 156.98, is the projection for two equal legs up from November 21st. The banking index has been doing a lot of 3-wave price action, especially since the July low. It has been doing a lot of reversals after equality is achieved in the two legs of the 3-wave move. The short-term pattern for the banks suggests a quick rally tomorrow to reach its projection near 157 before it reverses and heads back down. If it does that we could see banks head for a new annual low before the end of the month. If the banks do that, follow the money.

Whether or not you trade oil we all watch its price and wonder how much longer we're going to enjoy low gas prices and heating oil. So I thought I'd update where I think we are on the oil charts.

Oil, continuous contract, Monthly chart
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The monthly chart shows the support level near $41 which is where oil is currently getting a little bounce. But so far it doesn't look like the bounce is going to amount to much and the uptrend line from 1998, near $34, could be stronger support. The decline from July 2006 is shown in more detail on the daily chart:

Oil, continuous contract, Daily chart
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The decline became a little steeper after the bounce in September and is shown by the steeper parallel down-channel. The mid line of the steeper down-channel crosses the longer-term uptrend line from 1998 (near $34) next Monday, December 15th. That would make for a very interesting setup to trade oil from the long side. ETFs USO and the 2x leveraged DIG are trading vehicles and have options.

Economic reports, summary and Key Trading Levels
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It was a quiet day for economic reports and tomorrow's report probably won't have much influence. Today's report on pending home sales was discouraging for homeowners, at least those who are trying to sell. But it wasn't new news for the market and the market didn't react to the report. Friday's reports will potentially be market moving otherwise we have a quiet week in that regard.

The bottom line is that we remain in a potentially very choppy price pattern that will be full of whipsaws as the bulls and the bears each press their case. We will probably see the market react strangely to news which will make predicting direction that much more difficult. On top of that we've got opex coming up and the Thursday prior to opex (a day when many will roll out of December futures contracts and into March contracts) is often volatile and can sometimes be a head fake day. Heading one direction on Thursday, or Thursday morning, often gets reversed hard into opex. So be careful this week and make no assumptions about any trends. Expect reversals of reversals and trade accordingly.

We've entered a trader's market (vs. buy and hold) for the next many years. And within that traders market there will be times when you can do swing trades and other times you'll need to concentrate on day trades. We're into a day-trading environment as the market hammers out a corrective pattern. Once the oversold conditions have been worked off and people start feeling bullish again (it's already happening) we'll be ready for another leg down.

Options players will have a tougher time right now--directional plays will be difficult except for day trades (time premium is likely to wither away while waiting for the market to go somewhere). Credit spreads are at risk of getting run over unless you can time the sales closer to the edges of the trading range. In a choppy environment it will generally be better to be a seller of options rather than a buyer but clearly the risk is higher if the market suddenly makes a big move against you. Stay disciplined about your stops/hedges.

Good luck and I'll be back with you on Thursday to see how we're set up for opex week.

Key Levels for SPX:
- cautiously bullish above 900
- cautiously bearish below 818
(either side is only for a quick trade)

Key Levels for DOW:
- cautiously bullish above 9000
- cautiously bearish below 8100

Key Levels for NDX:
- cautiously bullish above 1270
- cautiously bearish below 1096

Key Levels for RUT:
- cautiously bullish above 520
- cautiously bearish below 423

Keene H. Little, CMT
Chartered Market Technician

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