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Market Wrap

Rethinking the Fed's Actions

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Market Stats
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Tuesday's post-FOMC rally was more short covering than anything else, aided by some hopeful bulls that the Fed really really can save the economy and by extension the stock market. There was one more brief attempt to rally the market higher on Wednesday morning but it's been all down hill from there. What the bulls have going for them so far, other than a couple of support levels barely holding, is that today's selling volume was slightly less than Tuesday's and Wednesday's volume.

As for other internal market breadth indications we're getting a mixed bag this week. The daily advance-decline line over the past couple of months is the picture of indecision but with higher volatility than we saw prior to September. Speaking of volatility, it made a move lower today and was looking like we should see some bullish resolution in price. But VIX can be unreliable during opex as traders square positions and are not necessarily make directional bets on the market. This can skew the "normal" readings and I tend not to give VIX or put/call ratio numbers much credence during this week, especially triple witching.

The choppy price pattern is a reflection of lack of conviction on both sides as neither is able to drive this market anywhere. I have some concern now that we are reaching some short-term overbought conditions while seeing sentiment turn more bullish. While all of this is not necessarily helpful for day-to-day trading it does give us a heads up that the current bounce off the November lows could be running out of steam. Whether today's drop was the start of something more serious can't be known yet but there's that risk for long players.

There's not much news to cover today as it's just more of the same--the government is going into debt big time while it takes over for the consumer and tries to spend our way to wealth. It was announced today that Obama's economic team is putting together a stimulus package that will cost roughly $675B to $775B (what's another $100B among politicians). But wait, there's more. If Congress hurries they can throw in an extra couple hundred billion more and get it up to $850B to be sure their districts can participate in the new round of porkfest.

I'm being cruel (deservedly I think) but in fact I'd rather see infrastructure spending than pouring it into a black hole known as our banking institution. At least with infrastructure spending we'll put people to work and have shiny bridges, non-leaking water pipes and smooth blacktop roads at the end of the spending. But my fear is that with Congress feeling like they have free rein to spend like there's no tomorrow they will. And tomorrow could be painful.

I recently read that a tactic the government may try to employ is an elimination of the debt by purchasing longer-dated securities in a deflationary environment and then pay it back over the next 30 years with inflated dollars (hopefully not too hyper-inflated the way we're heading). The Fed informed us on Tuesday that it is considering purchasing these longer-dated securities and it would be in an effort to drive rates lower on the bonds, or at least keep them artificially low for another year while the Fed monetizes the debt. It's why the bond market has rallied so strongly this week. The government will be able to lock in a very low interest rate and then start paying it off over the next 30 years with inflated dollars (which devalues the debt). Brilliant plan I must admit.

In the meantime I'm just trying to figure out what price has been doing since the November low. It looks like a very corrective bounce and points to a more significant drop back down but what's not clear yet is how far the bounce will make it. On to the charts, which haven't changed a whole lot in the past week:

S&P 500, SPX, Daily chart
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As mentioned earlier, the bounce off the November low looks like a correction--overlapping highs and lows and a bunch of corrective 3-wave moves, including the latest bounce from last Friday's low. It keeps alive the possibility we'll see the market turn right back around on Friday and start the next rally leg (Santa Claus could be firing up his reindeer). In fact that's what I'm showing on the daily chart--another small leg up to at least the downtrend line from October 14th (the top of a potential sideways triangle pattern that finishes over the next couple of months) before turning back down and heading towards the bottom of the triangle pattern-- probably near 800 or down to the October 2002 low of 768 (dark red).

Higher potential (shown in pink) exits to a Fib projection near 952 which could take SPX up to the top of a rising wedge pattern for price action since the November low. Less probably in my opinion (but not out of the question) would be a move above 950 and up to the longer-term broken uptrend line from 1990 (1005) or even up to 1050 to fulfill the inverse H&S price objective (although that pattern doesn't look appropriate any more).

The rising wedge pattern for the rally off the November low is shown more clearly on the 120-min chart below.

Key Levels for SPX:
- cautiously bullish above 960
- cautiously bearish below 850
(either side is only for a quick trade)

S&P 500, SPX, 120-min chart
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Today's decline broke the uptrend line from November 21st (sitting near 880) but then recovered back above it for the close. It's the closing price that matters so as of tonight the bulls still have the ball. A continuation lower on Friday would target 851 first and then 810 if 850 gives way. I show a bounce off 810 (or 851 if it holds) but that's not a given yet. I'll have to evaluate that potential if and when it gets there (if a 5-wave move down is completing at the same time then it will be a good setup to try the long side). In the meantime, if the bulls don't fumble the ball early Friday we should see another leg up to at least the downtrend line from October 14th near 933 and then higher potential to Fib projections at 945-952. A move up to either of these levels will be the time I'll be looking for a short entry for a ride back down into January.

Dow Industrials, INDU, Daily chart
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As I went through dozens of charts this afternoon I noticed how similar they all are. The market's various sectors are very much in synch. Consequently the major indices all look the same. But for each I'm showing slight differences, either in the wave count, where we could be in the potential sideways triangle patterns or the possibility for a relatively minor pullback to be followed by a stronger rally in January (shown on the NDX and RUT charts).

For the DOW I'm showing the possibility that we started the sideways triangle pattern after the October 10th low instead of the November 21st low. It doesn't mean a whole lot yet but could be an important difference after the final wave-e high in early February (or wherever it finishes). I'm showing the possibility (in pink) for the DOW to rally up to the 10300 area to hit a Fib projection and downtrend line from May but it takes a rally above 9400 before I'll consider that possibility as a higher probability.

It doesn't show well on the daily chart but the DOW broken its uptrend line from November 21st at 8670 and was not able to get back above it before the close. A bounce up to it for a retest and failure on Friday would be a bearish setup.

Key Levels for DOW:
- cautiously bullish above 9400
- cautiously bearish below 8300

Nasdaq-100, NDX, Daily chart
[Image 5]

I'm showing the same sideways triangle idea on the NDX chart (dark red). The leg up from November 21st may have already completed (confirmed with a break below 1150) or will complete after slightly higher to a target of 1280. One difference I'm showing on the NDX chart is the possibility we'll get a larger A-B-C rally (pink) into the end of January instead of consolidating sideways. The previous bounce highs in October and January would be typical retracement levels for the correction before heading for new lows early next year.

The reason I'm showing a few different ideas for how the 4th wave correction could play out is because it's too hard to tell early in the correction what kind might play out (there are 11 different EW corrective patterns) so I show what I consider the higher probability corrections and then test it each step of the way in hopes of getting a jump on where the next turn could be. But these 4th waves are the most difficult for traders to trade so I'll continue to caution everyone about not taking excessive risks in this environment. Knowing when to trade and when to sit on your hands is a secret to trading success.

Key Levels for NDX:
- cautiously bullish above 1340
- cautiously bearish below 1150

Russell-2000, RUT, Daily chart
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The RUT's chart looks very similar to the NDX chart but could just as easily look just like the one for the DOW and SPX. A break below 440 might result in a trip down to the 400 area (dark red) or find support near 440 and then head higher into January (pink). There are several possibilities in between and we need to stay aware of the potential for a lot of choppy and whipsaw price behavior.

Key Levels for RUT:
- cautiously bullish above 520
- cautiously bearish below 440

Banking index, BIX, Daily chart
[Image 7]

The pattern of the banks continues to call for another leg down to a new low before potentially putting in a more significant low. While it's possible we'll see a bigger rally up to the top of its wider parallel down-channel, near 180, I see the higher probability as a move lower from here or a continuation sideways as shown for the broader averages.

As I said, the other sectors I usually cover are all looking the same so there's not much sense in repeating myself. A look at oil and gold shows a different picture when trying to get a sense of what commodities are doing. The dollar sank quite a bit this week (the Fed's intention I'm sure, or if I'm to be kind, it's what the Fed is willing to sacrifice for the more important problem of fighting deflation) and a falling dollar is normally bullish for commodities. Certainly the fears of inflation are driving many into the comforting arms of gold and it has rallied strong from the low on December 5th.

Gold contract, continuous, Daily chart
[Image 9]

Gold's rally on Wednesday took it right up through its 200-dma and to the top of its parallel up-channel for price action since the October low. It was not able to hold onto its 200-dma today. If it manages to push a little higher it could tag its downtrend line from July, currently near 892 where the top of the up-channel crosses it next Tuesday, December 23rd. I don't think we've seen the final low for gold and therefore a rally to that 892 level could be a very nice short play setup. The downside target remains the $600-650 area by early next year.

Gold bugs have been touting the benefits of owning gold because they feel the US dollar is going to head for new lows. While new lows for the dollar is a distinct possibility I think deflation will be a greater threat than inflation next year and all asset classes will remain under price pressure, including gold. But once deflation is stopped (could be a year or more) and people start seeing significant inflation problems on the horizon then the gold bugs will be correct. If my analysis on this is correct we'll have a "golden" opportunity to put some gold into our portfolio next year.

After the Fed's announcement to destroy the dollar, er, I mean fight deflation, the commodity index had a nice rally on Tuesday, along with the stock market. But like the stock market commodities have given back those gains even while the dollar dropped further on Wednesday. The dollar bounced today but I'm not sure if the dollar is just getting a dead-cat bounce. But while commodities, and certainly gold and the euro were rallying, oil continued to sink. Fear of a global recession, or worse, continues to threaten global demand for oil and the continued build up of supplies. Kind of like the housing market in 2005/2006. Oil continued to sink lower this week and may have a little further to go:

Oil contract, continuous, Daily chart
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Oil has been tracking parallel down-channels for its decline since July and the bottom of the small down-channel that it's currently in is near $32, slightly below the longer-term uptrend line from 1998. I think we'll see oil hit that level and find support and I'll be very interested in a long play on oil at that level. Buying USO (or calls, or sell bull put spreads) would be a recommended way to play it.

Economic reports, summary and Key Trading Levels
There are no major economic reports for Friday so the market will be on its own and dealing with final opex settlement (watch for price pinning at strike levels).

Today's reports included the unemployment numbers and while the latest week's number showed fewer unemployment claims the longer-term picture continues to look bleak. Most expect unemployment claims to continue ticking higher after the holidays. The current picture does not look good:

Initial Unemployment Claims, 4-week average, 1990-present
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The large spike up since late 2007 is downright scary and we're seeing numbers and a rate of increase that exceeds that of any previous recession since the Great Depression. I'm sure Obama's economic team is looking at this chart and wanting to get people to work quickly. In fact the effort is to find infrastructure work where money can be spent quickly--within the first 90 days. They don't want projects that must be designed and needing to go through a lengthy approval process. If a project is ready but needing funding it will probably get funded.

The Leading Indicators report, which was down -0.4% in November, showed a continued deterioration of the economy as both the coincident and leading indexes head south:

Leading and Coincident Indicators, 1992-present
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The coincident index reflected weaker growth during the 2002-2007 recovery, as compared to the 1990s even while the leading index achieved a higher high. This shows the leading index is not always accurate in portraying where the economy is headed. But certainly the steep decline from its peak in 2004 says something serious has changed. Of the 10 indicators six were negative, led by a large reduction in building permits. The largest positive contributor was money supply. I think we could have guessed that one.

The last report was the Philly Fed Index which showed a small bounce in December but still deep in negative territory. After November's dismal -39.3 (anything less than zero shows contraction) December rose slightly to -32.9 and better than the expected -42.0. That's the good news. The bad news is what's happening to prices paid:

Philadelphia Fed Index, 1992-present
[Image 13]

While normally we think of lower prices as good for us, there is great concern that prices are coming down too fast and in all categories. It's what's called deflation and if we get into a deflationary spiral where everyone continues to put off purchases thinking they can get it cheaper later then the economy grinds down and becomes slower and slower and reinforces the deflationary spiral. It's why the Fed pulled out the stops on Tuesday and announced they will be doing everything in their power (and creating power to do what they're not currently empowered to do) to fight deflation. It's why the stock market should be running very scared--the Fed just officially announced that they're panicking. They believe they have the tools to fight deflation but I'm sure they're smart enough to understand this is an issue of social mood and psychology. They can throw all the money they want but when fear grips people it doesn't matter what the Fed does. They're scared and they just showed their cards.

So that sharp drop in prices paid is a wake-up call to some serious problems in our economy and why we're hearing so many comparisons to the 1930s. This is the first time since that period of time that we're facing similar problems and the threat of a depression at this time is very real. And it will be global so don't trust those who tell you to invest in emerging markets because they'll recover faster or some other nonsense. The U.S. will fare better than most (and why foreigners will continue to flock towards our Treasuries, even the ones where you're paying the U.S. government to hold your money.

We'll be going through a rough patch well into 2009 but I view it as a very healthy cleansing process. I only hope we see a relatively quick cleansing rather than forcing it to get delayed which is what Japan has been facing. The Fed has shown a willingness to follow Japan's example of how not to do this but either arrogance or ignorance or both is taking us down the same path that didn't work for Japan but somehow magically is expected to work for us. Know where your money is and who is holding it. Capital preservation vs. return on capital remains the primary objective. And then together we'll do our best to take some profits out of this market, especially if you're willing to trade both directions.

For tomorrow the bulls need to do their thing out of the gate and then hold onto their gains. There's still a good chance we'll get the Santa Claus rally but it has to start early. Any further breakdown on Friday could result in a lump of coal in investors' stockings. Continue to trade lightly and quickly--take profits quickly and look for the next setup. Keep your losses smaller than your winners, win at least half of your trades and you'll be a long-term winner in this market. No home runs for now--take your base hits and love winning small rather than big.

One last chart before I go looks at the ISEE call/put ratio:

ISEE Index chart, Daily
[Image 14]

I had mentioned earlier that I don't like to use the VIX and put/call ratios during opex week because they can be skewed by options settlement. Plus I find it difficult to time the market with these indicators. However, they are good for a heads up for a potential reversal when you see sentiment swinging too far to one side. When you see ISEE call/put ratio get above 150 it's a heads that too many are buying calls and getting too bullish. Stay cautious about the long side--keep your exit in sight at all times and be sure you can beat the crowd in the rush for the door.

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

Key Levels for SPX:
- cautiously bullish above 960
- cautiously bearish below 850
(either side is only for a quick trade)

Key Levels for DOW:
- cautiously bullish above 9400
- cautiously bearish below 8300

Key Levels for NDX:
- cautiously bullish above 1340
- cautiously bearish below 1150

Key Levels for RUT:
- cautiously bullish above 520
- cautiously bearish below 440

Keene H. Little, CMT
Chartered Market Technician

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