Market Stats

I remember thinking back in 2007 that the top of the rally was any day now and every day seemed to continue slightly higher with only small pullbacks. There was just enough buying to keep the sellers at bay but the buying momentum kept decreasing. When it finally broke it was fast and I'm getting the same sense about the current market.

The day started off with a bang after overnight equity futures climbed higher and nothing in the morning economic reports dampened the buyers' enthusiasm out of the gate. But the new high was short lived and the rest of the day was spent dropping lower with some brief bounce attempts. But from a point perspective it looked like a very benign day. The DOW lost only 24 points (-0.26%). Considering the size of the rally it would be easy to blow off today's loss as just a minor blip in the greater rally.

But there are enough signs of topping that I think it's important to pay attention to each decline to see if it has the potential to turn into something more serious. That's what we'll review tonight.

Even the banking sector, which has been rallying strong this week, gave up its rally and closed in the red. The BIX left a spinning top doji at resistance so a down day on Friday would confirm a 3 candlestick reversal pattern. The bulls need to hope for another rally to finish the day in the green.

Techs have been underperforming the blue chips and that should be worrisome to bulls. Buying the techs is something people do when they're confident about the upside since they get a better ride out of the higher-beta stocks. When we consider the overbought nature of the market and the extreme level of bullishness it behooves us to pay attention to topping signals.

I came across the following chart on Monday from Elliott Wave International which shows the S&P from September 2007 at the top and the Daily Sentiment Index (from trade-futures.com) on the bottom. You can see the correlation between high levels of bullish sentiment and highs for the stock market.

S&P 500 vs. Daily Sentiment Index, courtesy elliottwave.com

The really scary part of the above chart, from a contrarian perspective, is how bullish traders have become. Bullish sentiment is as high as it was in early October, just before the market high. This is by no means a market timing tool but it sure does scream at you to be very careful about the upside. When you consider how fast the rally from July 8th occurred, it almost looks like a blow-off move and if it is then it will get retraced quickly. If so many are feeling so bullish about the market and chasing it higher (short covering and real buying) they will be the first to bail in a hurry out of disappointment in thinking they may have bought the high again.

So knowing the market is ripe for a change in sentiment we look for evidence of when (not if) a high is approaching. Sentiment is not a market timing tool. The next chart shows the NYSE at the top and the advance-decline line at the bottom. This also is not a market timing tool but it's important to look for evidence that new price highs are not getting the same kind of support.

NYSE vs. Advance-Decline Line

The top chart of the NYSE shows the higher highs of the rally since the March low. The bottom chart of the advance-decline line shows the lower highs from the initial high in March to the lower a-d line in June vs. the new price high in June. This was a warning that the June high might have been its last but obviously not. Now we've got new price highs in July/August and the a-d line has bounced higher but not above the initial March high. Once again we've got a warning about the rally.

Another view of this is a chart that was shown by Elliott Wave International that shows the sharp rally from July 8th and how it quickly lost momentum when measured with MACD. In the middle they show the lower highs in the a/d ratio as price pushed higher and that negative divergence won't last forever. When I combine these warning signals with the EW (Elliott Wave) count of the rally I get a strong sense that the rally either ended at today's high or is within a day or two of a top.

NYSE vs. Advance-Decline Ratio, courtesy elliottwave.com

The market's rally has been based on hope and that hope is still alive and well (as indicated by the bullish sentiment). The trouble is more and more information is coming out that shows the hope is misplaced, or at least early. Credit continues to contract and credit is the life blood of the economy. You wouldn't look so good if your blood were slowly and steadily drained from your body. Mortgage lending and consumer lending continue to fall with consumer lending down eight weeks in a row for a 13% decline (-$16B). Commercial and industrial loans have collapsed at a 15% annual rate over the past two months. Expectations for an inventory build is just more unsubstantiated hope.

The hope around increased home sales ignores the fact that much of the sales activity is from foreclosed homes which is dragging the average sales price lower. But the media likes to report just the brighter side of the news. I'd love to concentrate on just the brighter side as well but that would be irresponsible considering the investments that are at stake. So I stick with the charts to see what price patterns are telling me and I look under the hood to see whether or not the price move is being supported. This goes for a price decline as well.

With that let's get right to the charts. The SPX weekly chart shows the 38% retracement level at 1014 so there's a little more upside potential by that measure. The broken uptrend line from 1990-2002 is near 1040. The November high near 1007 is acting as resistance at the moment and the short term price pattern looks like it might have made a high today.

S&P 500, SPX, Weekly chart

Looking at that rally from March shows price continuing to struggle at the mid line of the parallel up-channel and the trend line across the highs from May-June. Along with bullish sentiment discussed above, RSI hasn't been this overbought since 2007. A pullback to the bottom of the channel by August expiration would have it dropping to its 50-dma around 935 before potentially setting up another rally into September, shown in pink. I show a projection up to 1072 for two equal legs up from the July low, which would be slightly higher than the broken uptrend line from 1992 shown on the weekly chart. A break below 920 would suggest a drop to the 850 area before another opportunity for the bulls to take it back.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1014
- bearish below 920

Zeroing in on the tail end of the rally leg from July 8th, the wave count shows the possibility for the completion of the 5th wave at Tuesday's high (or possibly at yesterday afternoon's high as a truncated finish). After breaking its uptrend line from July 10th through the July 29th low, it bounced back up for a retest of it yesterday and left a bearish kiss goodbye against it. From a short-term perspective I think SPX needs to stay below 1000 in order to support the idea that we've seen the high. Otherwise another push to a new high, shown with the dashed red line, into Monday will be a likely possibility.

S&P 500, SPX, 60-min chart

The DOW has the same setup as that shown for SPX but in this case I'm showing just a rising wedge pattern off the March low rather than a parallel up-channel. The significance of this is not subtle--a rising wedge pattern for a rally is bearish and the dark red wave count that I have on the chart calls the end of the rally here to be followed by new lows into the end of the year and into next year. The pink wave count needs a pullback and then a new high into September and that pullback should hold above 8500 before proceeding on up to about 9600 before finishing the rally off the March low. Either count is possible but both are looking for at least a deeper pullback as the next move.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 9400
- bearish below 8500

NDX is essentially the same as the DOW and SPX charts. Price has made it a little higher in terms of retracement of the decline from 2007 since it tagged the 50% retracement whereas SPX is struggling to reach 38%. As with the others it's struggling up against the trend line along the highs from May-June and now oscillators are rolling over from overbought at resistance. A "normal" market would experience a pullback at a minimum from here. I left the trend line along the highs from January-June in place because that's where price is currently finding support. A break below today's low would confirm that level of support is gone and I'd look for it to then act as resistance on any retest from below (near 1600).

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1630
- bearish below 1485

The semiconductors sport the same pattern as that for NDX. The trend line along the highs from January-June for NDX is the same one for the SOX and it stopped the rally. The most recent highs in the last few days have been met with bearish divergence and RSI has crossed back below the 70 line. It looks like a deeper pullback at a minimum should be next.

Semiconductor index, SOX, Daily chart

The RUT continues to look very similar to the blue chips except that it could be considered slightly more bullish here. It has rallied above the mid line of the parallel up-channel and so far is holding above it. A continuation of the selling tomorrow would change that but in the meantime the upside needs to be respected.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 575
- bearish below 500

So what's up with the banks? Someone lit a fire under the buyers and the parabolic nature of this week's rally looks like a lot of short covering helping the buyers. The only problem is that it could be a blow-off move--we know what happens to parabolic rallies. The rally stalled at the May high (it has still been unable to confirm the rally in the broader market to new highs above the May highs). It also achieved a Fib projection for the leg up from the July low. A relatively small pullback to about 120 followed by another push higher has a good chance of making a new high but then it would be ready for a deeper pullback/decline so in either case I think the run on the banks could be over. Who knows, a real run on the banks might not be far away (see end of newsletter).

Banking index, BIX, Daily chart

The rally off the November low for the home builders is an example of a choppy overlapping correction. The highs and lows of the moves overlap each other and that typically means it's a corrective move. The leg up from the July low can be considered the completion of the corrective pattern from the November low. The next move out of this pattern should be a drop to a new low below the March low (in what should be the final low).

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

I wanted to show the weekly chart of the transports because of the possible parallel down-channel for price action since the 2007-2008 highs. The top of the channel is where price has currently stalled and the significance is that these channels do a very good job at showing market symmetry. Many think the market is random but in fact we act and react to cycles and these typically show up in channeling. Therefore, considering the TRAN has reached the top of its down-channel at the same time I see a potential high for the broader market, it's potentially very bearish from here.

Transportation Index, TRAN, Weekly chart

As mentioned earlier in tonight's report, the bullish sentiment for the stock market is an extremely high 88%. For the U.S. dollar we have just the opposite. The Daily Sentiment Index for the dollar is just 3% bulls, a level reached only 5 times in the past 20 years. Remember the chart of the S&P vs. the DSI showed only 2% stock market bulls at the March low. The extremely low DSI for the dollar is warning us the selling has reached an extreme. And now we've got a wave count that can satisfactorily be called complete for the decline from March.

The wave count for the U.S. dollar is a clean 5-wave move down from the March high with the 5th wave either complete or in need of one more minor new low. Assuming for now that the decline from March is complete the next move will be a strong rally that will take it above the March high over the next several months. That kind of rally could be detrimental to both stocks and commodities which have both been running inversely to the dollar.

U.S. Dollar, $DXY, Daily chart

Oil is obviously one of the commodities that could react negatively to a rising dollar although that connection is not a given. Supply/demand is a factor and emotions can run even higher in commodities than in stocks. A parallel up-channel from January/February continues to contain price action so a break below the bottom of it, confirmed with a break below 62, would be bearish. Two equal legs up from July 29th is at 73.43 which is why I've got the key upside level at 74--any higher than that would likely lead to a run above 80 to the top of its channel over the next month or so.

Oil continuous contract, CL, Daily chart

Gold is in a similar short-term pattern but has been in more of a high level consolidation since the beginning of the year, which could be considered bullish. Two equal legs up from July 8th is at either 978.20 or 985.50, depending on how the move is measured, and then there is potential trend-line resistance near 993. So I've got the key level for the upside at 993 since I think it's risky to enter a long position below that level. A drop below the July 29th low of 927.60 would be bearish.

Gold continuous contract, GC, Daily chart

For both oil and gold (and the stock market) I'm leaning towards the downside because of the wave pattern on the dollar. For that reason I think we are looking at a shorting opportunity for both but keep your stops relatively close until we get some proof a breakdown is in progress. The short-term chart supports the idea that we'll get one more new high for both (and new low for the dollar) but I've found that often depending on that "one more new high/low" is met with disappointment.

Tomorrow's economic reports, other than the consumer credit report, have the potential to strongly move the market, especially considered what I see in the price pattern. I'm leaning to the downside but I don't discount the idea that we'll see a "good-news" rally to finish off the rally from July 8th (and potentially the whole rally from March). And if the market sells off on what's reported as good news we'll know we have a change in sentiment.

Economic reports, summary and Key Trading Levels

I normally don't like to pay too much attention to what could be called hearsay since much of it can't be substantiated. But as most of you know, I'm very concerned about our economy and firmly believe we're far from seeing the end of the bear market, one that should be more severe than that experienced during the Great Depression. At times like this it's not what we want to hear but we can stick our collective heads in the sand or pay attention to the real news around us, such as the continuing credit contraction, increased home foreclosures, expanding unemployment, reduced consumer spending, a U.S. Government debt bubble (the last one?) and the continuing irresponsible behavior in our financial markets, not to mention the control they have over our government.

So with that I'll pass along this from a reader (thanks Greg): "The Harry Schultz letter just announced U.S. embassies have been receiving enormous amounts of U.S. cash and they are being told to purchase local currency. Enough local currency to last a year or more. Schultz believes we will see an FDR style bank holiday w/in next 120-150 days. The letter says "inside the State Dept, there is a sense of sadness and foreboding that something is about to happen."

I of course have no idea what could cause a "bank holiday" before the end of the year but it wasn't good when FDR had to close the banks to prevent a run on them and it wouldn't be a good sign this time. After a significant selloff people become truly scared about what's happening. There was a lot of talk of financial Armageddon as we headed into the March low. I warned then that a bottom was soon going to be put in and while the rally was earlier and stronger than I expected, it has clearly wiped away any concerns about the economy. This is very typical of the rally that corrects the initial leg down.

My study of EW patterns shows each wave has a personality. The first wave down is scary but it takes a while for people to recognize that the market is in trouble. They get scared but easily push their concerns away once we get a rally started again. The 2nd wave bounce (the rally from March) convinces most that the bear market is over and good times are here again. The extremely high bullish sentiment of 88%, matching October 2007, is picture perfect sentiment for this rally. It has accomplished, from a sentiment perspective, exactly what it needed to.

The third wave down is almost always the strongest. It's called the "wave of recognition" as most people begin to recognize that the fundamental problem with the economy is far worse than originally thought and certainly much worse than what the hope-filled rally has been all about. For this reason I wanted to pass along Harry Shultz's warning. Again I don't have a clue whether he's out in right field or instead has some good intelligence info. But considering where we are in the wave pattern, with the knowledge that we could start the third wave down at any time, something bad in the financial markets would certainly qualify as "recognition" that something serious is wrong.

My warnings of a market top have been early, as they were in 2007 but considering the marginal gains in the market since I've been warning traders to not trust the upside and to get ready for at least a deeper pullback, I'd rather be in cash early and protecting my capital than worrying about squeezing a few more pennies out of my capital. I can only suggest you do the same.

Tomorrow should be very telling. If the market drops hard, as it's potentially set up to do, it will be the signal that the top is in and I would look to short bounces for at least the next few weeks until we see what develops to the downside. If the market rallies instead (we should get a reaction one way or the other to the employment numbers) then another day or two of rally, watching for potential resistance near SPX 1014, should be all we'll get. Then be ready to play the downside.

On the live Market Monitor at the end of today I had suggested a put play with some relatively cheap front-month, slightly OTM options since there is the potential for a big move down. But it's a little bit of a lottery play so I wanted traders to consider it as such. If the employment numbers are considered bullish and we get a rally instead it could be short lived but at least a lottery play shouldn't cost you much. We'll know before the market opens which direction it will probably head for the day.

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

Key Levels for SPX:
- cautiously bullish above 1014
- bearish below 920

Key Levels for DOW:
- cautiously bullish above 9400
- bearish below 8500

Key Levels for NDX:
- cautiously bullish above 1630
- bearish below 1485

Key Levels for RUT:
- cautiously bullish above 575
- bearish below 500

Keene H. Little, CMT