Market Stats

The market initially sold off sharply this morning but has been common in this market, the buyers loved the dip and started buying again, driving the indexes back into the green. This kind of market action has driven bullish vs. bearish sentiment to an extreme, which I'll get into later. Supposedly the market reacted to the weak GDP number that was released this morning, which came in at -1.0% annualized for the 2nd quarter (it was -6.4% in the 1st quarter). This was the same as the first estimate a month ago so it should not have been a surprise to anyone. From a year ago GDP is down -3.9%.

The significance of negative number for the 2nd quarter is that the economy has contracted four quarters in a row now, something it hasn't done since the Great Depression. What did catch a few by surprise is the inventory reduction which were cut faster than had been estimated. This has many speculating that the rebuild of inventories will happen sooner and therefore will be positive for GDP. The jury is still out on whether or not inventories will be rebuilt. Insider selling at companies, as compared to buying, says the business leaders are not quite so positive on that score.

Some disappointing news out of the FDIC was another reason given for the early decline. If you'll remember, in the August 6th newsletter I had mentioned the Harry Shultz warning that we could see a "bank holiday" by the end of August, which he speculated could be the result of a run on the banks due to the FDIC report on 2nd quarter results. I speculated at the time that if enough people know of the warning we would probably not see any dire warnings come out of the FDIC (call it "managed" news from the government).

The FDIC had their Board of Directors meeting earlier this week and their report was late in getting published. Hmm, wonder why that was. But you can put lipstick on a pig and it still looks like a pig. Their report was not exactly bullish for the banking industry and considering the fact that the stock market rally has been based on the premise that the banking industry has turned the corner to health it certainly begs the question as to why the stock market has rallied so much. Or more importantly, why is the stock market still holding up and why did it rally off this morning's low?

We know that the Fed is has been very busy running their printing presses 24/7 and that money has been making it into the monetary system through various channels, one of which is the stock market. The primary banks have been given lots of cash and they've been more than happy to trade the markets with it. It's certainly acted the way the Fed wanted it as we've seen lots of bullish stimulus. Bullish sentiment has now climbed higher than it was in 2007 (89% vs. 88% back then, according to trade-futures.com and their Daily Sentiment Index) and it's a warning that the rally is running on fumes. It won't take much to turn all that bullish sentiment into worry which will be followed by selling.

The bears have virtually disappeared. The latest information from Investors Intelligence Advisors shows the level of bearish investment advisors has now dropped below 20%, the first time since October 2007. The following chart of bearish sentiment vs. the S&P 500 was done by Elliott Wave International:

IIA Bearish Sentiment vs. S&P 500

When bullish vs. bearish sentiment reaches an extreme, as it did in 2007 and then went to the other extreme at the March 2009 bottom, we should be looking for reversals and not a continuation of the trend. I know, the trend is your friend, and sentiment indicators are not timing tools. But they provide a warning tone, similar to the one that warns a pilot that the airplane is about to stall. The airplane may still be climbing or holding altitude when the stall warning goes off but it won't be climbing for long.

What's different this time is that we have a massive effort by the Fed to re-inflate the economy, the likes of which we've never seen before. The multiple stimulus efforts by the government have now cost more than FDR's New Deal and the two world wars on either side of that, combined. It is simply mind boggling how much debt the government has taken on. Their effort has been to stimulate the consumer and one way to do that is to create a bullish stock market (it's much harder to create a bullish housing market, although they've tried there also).

The President's Working Group, the heretofore secretive PPT (Plunge Protection Team) is no longer secret. They've made it quite clear that a "healthy" stock market is vital to the security of our financial institutions. Therefore many bears have gone into hibernation, believing the market can't go down when the government is spending billions to prop it up.

One of the government's efforts to stimulate the consumer was the Cash for Clunkers (C-f-C) program. It didn't matter that it was stimulating the consumer to take on more debt, just as it didn't matter to Greenspan back in 2004 that he was encouraging home buyers to use variable interest rate loans (at the bottom of his interest rate cycle). Our government, the protectors of the people (cough) cares only about its survival and not the people it is presumed to protect. Two weeks ago I had warned that the C-f-C program would stimulate short term demand, to the detriment of future demand, and that people who were not in a position to buy a car were being enticed to borrow and spend anyway. Now comes a survey of C-f-C buyers, discussed in a story found yesterday's USA Today, which shows 1 in 4 C-f-C buyers now regret the decision to buy a new car that they had no intention of purchasing just yet. They don't like the fact that they now have a big loan to pay off. I contend many of those loans will not be repaid and many cars will be repossessed.

The government has encouraged these households to take on more than $11B of NEW debt. Maybe it's just me but I consider that totally irresponsible of our government, but then again I was an early critic of Greenspan. The CEO of Edmunds.com said "Cash for Clunkers distorted the market in a way that benefited the industry for four weeks, now the payback begins". He said half as many people are researching buying a new car on their website as were looking during the peak of the clunker program. And now news that Toyota is poised to slash production by as much as 580,000 vehicles or 6% to reduce losses.

Speaking of loan defaults, the banking industry is going to be dealing with this problem in a big way for a long time. Getting back to the FDIC's 2nd quarter report, their deposit insurance fund (DIF) stood at $13.3B as of March, which is down significantly from 2007-2008), but since then 60 banks have failed at a cost of over $19B. The FDIC has significantly increased the insurance premiums on banks to rebuild their coffers (once again punishing those who did the right thing in order to save the weaker banks who gambled away their holdings) but today the DIF stands at just .22% of insured deposits. Insured deposits have increased as many have scrambled to the safety of cash. The following chart shows the trend in each:

FDIC Insured Deposits and Deposit Insurance Fund Ratio

Congress has mandated that the FDIC maintain the DIF at 1.15%. Oops, the FDIC needs to do a little work on that one (hence the huge increase in premiums charged to banks). There are now 416 troubled banks as of the end of June, according to the FDIC. This is up from 305 banks at the end of March. I've read credible reports that say the real number is well over 1000. The FDIC's number is the highest it's been since 434 banks were on the list in 1994 following the S&L banking crisis. I have no doubt the FDIC will be going to the Fed before the end of the year and asking for a bailout loan.

The quarterly loss of the insured banks totaled $3.7B vs. last year's profit of $4.8B. That's quite a swing. There are estimates that banks have about $1T in bad assets that they are showing as a separate line item on the balance sheet. If the FDIC gets their way and requires banks to show these assets at actual value in January 2010 it's going to get ugly before then since none of the banks will be able to show they're profitable and the whole premise of this year's rally will go up in smoke. There's talk of having private equity take over troubled banks. That would be an interesting move.

FDIC's Chairman Blair said "Deteriorating loan quality is having the greatest impact on industry earnings as insured institutions continue to set aside reserves to cover loan losses. Of all the major earnings components, the amount that insured institutions added to their reserves for loan losses was, by far, the largest drag on industry earnings compared to a year ago." All told, more than 28 percent of all insured institutions reported a net loss in the second quarter, compared with 18 percent a year earlier. So I'll ask the question again--why has the banking sector rallied so strongly?

Silly question I know. It's all about investor sentiment and hope is a wonderful thing. Except in the stock market. It may be good for a quick hit but longer term hope always gives way to reality and the reality is we're in a longer term secular bear market where all of the previous bull-market excesses get squeezed out so that we can back to healthier growth. Bear market rallies tend to be very strong but short lived. In a secular bear market lasting a typical 18 years, a 6-month rally is a short period of time. Enjoy the ride but just don't get attached to it. Trade it, don't invest in it.

Today the bulls and the bears did battle again, as they've been doing all week, and once again the bears blinked. The bulls took a spike down this morning and turned it around. But what does the longer-term picture from here look like. Unfortunately it looks risky for both sides at the moment. While we plenty of warnings about a possible top in the making, we've had them before and the bulls don't look ready to give up.

The weekly chart shows the top of it rising wedge pattern continues to hold price down. In addition to the top of the wedge it has now reached the broken uptrend line from 1990-2002, the one that stopped the bounce back in November after breaking in October. Actually that longer-term broken uptrend line is closer to 1041 now, as will be the top of the wedge next week. SPX 1044 is a key Gann level off the Square of Nine chart so it will be interesting to see if SPX tags that level and finds it to be strong resistance.

S&P 500, SPX, Weekly chart

The daily chart shows the top of its wedge pattern more clearly and how price has been battling to get through it. The shooting star and hanging man dojis this week leave a bearish impression (looks more like a distribution pattern). A break of the uptrend line from July 13th, near 1012, would suggest we've seen the high for the rally. It will then become a question how deep the retracement will go but I think the uptrend line from March, near 960, would be the first downside target. As depicted in dark red on the weekly and daily charts, the March-August rally might be all the correction of the 2007-2009 decline we're going to get but we'll have time to assess that scenario if and when the uptrend line from March breaks.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1044
- cautiously bearish below 950

Zooming in further I'm showing the top of the wedge getting worked over this week. The bullish interpretation here is that the consolidation (choppy pullback from Tuesday's high) beneath that line of resistance will soon be followed by a break above it (shown in pink). The wave count for that interpretation is quite bullish for a run at least to 1070 and more likely up to 1121-1127 (which is shown on the daily chart with a Fib projection for two equal legs up from July at 1127 and the 50% retracement of the 2007-2009 decline at 1121). A break below 1012 would increase the odds that we'll see a move down to at least 975 if not 950 (depending on how quickly it drops).

S&P 500, SPX, 60-min chart

The trend line along the highs since May for the DOW is also keeping a lid on the current rally. The bearish divergence on the oscillators points to the need for bulls to be careful here until resistance is broken. The higher price high against resistance, accompanied by a lower high on MACD, accompanied by extreme bullish sentiment, is actually a very good setup for the bears (not many of them around anymore). If the bulls can push past resistance I see the potential to rally up to about 10200-10300. One can only imagine CNBC if the DOW pushes back above 10000. The party hats would out (and I'd be licking my chops for some nice barbecued steaks from fattened bulls).

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 9425
- cautiously bearish below 8800

NDX is sporting the same price pattern but has not been able to rally up to its trend line along the highs since May. It is however nearing its downtrend line from October 2007 through the June 2008 high, currently near 1670. Higher potential exists to a Fib price projection and the top of its wedge pattern near 1710 and then on up to the 1800 area. A break of today's low, as with the others, would likely mean a break of its uptrend line from August 17th and then we'd get to see if that August 17th low holds (and its uptrend line from March).

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1634
- cautiously bearish below 1563

Different symbol, same pattern and trend lines. It's bullish until it's not and if this week's consolidation breaks to the north we could see a run up to the 640-650 area. A break below 568 would be a bearish heads up for at least a test of its uptrend line from March. Below 530 would be confirmation a top is in place.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 578
- cautiously bearish below 530

Bonds have gone pretty much nowhere since the low in June but the bounce off that low looks to me like a correction of the previous decline. The wave count supports the idea that we're going to soon get some selling in the bonds and it could take TLT down to it June 2007 low near 83. That would see the both the 10-year and 30-year yields approaching 5%.

20+ Year Bond ETF, TLT, Daily chart

I think it's telling that the banking sector continues to struggle at the May and August highs and hasn't been able to run higher with the broader market. That's bearish non-confirmation. Its test of the May high was met with negative divergence and even the early August high has not been exceeded. They can always surprise to the upside, especially if the Fed decides they need another helping hand, but right now I view this as bearish.

Banking index, BIX, Daily chart

I'm showing the weekly chart of the home builders because I want to keep this year's price action in perspective to its larger pattern. If it looks and smells like a bear flag, and it does, we should expect more selling. It might only make a test of the November low, or drop slightly lower, but now that it has made it to the top of its flag pattern it looks to me like it's now ready for a turn back down. If it does make a new low I fully expect to see the bullish divergences continue (shown on MACD).

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

I'm showing a weekly chart of the Trannies as well because of the potential importance of where it has rallied to--the top of a longer-term parallel down-channel after a 3-wave bounce off the March low. It looks like a classic correction to the previous decline, even tagging the 50% retracement at the same time it reached the top of its down-channel. The next move should be down.

Transportation Index, TRAN, Weekly chart

For the past couple of weeks I've been recommending a long position on the U.S. dollar. For the past couple of weeks the dollar has been blowing raspberries at me. The dollar ETF, UUP, keeps threatening to break its downtrend line from March (a break of which could be another clue for the stock market rally to reverse as well) but hasn't been able to do it. Keep an eye on this one because a drop down to a lower Fib projection at 22.40 would support a continuation of the stock market rally.

U.S. Dollar ETF, UUP, Daily chart

Gold has been even more stubborn in not wanting to make a move. It has been stuck in a narrowing trading range since its February high. Gold is getting ready for a big move and I could argue each direction. A break of its sideways triangle pattern (more than a quick head-fake break), confirmed by a break of its previous high or low (near 992 and 905, resp.), will be the direction to trade. The potential move from here is about $300.

Gold continuous contract, GC, Weekly chart

While gold has been marching sideways, even while the dollar sank lower, oil has rallied since its February low. It's currently just shy of a 38% retracement of last year's decline, at 76.77, and the rally is running out of steam. I think there's a good chance we'll see oil and the stock market fall together. But if there's more rally left we should see oil make it up to the top of its channel and the 50% retracement near $90.

Oil Continuous contract, CL, Weekly chart

Unless the economic numbers come out significantly different from expectations I don't see them as being market moving tomorrow.

Economic reports, summary and Key Trading Levels

We've had a very good stock market rally and by the bullish vs. bearish sentiment readings it has clearly convinced most people that the bear market is dead, long live the new bull market. But this is the way of bear market rallies. Typically the correction to the bear market decline gets bullish sentiment to an extreme that is often greater than than it was at the top of the bull market. That has now been achieved and is a big warning to those who believe the rally will continue. Bullish advisors have convinced the majority of their clients to get back in the market so there aren't many left to convince.

The stock market is driven by investor sentiment. Crowd psychology is much different than individual psychology. As individuals we might decide that the stock market is not responding to appropriate concerns about the economy and therefore not be willing to buy. But as part of a bullish crowd we throw caution to the wind and get sucked up in the bullish vortex (or bearish in a decline). It's why the stock market tends to hit extremes on both sides. The bullish vs. bearish sentiment has hit an extreme (but can always get more extreme) and can safely be called irrational at this point. The stock market has priced in more than can be expected out of the economy (earnings) for the next couple of years. It would take the market staying flat for the next couple of years just to let the economy catch up. Is that the kind of environment you want to invest your money?

Investors are faced with a difficult choice--stay with the trend and hope there's more upside or take your money out of the market and hope you're not giving up additional profits. I think it's prudent to get out of the market and look to keep what's been made (or made back in most cases). If you want to play the short side of the market there is the risk that we'll see a continuation of the current blow-off move into a top. SPX 1070 or 1120-1130 remains upside potential. But I also think we're now very close to getting some downside surprises and those typically happen with gap down moves. It's hard to protect long positions and/or get short in that environment.

And soon a big move down in the morning is not going to get reversed like it has been. Buyers will jump in, thinking it always rallies back up, but then be forced out by a continuation lower. That's what causes the acceleration in selling. Today's buying may have been an end-of-month effort to hold the market up. We're now into the 3-day settlement window and that effort could disappear in a heartbeat. The summer rally of 2000 stopped dead in its tracks with a final high on September 1st.

When sentiment turns from bullish giddiness to fear the market will turn back down. It won't necessarily be tied to any news. Good news will get sold with bad news. Pundits will once again scratch their heads in wonderment that the market sold off on good news. Again, the extreme in sentiment says we're ripe for a reversal so take care here--we have plenty of warning signs now that the rally is running on fumes, just the opposite of the warning signs we had heading into the March low. This week's daily candles represent either bullish consolidation or bearish distribution. We'll soon find out next week which one it is.

I'll leave you with one last chart tonight to show why I can't emphasize strongly enough what the downside risk is in this market (which is more similar to the period of the Great Depression than at any other time since then). Bear market rallies are to be sold until people are disgusted with the market and want nothing to do with it. We're a long way from that sentiment. The following chart, courtesy of Elliott Wave International, shows the bear market rallies followed by new market lows. Each break of the uptrend line for the bounces led to new lows. The current uptrend line for us to watch in this regard is the one from the March low.

Bear Market Rallies during the Great Depression

Good luck as we finish up summer trading and get ready for the return of the masses. I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1044
- cautiously bearish below 950

Key Levels for DOW:
- cautiously bullish above 9425
- cautiously bearish below 8800

Key Levels for NDX:
- cautiously bullish above 1634
- cautiously bearish below 1563

Key Levels for RUT:
- cautiously bullish above 578
- cautiously bearish below 530

Keene H. Little, CMT