Market Stats

A look at the internals shows a bullish bias to the day, with the advancing volume and issues running a little ahead of declining. But the new 52-week lows beating out new 52-week highs is becoming worrisome again. The market is a lot closer to its highs than lows and yet more stocks are starting to make new 52-week lows. It's also worrisome whenever the small caps do not participate in a rally attempt. But the market generally left a doji day in place which is the mark of an indecision day. Bullishly, it could be viewed as the middle candle of a 3-candle pattern called the morning star. If tomorrow is an up day we could have a reversal pattern in place. If you'll look at the daily chart of any of the major indexes you'll see each of the pullbacks in August, September and October essentially started with this pattern.

But even if we do get an up day tomorrow I'm thinking it's going to be different this time. The move down from the October high looks impulsive and that should mean the market has put in its high and that the new trend is down. Friday's new low cemented the deal for the bears and it's time to use bounces to further lighten your holdings and/or play the short side of the market. If we don't get a bounce tomorrow and it declines instead below today's low there is the potential for the selling to get very strong and very quickly. There is still a crash potential hanging over the market right now and today's price action has not negated it.

This morning's economic reports included the ISM (Institute for Supply Management) for October, which is a measure of manufacturing output. It experienced a big jump from September, climbing from 52.6% to 55.7%. This is encouraging but as with several of the economic metrics we've seen recently, much of the renewed activity came from a demand pull. The cash-for-clunkers and other government stimulus programs, such as the home buyer's credit, have resulted in pulling demand from the future into September and October. The unfortunate result is that the succeeding months have shown a significant reduction in demand.

Obviously if the ISM could remain above 50 it would indicate continued expansion and that would be a good sign. We'll have to wait for November's numbers to see how well our economy is doing. The increased manufacturing activity also boosted the employment index, rising from 46.2 in September to 53.1 in October.

Helping the increase in the manufacturing has been an inventory rebuild after inventories were slashed to the bone in the past two years. While manufacturers were doing what was necessary to protect themselves from excess inventory, based on their observations of a lack of demand from consumers, they tended to underestimate the effect of government stimulus. Now as they've increased inventory to take care of this government-induced demand the likely scenario is that the demand-pull will lead to demand-push. The crash in car sales following the cash-for-clunker program is a perfect example of demand being pulled forward and then nothing following it. The same thing is likely to occur with the ISM number next month.

Home buying looks like it got a big boost in September. Pending sales rose a seasonally adjusted +6.1% from August (which was also up +6.4% from July), making it the 8th consecutive month of increases for the index. Sales typically drop in the fall so when the number is looked at on a non-seasonally adjusted basis the pending sales number was actually down -7.8% from August. Using seasonally adjusted numbers is an attempt to smooth the data. The index is at its highest level since December 2006 and up +9.2% year-over-year. As a headline number that of course sounds very good. But unfortunately, looking under the hood once again raises questions as to what it really means looking forward.

First, pending sales is not sales. Many pending sales don't result in a sale because of a multitude of reasons, lack of financing being a big one. Even pre-approved buyers often go to the signing and find the bank was not able to secure funding.

Second, like the cash-for-clunkers program, we've seen a lot of demand pulled forward as fist-time buyers rush to close on a house before the $8000 tax credit program expires at the end of this month. It typically takes one to two months to close on a house following the pending sales contract. There's talk about the program being extended but I suspect it will not be nearly as effective as the first one because those who wanted to buy and could take advantage of the program have already stepped forward to take advantage of it. There could be a dearth of buyers behind this.

Weyerhaeuser (WY) is a company whose business is largely tied to the home construction market. It had an earnings call last week and one of the things they talked about was the demand picture as they see it. They noted some improvement in housing construction during the 3rd quarter but it is noteworthy that they also saw a slowing in the momentum from the 2nd quarter into the 3rd quarter. If that slowing trend continues, which appears to be the case, the 4th quarter will likely come in lower than the 3rd quarter. Again, with the demand having been pulled forward, and the increase in mortgage delinquencies and home foreclosures, the demand for new homes is already dropping and will probably drop below trend as we see a correction to the "new normal", which will be a lower level for at least a while longer.

Part of the growth problem in housing has to do with the availability of money. We know credit has tightened at banks, where they've returned to more normal lending standards (if not tighter than normal), and we know people have become less inclined to borrow. Borrowing against ones home has become more difficult as well. In fact a recent statistic shows that borrowing against home equity has declined every quarter since the beginning of 2006 and for the first time since the 1970s the net borrowing has gone negative. Homeowners are for the first time building their equity back up rather than taking it out. At the height of the housing bubble, in 2006, homeowners' equity was lower than it had been at any time in the preceding 30 years. That's finally being reversed.

Many of the riskier loans during the housing bubble came from lenders who were selling the loans. The subprime mortgages were an example. The option ARMs, interest-only loans are more examples. The subprime mortgage defaults are being followed by the next wave of these option ARM loans, which are prime loans so the problem is more significant. Once the housing bubble burst, and the market for repackaged loans dried up, the lender of last resort has become the Government Sponsored Entities (GSEs), which are Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae (Government National Mortgage Association). Ginnie Mae is involved in government-backed loans such as FHA and VA loans.

Ginnie Mae is the only one with an explicit guarantee of backing by the US government, although we know the implicit guarantee for the others is pretty explicit. Ginnie Mae invented the Mortgage-Backed Security (MBS) in 1968 as a way of freeing up capital that could then be lent out again. It took nearly 40 years to use a good tool to excess but then again, that's what Wall Street does best. All the GSEs stepped in as the buyers of last resort when other avenues to sell MBSs dried up. Because the government does not want to see the home mortgage business dry up Congress is mandating the FHA continue to cover the riskier loans.

Banks are having a much tougher time selling the riskier loans to the market so the GSEs have been the buyers of last resort. At this point, the GSE's own or guarantee almost 95% of new residential mortgages, up from about 60% in 2006. The good news is that the stricter lending standards imposed on the banks will keep people honest (from buyers and sellers to appraisers to mortgage lenders). The bad news is it has squeezed a lot of buyers out of the market and that will slow the housing recovery. The other bad news is that the government is on the hook for essentially all new loans.

Due to the large number of non-performing loans, and the expected increase in defaults in the coming year, the GSEs are expected to be in a lot of trouble by this time next year. The former chief credit officer for FNM, Edward Pinto, said a couple of weeks ago at a Congressional hearing: "The Federal Housing Administration appears destined for a taxpayer bailout in the next 24 to 36 months." The FHA went from insuring 6% of new mortgages on 2007 to 21% last year. They're now insuring almost 6M single-family mortgages, many of which required only a 3.5% down payment, with a total value nearing $700B. FHA's cash cushion against these mortgages amounts to about $30B so there's a greater than 20:1 leverage ratio there. It only takes a 5% loss in their portfolio of mortgages to wipe out their cash reserves and guess who will pick up the rest. So what have learned in the past three years? Apparently not a whole lot.

For a picture of the failure rates of the loans that the FHA is insuring is shown in the chart below. The chart shows that the more recent the loan, the faster the failure rate. I hate to see where the 2009 loans will fall on this chart.

FHA Loan Defaults, chart courtesy AgoraFinancial.com

Our Congress, who I've called economically illiterate in the past (that's just a statement not a slur, well, maybe a little one), are of course part of the problem. Congresswoman Maxine Walters said at the Congressional hearing a couple of weeks ago, "Let's be clear, without the FHA, there would be no mortgage market right now." But it doesn't stop there. The chairman of the House Financial Services Committee at hearing said, "I don't think it's a bad thing that the bad loans occurred. It was an effort to keep prices from falling too fast. That's a policy." If you wonder why our financial system is in trouble, look no further than the ones who write the rules. And it starts with us, those who elect these people.

And the news just keeps getting better. In a story out in Bloomberg on Friday, billionaire investor Wilbur L. Ross, the guy who is famous for sniffing out value in the junk heap called bankruptcies, was quoted as saying the U.S. is in the beginning of a "huge crash in commercial real estate. He went on to say, "All of the components of real estate value are going in the wrong direction simultaneously. Occupancy rates are going down. Rent rates are going down and the capitalization rate -- the return that investors are demanding to buy a property -- are going up."

And now the International Monetary Fund (IMF) is beating up on us. Simon Johnson, the former chief economist of the IMF, was speaking befoe Congress last week and told them that the debt path we were on was out of control. Many cite Japan, which has been running debt loads well over their GDP for years, as a reason not to get too worried about carrying a high debt load. But Johnson issued a warning about Japan too, saying there was "a real risk that Japan could end up in a major default".

High Frequency Economics chief economist, Carl Weinberg, added to these thoughts last week by predicting that by April, Japan’s debt/GDP ratio will be at 250%. At that level, he said there is no going back. The only outcome is economic collapse. That makes me think we don't want to use Japan as a successful economic model and yet that's precisely the path we're following. And we don't have a Congress that's smart enough to figure it out. Do your part in any election cycle to throw the bums out and let's hope we get at least some sanity in place.

Enough on the economy, let's take a look at the charts to see what's changed from my last update on Thursday. Thursday evening I had mentioned I thought the strong short-covering rally into the close looked like a termination kind of move and suggested we'd see an immediate reversal back down on Friday. Once we got that move to a new low below Wednesday's it created a 5-wave move down from the October high. That impulsive move establishes the new trend and therefore is a strong statement against any expectations for a move to another new high. In other words, we should be looking at any bounce as an opportunity to get on the short side of this market.

This week's candle on the SPX weekly chart, which is only today's trading so far, is just below the broken uptrend line from March and the broken uptrend line from 1990-2002. The latter trend line has seen price oscillating around it since August. I'm showing the potential for a bounce back up to the broken uptrend line from March before heading lower again but so far that's not certain.

S&P 500, SPX, Weekly chart

The daily chart below shows SPX broken below not only its uptrend line from March but also the one from August. This latter trend line showed the pattern of higher lows since August and the break of that line is important. It might be recovered this week if the market can get a bigger bounce to retrace some portion of the October decline but it needs to hold above today's low in order to maintain that potential. I'm showing a bounce back up to the broken uptrend line from March, perhaps up to the 1070 area, but we'll have to see how it develops. Keep an eye on the 38%-62% retracement zone (1059-1075, shown on the 60-min chart below the daily chart) for resistance and a shorting opportunity.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1090
- bearish below 1020

On the 60-min chart below I'm showing a 5-wave move down from the October high. If that's correct we should get a bounce into Tuesday/Wednesday that retraces some portion of the decline and then head lower again. The October decline would be wave 1, the bounce would be wave 2 and then the next leg down would be wave 3. Since 3rd waves tend to be the strongest moves it means the next leg down should be stronger than what we've seen so far.

S&P 500, SPX, 60-min chart

As noted on the chart above, a break of today's low near 1029 could be uber bearish (I've noted on the chart that it could lead to a crash leg). I don't want to get into the details of an EW count that supports that view but it has to do with the move down being a series of 1st and 2nd waves and today's new low below Friday's is what has me concerned that that's what's playing out. It calls for extremely hard selling from here and therefore take a break below today's low very seriously as it could get carried away to the downside and in a hurry. I don't like to plan on market crashes because they're so rare. But by the same token I like to be aware when the setup is there for the potential.

The DOW has been holding up relatively well. It has not broken either of its uptrend lines like SPX, although it did break its uptrend line from July through September 3rd, tested it and then dropped lower. So far that's bearish price action but if it can hold above 9600 it at least maintains the potential to get another bounce back to 10K. I think it would be a good shorting opportunity up there but it would have to be evaluated at the time.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 10000 (to about 10200-10300)
- bearish below 9600

NDX left what's called a spinning top doji and as mentioned above it typically marks a day of indecision. But when it follows a series of down candles, as it has, it warns of an impending trend change (short term in this case but still it warns of a coming bounce). The 50-dma near 1697 would be the first upside target for a bounce with higher potential after that. But the October high should stand and the decline should continue once the bounce (2-3 days perhaps) finishes. Any drop below today's low should be taken seriously since hard selling may follow.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1754
- bearish below 1690

Looking to the semiconductors for some clues about the techs, they're not helping tonight. The SOX also left a long-legged doji which has reversal connotations but needs a bullish day tomorrow to support it. What is bullish is the fact that the SOX came down for a test of the broken downtrend line from 2000-2007. The last test (and it wasn't even tagged like it was today) was in early October which led to another rally to a new high. I don't think we'll see any more new highs but it could certainly lead to a bigger bounce back up. Watch its broken uptrend line from February, near 303, for resistance. Higher resistance would come from its 50-dma and new downtrend line from October, both coinciding near 314 on Wednesday. That would deserve a serious look by anyone looking for a short entry.

Semiconductor index, SOX, Daily chart

Another index, another doji. Today's trading range was fairly wide but neither side won. We'll have to wait for tomorrow to see who's not tired. Maybe a bounce back up to its broken 50-dma near 595 or a breakdown that could get severe (especially if it breaks support near 550).

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 600
- bearish below 550

The banks got a decent bounce today and the BIX nosed up to its broken 50-dma and proceeded to get its nose punched. It also tested its broken uptrend line from July and fell back from it. Both are bearish but it this index could be a glutton for punishment and try it again tomorrow. If it can power above 130 it should be able to try for a retest of its broken uptrend line from March. I don't think it will have success getting any higher than that, if even that.

S&P Banking index, BIX, Daily chart

I showed the chart of the KBW banking index, BKX, because of its precarious setup on the chart. It has broken significant support near 43.50 on Wednesday, bounced back above it on Thursday, drove back down to a lower low on Friday and today it bounced back up to it, practically to the penny (43.47 was today's high). This line is important and the market knows it. Follow the money if this one breaks down early. If it manages to bounce back above the line with a broader market rally tomorrow, the bulls will get a reprieve but I think it will be relatively short lived.

KBW Bank index, BKX, Daily chart

The "good" news about pending sales didn't do much for the home builders. But the index also finished with a doji day and it bounced off its 200-dma today. Both are potentially bullish for a reversal tomorrow. How high it would bounce is the question but I doubt it will make it above its 50-dma. I'm showing only a relatively small bounce before continuing lower. I'll be watching the downtrend line on RSI for some clues--a break of that downtrend line would indicate a bullish trend change is coming. Otherwise this remains in a downtrend (within a larger uptrend from last year but I think that too will end).

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

The TRAN is one of the indexes that has broken below its October low AND its September low. This follows a double top in September/October. The downside projection for the double-top formation (the distance from the tops to the valley) is a little above 3200, which would coincide with a test of its 200-dma. But first we could see a bounce back up to just shy of 3800 to correct the 1st leg down from the October high.

Transportation Index, TRAN, Daily chart

The US dollar is flirting with its downtrend line from August, which is the top of its descending wedge pattern. A break above this line and then its 50-dma at 76.86 should lead to a strong rally. Even MACD is threatening to get above the zero line. But as depicted on the chart below, it looks like it could get one more pullback before breaking resistance. Assuming the dollar does rally, it will be depressing for most other assets.

US dollar contract, DX, Daily chart

The tight linkage (inverse relationship) between the stock market and the dollar can be seen in the next chart. Line up the highs and lows of each and it's hard to argue the influence of the dollar. Except for a few brief periods they essentially mirror each other.

SPX vs. US dollar, Daily chart

If the dollar pulls back a little further that would help gold make a new high which is what it looks like it wants to do. A new high would likely be accompanied by a negative divergence on the oscillators and that would help confirm the wave count calling for a tradable top. I show the potential for a rally up to a Fib projection near 1134 but I have my doubts about that one. Maybe 1080-1090 before rolling back over. If the dollar simply rallies from here we could see the metals turn back down without a new high.

Gold continuous contract, GC, Daily chart

The gold miners will obviously be influenced by both the price of gold as well as the stock market. If they both are going to decline further, as I believe they will, the gold miners should not stand a chance against the bears. Right now GDX is bouncing on its uptrend line from October 2008, looking more like a consolidation than something more bullish. Maybe it gets back up to its 50-dma for a retest but it should make it down next to its uptrend line from January which coincides with its 200-dma.

Gold Miners, GDX, Weekly chart

Like gold, I see the possibility for oil to push to at least a marginal new high, perhaps to a price projection near 83. But that's not a given and I'm watching the dollar to see whether it will pull back a little further before pressing higher. Oil should be ready soon to break below 70, which would confirm we've seen the highs for oil for now.

Oil continuous contract, CL, Daily chart

The only other economic report this morning that I didn't mention was the Construction Spending which came in better than expected. With all the good economic news we had this morning it's a wonder we didn't have the market close a lot better today. Spending for private residential housing was up +3.9% but private nonresidential spending declined -1.8%. Public spending helped by increasing at a +1.3% from the previous month. If viewed as a year-over-year number, outlays were down -13% so it was a good news/bad news thing. And again, most people recognize the short-term nature of the increased spending on residential construction.

Tomorrow's economic reports are relatively minor and should not be market movers. And besides, how can we tell which way the market is going to move based on the news anyway. It appears we're moving back into a sell-the-news time. Wednesday's FOMC announcement could move the market but only if they significantly change the wording of their statement. It could do the cha-cha-cha around the news but end up net zero.

Economic reports, summary and Key Trading Levels

One metric that's worth reviewing is something called buying climaxes. This is a measure of the number of stocks that achieve new highs for the day or week and then close lower than the previous day/week. The measure of buying climaxes for the week is more significant than just one day. InvestorsIntelligence.com tracks this and they reported last week that it was clear to them that stocks were in the process of being distributed during October from smart money to retail. For the week prior to last week, they reported an extreme value of buying climaxes--602 stocks. It was only the sixth week in the history of II’s data base where there were more than 500 buying climaxes and it pushed the cumulative total for October to over 1,400. This metric further supports the idea that we've seen the market's high for the year.

And just as a side note, and because I like beating up on Mad Money's Jim Cramer, he provided another example of why I like to use his opinions in a contrary manner. If he says buy, you should sell and vice versa. I say that half jokingly and acknowledge that he at least puts himself out there and tries to make some sense of the market and gives better understood recommendations than a "hold" which means sell in analyst-speak.

But Cramer's recommendation a week ago to buy CIT will probably go down right next to his call to buy Bear Stearns a week before it too declared bankruptcy (oh, he meant invest in, or what he really meant was it was OK to put your money in their bank). A company will soon not want a buy rating from Cramer otherwise they'll have to get their lawyers ready to file for bankruptcy. Sorry Jimmy, you make it too easy.

The market remains perched on the edge of a cliff and price action on Friday and today has not reduced the chances of a severe selloff (the crash scenario). I'm not predicting a crash but only warning of one. Unless and until the market can rally back above today's highs there is the risk that this afternoon's bounce will lead directly to strong selling, a breakdown in the market. Stay very aware of this possibility if you're on the long side of the market. Any selling tomorrow that takes us below today's low could quickly get out of control. At least that's the Elliott Wave pattern possibility.

Countering the breakdown scenario, it's looking like we should see a higher bounce tomorrow, one that will begin to correct the October decline. A typical price and time retracement would be about a 50% price retracement by Wednesday. It could go flatter, higher, last all week or peter out after tomorrow. I'll be watching it carefully in an attempt to call a short play setup in the Market Monitor. Catching the next wave down should be a real money maker so it will be worth taking a couple of stabs at finding the top of the bounce. If it breaks down sooner it will just mean the need to chase it lower and I always hate doing that (I always worry I'll buy the bottom and have to deal with a v-bottom). I'm probably the only one that worries about that (wink).

Good luck and I'll be back with you a week from Thursday.

Key Levels for SPX:
- cautiously bullish above 1090
- bearish below 1020

Key Levels for DOW:
- cautiously bullish above 10000 (to about 10200-10300)
- bearish below 9600

Key Levels for NDX:
- cautiously bullish above 1754
- bearish below 1690

Key Levels for RUT:
- cautiously bullish above 600
- bearish below 550

Keene H. Little, CMT