Market Stats

Todd and I have switched evenings this week and he will be with you on Thursday.

After Friday's big recovery, today was a consolidation day. The market has high hopes that the Fed will come to the rescue with some words of wisdom and a new program to help the stock market, um, I mean the economy improve. It used to be the Fed would always try to make it clear that their policies were not targeting the stock market but that hasn't been heard for a long time. It's well understood by most, with the financial markets so interwoven into the economic well being, that the stock market is a reflection of the mood of the people. Therefore targeting the stock market has been a very specific goal since at least the LTCM incident in 1998. So the stock market participants wait with baited breath for the Fed to tell them that everything will be all right and that the QE2 (Quantitative Easing Part II, or more appropriately called monetization of the debt) will surely fix the problem this time.

I often mention that hope and optimism are wonderful attributes of the human spirit. Without them our country would never have been founded and immigrants would not still be pouring into the U.S. in hopes of building a better life for themselves and their families. Without hope we would never overcome adversity. It's the driving force behind human endeavors. But in the stock market hope and wishful thinking can be killers. So the hope that the Fed can rescue us is very likely going to lead to disappointment. With interest rates virtually at zero and the Fed owning a bloated balance sheet as it is (don't forget, the Fed is a consortium of private banks, not Federal, and they're not going to want to destroy their own balance sheets for "the good" of the country), there is little more the Fed can do. It will be interesting to hear what they say they will do (knowing words can be as powerful as deeds).

The Fed is of course very worried about deflation--they know how hard it is to fight it once it's entrenched. Bernanke's reputation is staked on not letting deflation happen on his watch (he declared years ago that it can't happen with the tools available to the Fed, tools that have failed him miserably so far). A continuation of the slowdown in the economy has many worried about another recession or something worse. If deflation takes hold the Feds know what a battle it would be and how it could develop into a depression.

Since entering the Great Recession in late 2002 I've been discussing the idea that we will experience deflation long before we'll see an inflationary spiral (the inflation coming from an excess monetary boost from the Fed). Deflation also fits the scenario found after a credit bubble. For years most economists have discounted the idea that we'll ever see deflation. Most believe the Fed has too many tools at its disposal to ever allow deflation to take hold. Market participants have the need to feel the Fed is in control but my argument has always been that the market drives the Fed and not the other way around. I've pointed to Treasury yields many times in the past to show how the Fed follows rates; it does not dictate rates.

I've also talked about the secular bear market that we're in (since 2000) and how we're due a 3rd wave down (the next decline which probably started from the April high). The 3rd wave is called the "recognition" wave as most participants begin to understand that the longer term trend has more room to run (down in a secular bear). This recognition is now starting to show up in the talk by several Fed heads. While some, like Bernanke, can't publicly admit (yet) that we're experiencing deflation now, several Fed heads are in fact talking about it. I've seen recent polls that show about a third of the population believes we're heading for a depression. This is all part of the recognition wave to the downside that will develop next. Many will say it's just a self-fulfilling prophesy; I say it's social mood manifesting itself in the stock market and economy.

We're seeing more stories about prices dropping, which again for consumers is not a bad thing (we all like paying cheaper prices for things). Even food is starting to show signs of deflation. During the company's recent earnings call, Safeway Chairman, President and CEO Steven Burd discussed the problem of deflation in their business. The company had accurately predicted a 1% deflation rate for the first quarter but it's become worse than expected since then. Safeway had anticipated inflation of 0.5% for the second quarter but the company instead experienced 2.4% deflation. Management is clearly disturbed by this--in their earnings call they mentioned the word "deflation" 57 times. The word "deflationary" was used another 3 times. You can bet Safeway is not the only one recognizing this problem and they will not be alone in pressuring their suppliers to lower their prices. This is how it ripples through the economy.

We're also hearing more stories about debt disasters and warnings about credit card troubles. As asset values continue to drop but debt burdens remain high, many are now becoming more worried about how they're going to pay off their debts on decreased asset values and with reduced incomes. This is one of the damaging aspects of debt in a deflationary environment and exactly why I've been saying for years that the best thing you can do is get out of debt and go to cash.

Because people tried to improve their life style, often through the use of credit, debt levels went out of sight. As debt loads increased and asset values started coming down we saw debt-to-asset ratios skyrocket through most of the 2000s. It's a long way back down before even the level seen in 2000 is achieved, as can be seen in the following chart:

U.S. Household Debt-to-Asset Ratio, 1950-2010, chart courtesy elliotwave.com

As asset values decline further over the next few years we'll probably see the ratio climb even further. As people realize they owe so much money on declining assets they will feel even poorer. Deflation will have people holding back for lower prices and when feeling poorer they'll hold back even more. Producers will lower prices to entice buyers and the vicious cycle will run its course.

This is part of the hangover effect of a credit bubble and it's why they all unwind the same way. Why people, and nearly 100% of economists, have been thinking it will be different this time is what has had me perplexing (I am far from being a trained economist). Once the process of recognition takes hold, and we're starting to see some economists now talking about it, we should see asset values drop even further as people begin to sense real fear about owning anything, especially if they still owe money on that declining asset.

The government, and the Fed, will of course fight this every step of the way. They'll throw more money at the problem, especially since the government is the last great hope of the people. Until people lose confidence in the government, and demand they stop spending our money unwisely (that process is starting), we will see politicians in an all-out effort to save their own jobs by spending money we don't have.

Each time the government has spent more "stimulus" money (with more debt) we've seen only a temporary effect (cash-for-clunkers, home-buyer's credit) but then the reaction after the program is usually worse than before. Even the spike up in the Weekly Leading Economic Indicator has been followed by a spike back down. The latest number on Friday, -10.3%, continues to show an economy that's tilting back towards recession.

The cash-for-clunkers program cost U.S. taxpayers $3B and it would be nice to know what we got for our money. Edmunds.com analyzed the before and after sales data and determined that the program resulted in only 125,000 additional cars sold over and above the current rate (sales dropped 30% after the program ended). That works out to a cost to the government of $24K per extra car sold (people who were going to buy anyway got the credit). They should have simply given the money to GM. Oh wait, they already did that. The home buyer credit program cost taxpayers nearly $13B just through last February. I can only imagine the cost through April. Now we're seeing home sales crash back down.

And furthermore, high-risk buyers who were enticed to buy a new car or a new house have already demonstrated the risk with these programs. With the cash-for-clunker rebate program there is already a repossession rate that is more than twice the rate of those who bought a car without the benefits of the program. Many who took advantage of the home-buyer's credit were first time buyers and therefore prior renters. Many of them are now saddled with a higher level of debt on a declining asset value. Will we see an increase in the foreclosure rate of these first time buyers as a result? The data would suggest we will.

So a government effort, with borrowed money, to stimulate the housing market has a good chance of making it worse once those additional foreclosed homes are back on the market. These will be homes that would not have been built otherwise and the government programs are trying to prevent something that is going to happen anyway--the economy will drop into a depression (deflationary times) to correct the excesses built up over decades of easy credit. The sooner we get through it the sooner we can get back to growth and a market that will be a whole lot more fun to trade.

These efforts to avoid any downturn (since when has a downturn been so bad that it warrants spending trillions of dollars to prevent it from happening?) are spreading to other organizations. GM is having trouble getting people to buy its cars--many can't get the credit they need. To solve this problem GM purchased AmeriCredit, a subprime lender, so that they can provide "loans and leases to buyers that it must now turn away for lack of financing." GM is now essentially providing the money to the buyers; they're paying the buyers to buy their cars.

FDIC is managing failed banks by providing zero-percent financing to private companies to complete the construction projects that got the banks into trouble. Think real estate developments in Florida, Las Vegas, etc. The FDIC is paying companies to complete these projects so that the banks will not have to take a loss on the loans for the projects. The assumption is that the completed real estate project will then be sold for a profit and everyone comes out a winner. In doing this the FDIC is turning itself into the holder of last resort for loans to complete these real estate projects that will languish on the market for a long time and eventually sell for pennies on the dollar. Who pays the bill for this? The taxpayer (not the buyers of the failed banks).

I could go on but you get the idea. The effort by government organizations, including Government Motors, to prevent any kind of slowdown is costing huge sums of money that is only further increasing the levels of debt and at a time when income levels are dropping dramatically (for the government too). And the more money that the government borrows the less that is available for legitimate businesses needing legitimate loans (investors are putting their money into Treasuries rather than company or municipal bonds).

Government debt is the last and greatest bubble on earth. When it pops, as it's starting to do in many European countries, it will be felt around the world. While the process could take years to unfold, it's the situation we're currently in. If that sounds like the makings of a new bull market then I've also got some Florida land (in the process of being drained) that I'd like to sell to you. I'll even throw in a certain bridge in NY for you. It may not be pleasant to think about but it's reality. I choose reality over wishful thinking even though I know it annoys the hell out of my friends and family. While a bear market is no fun, there are ways to protect yourself and if armed with some knowledge and techniques there's even a way to profit from one. My goal is to be one of the ones left standing at the end of this journey and be ready to help however I can.

As we near what will likely be the last best hope for the bulls, let's see how the charts are setting up for Tuesday. Today's little rally was on the lightest volume of the year (in fact in the last year other than the post-Christmas light volume). It would appear most traders are simply waiting for the FOMC announcement to be over with before they place any more bets.

I'll start with the NDX charts tonight, just to keep it a little different, and use its weekly chart instead of SPX. Following the flash-crash low on May 6th we've seen a few attempts to break the new uptrend line from March 2009 through that May low but each attempt was rebuffed by the bulls until it finally broke on a weekly closing basis on July 2nd. But since that low the market has been rallying and NDX has pushed back up to the underside of its broken uptrend line. This is the 5th week that it has bumped its head on that trend line without being able to break back above it. In the meantime you can see on RSI that it too has bounced back up to its broken uptrend line from March 2009. Clearly a rollover from here would look bearish and that's what I'm expecting to see.

Nasdaq-100, NDX, Weekly chart

Monday's trading had NDX jumping above the top of a parallel down-channel created off the line between the late-May and July lows and a parallel attached to the April high (this kind of channel often shows the symmetrical moves in a market). So that's potentially bullish. For now I see upside potential to the top of its rising wedge pattern for the bounce off the July 1st low, currently near 1940 (possibly only as high as its 62% retracement of the April-July decline). The pattern turns bearish if it drops back below Friday's low near 1873.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1950
- bearish below 1873

The decline on Friday had SPX dropping right to its uptrend line from July 1st, which is the bottom of its rising wedge pattern, and the bulls stepped in and bought support. They're hoping to prove to the bears that the pattern off the July low is actually a very bullish pattern and that price will soon explode out the top of the wedge, just as they've done to prior rising wedges.

The top of the wedge for SPX is currently near 1145-1146 so there's clearly some upside potential there. On Tuesday afternoon we'll get the FOMC announcement and either a pre-FOMC or post-FOMC rally could have SPX tagging the top of the wedge. As shown on the daily chart below, two equal legs up from July 1st would be at 1145. It's possible the move up from July is an a-b-c rather than as labeled so the fact that 1145 crosses the top of the wedge tomorrow is an interesting "coincidence".

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1145
- bearish below 1107

Moving in closer to the move up within the wedge pattern, if we're looking for the 5th wave from the July 30th low then two equal legs up from July 30th is at 1146.46, which "coincidentally" is very close to the projection shown on the daily chart at 1145 and the top of the wedge. It would be a typical finish for the rising wedge pattern if we get a spike up to that level on the FOMC announcement. It's common to get the final leg of an ending diagonal as a throw-over (or throw-under when it's to the downside) on a news event. A poke above the top of the wedge followed by a drop back inside it would be the sell signal. A break below 1107 at any time now would indicate the top is already in place.

S&P 500, SPX, 60-min chart

But continue to keep in mind that this rally could fail at any time. We are into what should be the final leg of the rally from July 1st. The lower Fib projection shown on the above chart, at 1131.45, may be all we'll get (which would be just a retest of the July 21st high). The pattern of the move up from Friday can be considered complete, which is another factor to consider if you're thinking of holding out until the higher level. A trend line along last week's highs intersects 1131 tomorrow morning so a failure there could mark the top of the rally.

S&P 500, SPX, 30-min chart

If the market is able to put in another leg up tomorrow, SPX 1140-1146 is an interesting zone for a couple of reasons, other than those described above. We could get some symmetry between the November 2008/March 2009 bottom and the April/August 2010 top. The difference between the November 2008 low and March 2009 low was 75 points. If you take 75 points away from the April high of 1220 you get 1145.

Looking at the Gann Square of 9 chart, one full circle (360 degrees) from the July low of 1010 is 1141 so these two numbers "vibrate" off each other. The March 2009 low at 666-667 is 4 squares (levels) away from 1143-1144. All of this doesn't mean the market will make it up to this area, or stop there, but there are enough reasons why it will probably be an important area to watch if it rallies up to there and stalls, especially if done around the FOMC announcement.

Gann Square of 9 chart

If the DOW manages a throw-over above the top of its rising wedge pattern it should be able to tag 10800. If SPX makes it up to 1145-1146 the DOW should be able to get closer to 10900. So it'll be interesting to see which one holds sway over the other (assuming either one will be able to make it higher). Back below 10515 would tell us the top is already in place.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 10800
- bearish below 10515

The RUT has looked weaker than the others although it was relatively stronger today. But it has not been able to challenge last week's highs, let alone the July 27th high. Its pattern is not as clear as the others at the moment and it does not have the same rising wedge. It could certainly rally to a new high with the others but it's been unable to get above the downtrend line from April through the July 27th high. If it rallies up to about 670 on Tuesday it would retest its broken uptrend line from July 20th.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 670
- bearish below 639

The financial sector ETF, XLF, looks closer to a breakdown instead of looking for a new high. Follow the money if XLF breaks Friday's low and certainly the July 30th low at 14.53. Today's bounce had XLF finding resistance at its 200-dma and left a bearish dragonfly doji. If it can press higher tomorrow it could struggle with its downtrend line from April, near 14.94, its horizontal resistance near 15 or slightly higher at its broken uptrend line from July 20th, near 15.12. Needless to say, the area surrounding 15 could be tough resistance.

Financial sector ETF, XLF, Daily chart

The broker index left a very interesting setup on Friday and it's not much changed after today. On Thursday and Friday each day's candle is a hanging man at price resistance at 110.38, which is where the bounce off the July low has two equal legs up for an a-b-c bounce correction to the April-July decline. The high on Thursday and Friday was 110.52 and today's high was 110.75. As with the banks, if the brokers start breaking down it could be difficult to rally the market any higher. SPX 1145-1146 would be very difficult without XLF and XBD on board. The bulls clearly have their eyes on the 200-dma above at 112.97, and the 62% retracement at 113.03.

Securities Broker index, XBD, Daily chart

The TRAN appears to be working its way slowly higher in a tight wedge pattern. At the moment it fits very well as the final 5th wave of its bounce pattern from July 6th.

Transportation Index, TRAN, Daily chart

Last Thursday I showed the U.S. dollar contract so today I'll show the dollar ETF. UUP closed at support on Friday at the March low at 23.34 (the dollar dropped close to the 62% retracement of its November-June rally but continues to hold near its downside projection I had shown on its chart at 80.55. It should be setting up for a rally out of its down-channel any day now and it continues to look like a good setup for a reversal with the stock market. Whatever the FOMC announces, at this point it's looking like a good setup for a rush back into the U.S. dollar.

U.S. Dollar ETF, UUP, Daily chart

Instead of the gold contract I'll show the gold ETF, GLD, and it bounced up to its 50-dma on Friday and got turned away. Today it dropped back down a little bit and it's very possible the bounce correction has now finished. A drop below 116.35 would be a sell signal.

Gold ETF, GLD, Daily chart

The gold miners ETF, GDX, left a bearish shooting star at resistance (its broken uptrend line from February) on Friday and today it left another bearish candlestick, a dragonfly doji, at its 50-dma. This candle could be called the hanging cat (you've seen pictures of a cat hanging onto a rope with just its front claws with the title "Hang in there baby"). It could always try again for the broken uptrend line but this one is giving off sell signals right here right now.

Gold Miners, GDX, Weekly chart

Friday's drop in oil had it dropping back below its uptrend line from July 2009, which is obviously bearish. Today it closed back up at the line. If it continues to drop tomorrow I think that would be a good sell signal. But the pattern is choppy enough to keep both sides guessing for a while. It takes a drop below 75.90 to confirm the bears are in control.

Oil continuous contract, CL, Daily chart

The past week's rally/consolidation has had a bullish effect on market sentiment. Bullish sentiment is running very high, the short ratio in stocks is very low, the ISEE call/put ratio was high again today (more call buying than usual) and the VIX is pressing lower, albeit marginally. The pattern for the VIX suggests an ending pattern to the downside, mirroring the ending pattern to the upside in the stock market. If we get a little more rally tomorrow we should see the VIX below 21 but I don't think we'll see it below 20. This looks ready for a reversal back up.

Volatility index, VIX, Daily chart

There were no major economic reports today and only minor reports tomorrow, except for the FOMC announcement at 2:15 PM. Expect the obligatory stop runs to the upside and downside before the market settles on a direction. We might not get a true sense of direction until Wednesday.

Economic reports, summary and Key Trading Levels

When the market was rallying into its April high I was saying the upside potential is dwarfed by the downside risk. As traders we should be looking for at least at 2:1 reward:risk ratio and preferably 3:1 or better. This helps override losses and ensures you'll have a winning trade record. An additional 2-3%, or even 5-10%, to the upside had a much smaller reward:risk ratio than was acceptable because of the downside risk that was present at the time. I'm feeling the same way as we near what I believe to be the end of the correction to the initial decline from April. I received the following from a hedge fund manager who compares our current situation with a tall building. In his words (thanks Austin):

Going Up?

We got a call last week from one of our sophisticated clients asking if he should initiate a long position early this week and take advantage of a potential run up to our upside target of 1131 - 1146 on the S&P before the market rolls over. He reasoned that before the market sells off as our technical indicators presage, that a potential 20 S&P point upside move looked attractive and that he could simply close out the LONG position at THE TOP and reverse and go SHORT after the market tops.

I reminded him that 1) we were very close to putting in a meaningful top, 2) SURPRISES occur to the downside and that 3) once the market rolls over, establishing short positions can be a challenge especially if we have another mini flash crash like we saw on May 6th.

So I asked him what floor on the elevator??? What floor?, he replied.

Yes. What floor of the building was he planning to go LONG and then get off "at THE TOP"??

Well, I guess I am on the 10th floor and looking to lock in gains on the next floor higher -- say on the 11th or 12 floor, he answered.

So you are visualizing a 10-20% move up [SPX 1233-1345] before the market finally rolls over if my math is correct with my elevator word picture? NO! he replied. My bad! A 20-point S&P move is merely a 2% gain. (1141-1121 = 20 / 1121 = 1.8%)

So to better visualize the FLOOR that we currently precariously stand upon, I said you need to better think of the Sears Tower, now known as the Willis Tower instead of the 12-story industrial building he was calling from. No, I was not going "INCEPTION" on him. Although it was a great movie and I highly recommend it. I was merely trying to give him a better word picture of where we actually stand in the market today.

If you are not from Chicago, you really don't have an appreciation of how massive (and tall) the building really is. See pictures below. And unless you are standing on the 103rd floor looking directly down, you don't have an appreciation of DOWNSIDE RISK lurking below.

I told him that not only was his elevator precariously holding near the 103rd floor but that we were getting ready to tumble down to the 86th floor (16% drop down to the 944 on the S&P) or all the way down to 60th floor in a New York second if the double dip recession comes to fruition (41% drop down to 667 on the S&P).

So I asked him if he would rather try to squeeze ONE MORE floor of profit to the upside OR start building his core short position on any minor new highs (if we get it) for the BIG ride down??

Well if you put it that way, I guess I should start building core short positions right here right now AND on any minor new high to the 104/105th Floor.

So as we head into this week's market action on LIGHT summer volume ahead of the volatile Fed announcement remind yourself: YOU ARE STANDING IN AN ELEVATOR OR A GLASS SKYBOX on the 103rd floor of the Willis Tower!! What's the risk? Trade accordingly!!

Willis Tower, Chicago

To which I'd add, "So trader, tell me, do you feel lucky?"

As I look over the various stock indexes, the commodities and the dollar, I have a strong sense that we're set up for reversals on all of them. The dollar looks ready to rally and stocks and commodities look ready to decline (I can't get a good read on bonds as of tonight). Even the VIX looks like a setup for a reversal. The FOMC announcement is looking like the catalyst event to start the reversals. Whether these various markets wait for the FOMC (with a post-FOMC move to finish their respective rallies/declines) or start their reversals in front of, or coinciding with, the announcement is hard to judge.

At the very least I'd be very careful if looking for a continuation of the current trend. The glass skybox you're standing on may not survive the next earthquake. At least have a parachute strapped on your back.

Good luck through tomorrow's trading and be real careful after 2:00 PM--this market has pinned a lot of hopes to the Fed doing and saying the right thing. I've rarely seen the market happy with the result. Flat is a position until a direction is established. I'll be back with you a week from this Thursday.

Key Levels for SPX:
- cautiously bullish above 1145
- bearish below 1107

Key Levels for DOW:
- cautiously bullish above 10800
- bearish below 10515

Key Levels for NDX:
- cautiously bullish above 1950
- bearish below 1873

Key Levels for RUT:
- cautiously bullish above 670
- bearish below 639

Keene H. Little, CMT