That is not the kind of headline the stock market wants to see and the knee jerk reaction was a drop below Dow 10,000.

Market Stats Table

Existing Home Sales fell -27.2% in July according to data from the National Association of Realtors report this morning. Sales fell to an annualized rate of 3.83 million homes from the June rate of 5.37 million. Analysts had expected a decline but only to 4.83 million. The drop of a million home sales more than expected was a serious shock to the market. Months of supply soared to 12.5 and a new record high. The pace of home fell to a level not seen since 1995.

The homebuyer tax credit produced the first spike in October and then sales declined after that credit ended. The credit was eventually reinstated with even better metrics that included additional buyers but the resulting sales spike was lower. Once the second credit period expired the pace of sales fell off a cliff. This is a clear example of how stimulus programs pull sales forward leaving a void of activity in future periods.

All four census regions showed month over month sales declines of 20% to 30% so the lack of activity was nationwide and not region specific. The number of single-family homes for sale fell to an 11.9-month supply and the lowest level since 1985. Homes for sale increased in July while sales declined. Record low interest rates have been unable to draw buyers back into the market. The unavailability of credit and the strict requirements for home loans is hurting the market. The homebuyer tax credit was an addictive drug for homebuyers and the removal of the tax credit has put the housing sector into withdrawal.

The downside risks to the economy are huge. Home sales should continue to decline until spring. This will hurt new home sales as well and cause another round of layoffs in the construction sector. Home prices will fall again and foreclosures will increase. This is a major problem for the U.S. economy.

Home Sales Chart with Tax Credit Spikes

Homebuilders imploded at the open but many rebounded to close in positive territory after several brokers reiterated buy ratings. Citigroup said the "Risk-reward profile is more favorably skewed." JP Morgan said homebuilders offer a "Compelling risk/reward" and Barclays "We remain positive on the builders." Obviously those brokers must have a considerably longer time horizon than most readers.

Toll Brothers (TOL) will report earnings n Wednesday and it will be interesting to hear how they are dealing with the downturn and more importantly hear their guidance for the next six months. I do believe that the current cutback in housing starts will eventually lead to a shortage of homes and a rapid spike in prices and profitability. The only question is when that will happen. 2011 or 2012?

While Citigroup was reiterating its buy on the homebuilders it was cutting its outlook on building supply companies like CRH and MLM. I am guessing it is a case of different analysts with different views. One firm, CRH Plc (CRH), warned today that earnings would decline sharply due to a faltering U.S. economic recovery. CRH is based in Ireland but 50% of its sales are to U.S. clients. The company said conditions in the U.S. had declined significantly since mid July.

Earnings fell -20% and they guided sharply lower for the next six months. Citigroup cut CRH to a hold and share prices declined by -16%. Other suppliers including CX, EXP, VMC and MLM all declined sharply as well.

The other major economic report today was the Richmond Fed Manufacturing Survey. The headline number fell from 16.0 to 11.0 but remained in positive territory unlike the Philly Fed report last week. The components declined at a slower rate than those in the Philly Fed. The two that stood out to me were the unfilled orders at zero from 16.0 just three months ago and the capital expenditure plans that were cut in half from last month. The shipments component (not shown) dropped from 22 to 11 after peaking at 32 in May.

Richmond Fed Components

Reports due out on Wednesday include Mortgage Applications, Durable Goods, Home Price Index and New Home Sales. The new home sales numbers should not be quite as bad as existing home sales but I seriously doubt it will be good news.

We knew the home sales numbers were going to be bad but nobody expected the severity of the actual decline. After the drop in the Philly Fed last week and the monster drop in the home sales this week you can bet the sentiment numbers over the next month are going to be very ugly. Friday's sentiment report cutoff 10 days ago so it won't reflect the bad news. The next one will be the really ugly number.

The GDP revision on Friday is now expected to decline from 2.4% to 1.2% and many analysts are expecting it to fall under 1% on the next revision. Analyst David Rosenberg from Gluskin Sheff said on Tuesday the economy is not in a double dip recession but already in a 1930s style depression.

Rosenberg wrote in a note to clients that even in the Great Depression there were high points with a series of positive GDP reports and stock market gains. Then as now those signs of recovery were unsustainable and only provided a false sense of stability. The 1929-33 recession saw six quarterly bounces in GDP with an average gain of +8% and causing the stock market to rally +50%. This time around there have been four quarterly GDP advances and the average is only +3%. Rosenberg pointed out that the current economic decline has come after two years of a Fed interest rate at record lows and after an increase in the Fed balance sheet of more than $2 trillion plus the largest stimulus program in history. He said, "This is not your garden variety double dip recession." He also believes we could see another 4-5 million lost jobs. He pointed out that historically the home construction sector employed three workers for every housing start. Today that number is closer to 10 and continued weakness in housing will force a return to historical norms. This is also true with all the industries that supply goods and services to the housing sector.

Gluskin Sheff Chart

Quite a few analysts disagree with Rosenberg but those that agree are growing in numbers. This kind of talk from a highly respected analyst is very detrimental to market sentiment.

Chicago Federal Reserve President Charles Evans said in a speech on Tuesday that the risk of a double dip recession has escalated. "I am increasingly uncomfortable with the lack of noticeable improvement in the labor market." Despite the current problems he believes the economy will escape a double dip and he believes the current Fed policy is the correct one. However, he said today's numbers would force him to lower his estimates for the recovery and he would probably support move Fed stimulus. He is worried that foreclosures could reach three million in 2010 with one million homes owned by lenders. That is drastically over the existing estimates by analysts.

The housing data and the comments by Evans are focusing the spotlight even more on the Ben Bernanke speech at 10:ET on Friday. This speech at Jackson Hole is not normally a revelation of policy but more of an informal luncheon talk. With the recent downturn of economics there is a growing hope that Bernanke will say something substantive to calm economic fears. While on the subject of the Fed there is a growing belief that the Fed is going to announce another stimulus move of some kind over the next 3-5 days.

Dollar Index Chart

Ten-Year Note Yield Chart

In a remarkable burst of speed two people were charged with insider trading on the announcement of the BHP bid for Potash. The head of a research arm at Banco Santander was one of the two people charged. Banco Santander is one of the banks advising BHP on the bid. The SEC said two of the bankers traded on inside information they obtained about the deal. The idiots bought $61,000 of out of the money call options and sold them for $1.1 million after the deal was announced. Let's see, professional bankers buying large quantities of OTM call options in a U.S. trading account just before the deal was announced and they did not expect anyone to notice? After the sale they immediately tried to move the money offshore.

Potash has more suitors than customers today. Rio Tinto said it may join with a Chinese partner like China National Offshore Oil Company (CEO) to breakup the BHP bid. Rio Tinto is probably the 4th or 5th company to express a desire to make a competing bid. The price on POT could go to the moon if this bidding war continues to heat up. Since China has a national imperative to corner the market on fertilizer I would bet that the eventual winner will have Chinese backing.

McAfee and Intel were sued by an irate shareholder claiming Intel paid too little for McAfee. You may remember Intel is paying a 60% premium at $48 for the software company and the stock was headed lower before the offer. McAfee has not been close to $48 since March of 1999. I would bet that suit is a colossal waste of money.

The banking sector may be the only sector with worse charts than homebuilders. The financial sector is losing ground fast and there appears to be no relief in sight. Fears of a double dip are weighing on the major banks because nobody wants to be caught owning the next Lehman or Bear Stearns if the double dip turns out worse than the initial dip. The flurry of eight bank closures last Friday is also weighing on banking sentiment. Among banks hitting new 52-week lows today were BAC, BK and USB.

Banking Index Chart

The markets had been down for the prior three days and that did not prevent them from stretching that string to four. Oversold can always become more oversold and we are seeing that in action. The Dow dropped -183 points at the open and recovered somewhat to trade down only -100 early in the afternoon but the "sell on close" strategy is alive and well. There are no bulls after 2:PM. Fear of darkness has become a powerful motivator again. Triple digit declines at the open convince traders they do not want to be long at the close.

Internals were severely negative with new 52-week lows hitting 467 and the highest level in nearly a year. That is even higher than the levels seen on the early July dip to 9,614 on the Dow. Sentiment is declining very rapidly.

The S&P declined -15 points and hit a low of 1046. This is very close to the 1040-1044 support dating back to February but I seriously doubt it will hold. I am sure there is a rebound rally in our future but I think the trend will remain lower at least until after Labor Day. Resistance is now 1060 and 1075.

S&P Chart

The Dow broke below 10,000 at the open and quickly rebounded to just over 10,100 but it was a short trip. The Dow was handicapped by huge losses in BA, CAT, IBM, UTX and CHV. Boeing lost -2.37 or nearly -4% on news the FAA was going to step up inspections of 737s.

The Dow is going to be under pressure as long as the economics continue to worsen. The double whammy is the large tech stocks added over the last few years that are also providing a major drag. A major market cycle analyst, Charles Nenner, has predicted quite a few of the major Dow moves in the past and he has been right on more often than not. In 2006 he predicted the initial housing crisis, the recession and now he is predicting a return to Dow 5,000 as the country falls into a depression. He was showcased on CNBC today and regardless of whether you believe him or not the existence of the high profile prediction is strongly bearish.

The support on the Dow is now 10,000 but it is more psychological than technical. The Dow has already declined -700 points since the August highs on August 9th. The 10K level may slow that already oversold decline but I don't think it will be the low for August. I believe we will retest the 9800 closing low from June. Resistance is now 10,100.

Dow Chart

I have nothing positive to say about the Nasdaq. The big cap techs are being sold hard on worries consumer PC sales as well as the corporate upgrade cycle has broken. Chip stocks have been warning on guidance and analysts are cutting their PC sales estimates. There are no positives for techs.

The decline below strong support on Tuesday clearly targets the 50% retracement level at 2063. I would be very surprised and suspicious of any tech rebound. Prior support at 2140 is now resistance.

Nasdaq Chart

The Russell tested critical support at 590 today and the initial test was a success. However, I think we will see that level tested again. If it fails we could see a stutter step at 580 but 550 becomes the next target. We need to focus on small caps over the next month to see when fund managers start buying stocks again. Until the Russell shows some strength the market will remain under pressure.

Russell Chart

In summary I believe the market will continue lower until after Labor Day but we could see oversold rebounds thanks to short covering at any time. The economics are simply too negative and worsening. Fear of a double dip is growing and this is not the climate for fund managers to suddenly start buying stocks. We also have the decline in the financial sector. The markets are not going to rally as long as the outlook for financials is worsening.

Over the weekend we experienced a hardware failure on one of our servers. This caused the newsletter emails to be delayed until Sunday night. When the process was restarted thousands of aborted emails from the failed process were sent to readers. We apologize for the extra emails and the delayed newsletter. Thank you for your continued support of Option Investor.

Jim Brown