Market Stats

The last two evenings after the cash market closed we've seen the equity futures driven higher, as if someone was trying to erase the previous day's losses. But then after the European markets opened, our futures took a nose dive and last night was no different. Today the European PMI (Purchasing Managers Index) was a disappointment, dropping to 53.8 from 56.2 in August. That's not a big drop but it was clear the market was not comfortable with the huge September rally built (again) on the hopes that we were pulling out of the recession. In Europe, Stephen Pope, managing partner of Spotlight Ideas, said "We've been almost basking in the sunlight over very impressive growth numbers in Europe, but to suddenly see the PMI number come back took the stuffing out. It shows the private sector is not capable of stepping up to the plate yet."

That last sentence is important. Much of the "growth" in the past year or so has been a result of government stimulus. But as that stimulus money is running out (and people are not in the mood for their governments to incur more debt for more stimulus that has not worked), and now after the demand pull-forward from that stimulus, we're left with nothing to follow up. The private sector has not bought into the "recovery" and has not geared up their production for the new "demand" (hence the continued high unemployment, which is why it's been a leading indicator this time around). Business leaders can see and feel the lack of enthusiasm from the consumers and have been hoarding cash rather than invest it in new capital equipment. They're also worried about government policies and taxes and have been hesitant to commit to new projects.

Compounding the problem out of Europe are the bond vigilantes. This is the name given to bond buyers who have been expected to balk at buying more bonds at the current rates. They are requiring higher yields to compensate for what they see as higher risk. This is driving the price of bonds lower (higher yields) and the spreads are widening between some of the riskier European countries (and states and municipalities in the U.S.) and the German bonds (Germany's bonds are considered a benchmark due to their relative safety, similar to U.S. Treasuries).

News about Irish and Portuguese bonds selling off is striking fear again in the financial markets. The news about the financial troubles of these over-indebted countries continues to plague the banks. As a consequence our banks took a bigger hit today relative to the broader market, which had the S&P down more than the DOW or techs. This is a story that won't go away, disappointing those who want to see the current stock market rally continue. Reality bites sometimes. Irish and Portuguese bonds have now driven their borrowing costs to "euro-era records".

The news only got worse after our 8:30 economic reports came out. The unemployment claims rose more than expected last week, up 12K to 465K. I'm sure there's more than one politician worried about that number going over 500K again. I'm sure we'll hear some creative spinning such as "We created over a million jobs through our job creation programs and the unemployment numbers would have been 600K without us doing what we did." Whatever.

At 10:00 AM we got the existing home sales, which came in a little better than expected (4.13M vs. 3.8M), and then Leading Indicators, which also came in stronger than expected, up +0.3% vs. +0.1%. These helped a bounce that was already underway after the gap-down start to the day (the lifters arrived right on cue). The market rallied up to close the gaps and retraced a portion of yesterday's decline. The NDX, thanks in part to the semiconductors, was on fire and tested Tuesday's high. But the afternoon was spent giving back the rally and even the techs closed marginally in the red.

The high on Tuesday, following the FOMC announcement, was a very good setup for a market reversal, as I'll show in the charts. It was a classic "buy the rumor, sell the news". There were many reasons why I was looking for a market turn and being a contrarian was one of them.

Bullish sentiment has hit extremes again, at some levels not seen since the April high or in some cases since the October 2007 and May 2008 highs. This week's Investor's Intelligence numbers show 41.4% of financial newsletter writers to be bullish. This is the highest since August 11th when the number was 41.7% bulls. August was the last market top. There's also over-the-top bullishness in gold while the bearish sentiment in the U.S. dollar, at 7% bulls, matches the November 2009 low in the dollar. Across the board we're ripe for reversals.

Tom McClellan, the son of the McClellans who developed the McClellan Oscillator among others, writes a newsletter and has a free weekly chart that you can sign up for (mcoscillator.com). He and I attend the local MTA chapter meetings and he's a very sharp individual when it comes to the market. His latest chart has to do with the VIX/SPX relationship and with the high inverse correlation (-0.75) between the two he has determined that the normal move in VIX is 5.4% for each 1% move in SPX. When that relationship deviates it's telling us something.

He has plotted this deviation (blue line at the bottom of the chart) and as he shows with the lines of divergence it warns of a market turn when there is divergence (at bottoms and tops). The current negative divergence of the VIX vs. the new highs for SPX is a warning of a top, just as it was back in April. It's just another check mark in the bear's column.

McClellan's VIX/SPX chart

From the FOMC announcement on Tuesday it is clear the Fed is worried, as well they should be. For the first time they said the dreaded 'D' word on Tuesday--Deflation. They did not say disinflation but instead came right out with it and essentially said they're worried about deflation. Deflation, once entrenched, is virtually impossible for monetary policy makers to do anything about. They fully understand that they can print all the money in the world but without consumer spending, all that printed money will sit in banks' coffers. They won't be lending it out because there will be no one to lend it to.

The Fed's surrendering to the use of the word deflation means only one thing to me--they're now admitting they might actually be losing control of the monetary situation we're in (they haven't been in control but they've been thinking for years that they have). They're preparing the market and people that deflation (and a depression) might actually happen. This to me is a remarkable admission. The stock market hasn't quite grasped the meaning of this but they will as part of the next leg down in the larger bear market cycle we're in.

The Fed will now be able to go on record as saying they warned us about deflation. We can expect more talk about this as an effort to alert us but not scare us into a panic. Deflation is short-term painful, especially to debtors like the governments around the world, and for people who are still up to their eyeballs in debt, but it's not something that should be so scary to normal people. The Fed and government will be more hurt by it than ordinary people (except those who suffer job losses of course), which is why they've been fighting so hard to prevent it. It's a cleansing process and in the end we'll be set back on a path of growth that should last for a long time. It's hard to welcome pain with open arms but knowing it's what will heal us in the long term I say bring it on and let's get it over with.

A fundamental change in consumer attitude is the reduction in their desire to own more stuff and instead put more money into savings. After years of gluttonous accumulation of more and more stuff, much of it on credit, there has been a fundamental shift away from spending and more towards saving. This, probably more than anything else, is what is thwarting the Fed's efforts to re-prime the economic pump. History is replete in the evidence that once deflation becomes imbedded on the national psyche there is no chance of financial policies pulling us out of it. To believe that the Fed will succeed this time, when no other nation in history has been able to do so in the past, is to believe it will be different this time. No nation in history has been able to reverse the collapse in its balance sheet that we're witnessing today. It must simply run its course and we'll pull out when social mood shifts again (and probably after we see our debt monetized and currency debased).

Our economy depends on spenders. The world's economy depends on consumption. If we collectively stop spending so much it will hurt our economy and many others like China which are so dependent on exports (even Germany). This will cause all kinds of ramifications such as protectionist measures by Congress and other countries (it's already started) which will only exacerbate the slowdown in the global economy. But it's human nature to protect one's own turf.

At any rate, the drop in consumer spending can be seen in the chart below, which plots the data since 1959. We've been in a nice parallel up-channel since the bottom in 1984. Spending hit a high just north of 84% of personal income in about 2004-2005. It briefly dropped below the bottom of the channel near 81% as we headed into 2009 and has rebounded a little since then. Government transfer of wealth payments (unemployment, stimulus payments, tax rebates, etc.) has accounted for a significant amount of this short-term increase in spending. As we've seen with each government program, the backside of these programs is reduced spending (after pulling demand forward) and will likely lead to a drop below the low seen in early 2009.

Personal Consumption Expenditures (PCE)

A big part of the reduction in spending is a result of a significant change in savings. Between paying down debt and socking more money into savings (not the stock market since people, including younger people, have been pulling money out of the stock market) the consumer has made a major shift from habits developed over the past few decades. The chart below shows the saving rate and as you can see we've broken the downtrend line from 1975. After bottoming below 1%, from a high above 14%, the current rate of 6% has room to grow. As debt gets paid off I suspect we'll see the savings rate continue to increase.

Personal Saving Rate

Both of the above charts are very healthy for our long-term health as it re-primes the consumer which in turn will re-prime the economic pump. But it won't happen for a few more years and that's why we will continue to suffer an economic malaise that the Fed has been trying to fight. We would be much further along the correction process, with far less government debt, if the government would simply let the correction run its course. But politicians can't (won't) do that because their constituents are screaming for government to save them. We need to save ourselves since the government is going broke at an accelerating pace (they're not done trying to save us).

So what does this all have to do with the market? Whether you trade currencies, metals, stocks or bonds, it will all be greatly affected by what's happening with our economies and what's happening to our currencies. After the Fed announced they will continue to do whatever's necessary to fight a slowing economy and deflation the dollar cratered and gold rose. The obvious concern there is Helicopter Ben will live up to his promise to flood the market with more and more worthless dollars, driving the value of them down while increasing the value of "real" currency such as gold.

But deflation actually has a very different effect on these. The dollar will increase in value (because all that printed money will not make it into circulation) and all other asset classes, including gold, will decline in value. As cash becomes more valuable (you'll be able to buy more goods with fewer dollars) it becomes more expensive to pay off old debt. Other "alternate" currencies, like gold, will lose their value. That's what I'm expecting to see over the next couple of years. Following that episode, with all the money creation efforts by the Fed, we could see an explosive time of hyperinflation and then you'll want to ditch the dollar and buy as much gold as you can possibly accumulate. But that's a ways off yet and we should have enough warning that it's coming (massive bank failures for one).

In the meantime it's time to batten down the hatches and protect yourselves from another round with the bears in control of the markets. The rally from March 2009 to April 2010 was a bear market rally (correcting the 2007-2009 decline) and the sideways price action since May 2010 has been a correction to the leg down from April. We're now due another leg down. The first downside projection for the S&P is to 950 if not 870 (July 2009 low and a downside Fib projection). The weekly chart shows the projection:

S&P 500, SPX, Weekly chart

The downtrend line from October 2007-May 2008 is currently near 1160. That's the upside potential if the bulls are not finished with this market yet. But notice the weekly candle as it stands today. It could change with a rally on Friday but right now it's a bearish shooting star, or an even more bearish dragonfly doji. This is a strong reversal candle but would be better confirmed with a red candle for next week. So why did the S&P stop where it did if we've seen the high?

I copied a section of the Gann Square of Nine chart below to show the potentially important SPX 1142-1144 level. The July 2010 low near 1011 is 3 cycles up from the March 2009 low near 666. If we use 666-667 as the March 2009 low then 4 cycles up from there is 1142-1144, with 1143 being arguably THE number. When levels are 360 degrees (1 cycle), or multiples of that, from each other they are said to "vibrate" off one another and the market reacts to these levels. Don't ask me how or why. I just know that they do (sometimes scary accurate). Tuesday's high exceeded this 1142-1144 level but not on a closing basis. The highest close was Monday's 1142.71 (close enough to 1143?) and Tuesday's attempt to exceed 1144 was batted down into the close. Important? Only time will tell but that was the reversal setup I was calling for on Tuesday.

S&P 500 Gann Square of Nine chart

At Tuesday's high the SPX also came close to the top of a parallel up-channel for price action since the July low (bear flag). If it wasn't for that Gann number above it might have made it. In addition to the downtrend line from October 2007 near 1160, I'm showing the price projection at 1158 for two equal legs up from July 1st. So that's the target zone if the bulls can get another push higher next week (month/quarter end). Watch the 200-dma near 1117 for possible support (at least for a bounce).

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish to 1158
- bearish below 1119

Updating the SPY chart from last week, when I discussed why I did not believe in the inverse H&S pattern that just about everyone was talking about, the volume pattern continued to support the idea that we were getting a head-fake break of the neckline into Tuesday's high. Tuesday's volume, the day of the break above the neckline, continued to show lower volume--not at all the kind of confirmation you need to see on a true breakout. Worse, Wednesday showed higher volume on a doji day. This indicated more than indecision and instead meant reversal in progress (indecision would have been another low-volume day). Therefore the volume pattern continues to support the notion that the break above the neckline was a bull trap (not a guarantee, just evidence).

S&P 500 SPDR Trust, SPY, Daily chart

Tuesday's high came very close to tagging the top of a rising wedge pattern since May. The wave count for it counts complete. A small break of the downtrend line from October 2007 did not hold. The doji days have been followed by a big red candle. While it can always push a little higher, that's not what this chart is telling you to do. The next big move is to new lows below July's and therefore I'm in sell the bounces mode rather buy the dips.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 10,800
- bearish below 10450

The Nasdaq Composite was underperforming the Nasdaq-100 during the rally and that was another warning. A lot of money was being poured into the big-cap high flyers like AAPL, which lifted the NDX. But the rest of the tech stocks were not getting as much loving. When that happens it's a bearish non-confirmation. The COMPQ pushed marginally higher than the price projection near 2347 for two equal legs up from July, and also just above the top of its bear flag pattern. Considering the setup, being overbought as well, I'd prefer the short side on the techs until proven otherwise.

Nasdaq Composite, COMPQ, Daily chart

Key Levels for COMPQ:
- cautiously bullish above 2350
- bearish below 2276

Tuesday's high came within less than a point from its price projection at 673.07 for two equal legs up from July. The sharp decline from there looks like a good reversal. It found support at its 200-dma today (near 648), which could be good for a bounce on Friday but I'd look at it as a shorting opportunity. If it's a high bounce you'll be able to lower your risk by placing your stop above Tuesday's high.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 673
- bearish below 643

Zooming in a little closer to the RUT's chart, the uptrend line for the rally from the end of August was broken yesterday, tested in the afternoon and then followed by this morning's gap down. The bounce back up today found that trend line to be resistance again. This can't be thought of as anything other than bearish and this afternoon's steep fall away from that kiss goodbye is a strong sell signal. While we could see the RUT bounce off its 200-dma tomorrow morning I think there's an equally good chance it could gap down below it.

Russell-2000, RUT, 60-min chart

The VIX gave us a "buy" signal today by breaking above its downtrend line from May. It stopped at its 50-dma and could still reverse back down but as long as it continues to rally from here it will be a sell signal for the stock market. If we are to start the next leg down of the bear market the VIX will quickly shoot above 50. VIX calls anyone?

Volatility index, VIX, Daily chart

As mentioned at the top of tonight's report, the banks got hit relatively hard today, thanks in part to continued worries out of Europe. The KBW bank index shows a sharp selloff since Tuesday and is back below its 20 and 50 moving averages after the rally failed just shy of its 200-dma. This chart is begging to be shorted.

KBW Bank index, BKX, Daily chart

The TRAN failed right at resistance at the top of its sideways triangle pattern from May, with a completed EW count for the triangle pattern. The setup is picture perfect for the start of the next major decline.

Transportation Index, TRAN, Daily chart

With worries about Helicopter Ben starting up his fleet of helicopters the U.S. dollar took another hit this week. The DSI (Daily Sentiment Index from trade-futures.com) has the bullish percent at 7%, the same level at the August low and the November 2009 low. Being short the dollar and long the euro is a very crowded trade and ripe for reversal. The dollar has now retraced 62% of its November-June rally and is leaving a bullish divergence against the early-August low.

U.S. Dollar contract, DX, Daily chart

Another rising wedge pattern, with a completed EW count for it, can be seen for the commodity equity index. It met its Fib target near 793 and tagged the top of the wedge almost to the penny yesterday morning. Once again, it's a good setup for a reversal back down.

Commodity Related Equity index, CRX, Daily chart

The gold bugs are out in force beating the drums of hyperinflation and why it's a great time to own the shiny metal. I get the feeling they're trying to convince themselves as well. Many commodities, gold and silver included, now have a DSI reading above 90% bulls. That boat is about ready to tip over. I'd be heading over to the high side about now. Just shy of 1297 is the 127% extension of the previous decline (June-July), which often marks a reversal level. It has now pushed marginally above a trend line along the highs from December 2009 (still in throw-over territory for a head-fake break). There is always the possibility we'll see the metals spike higher in an emotional climax of buying (common in commodities) but at this point I would say holding out for more may be turning you into a hog (pigs get fat, hogs get slaughtered).

Gold continuous contract, GC, Daily chart

Oil's short-term pattern is not clear at the moment and I could argue equally strongly for another leg up as part of a larger bounce off the August low (dashed line on the chart) or for the start of a sharp decline right from here. A break below 71.50 would support the sharp break lower while a rally above 76.38 would support another move higher before it's ready for another leg down.

Oil continuous contract, CL, Daily chart

We've got durable goods orders, which are expected to get worse (-2%), and new home sales, which are expected to get worse (270K). Sounds like an opportunity for a pleasant surprise. ;-)

Economic reports, summary and Key Trading Levels

I've been looking for an end to the price consolidation/bounce for the correction since May's low and it's been very difficult to identify where and when it will be. As we headed for Tuesday's high, especially knowing it would likely occur on the FOMC announcement (which could hardly have been considered good news so thank you PPT for a nicer short entry), I was really liking the setup for a reversal. We got it and now I've been watching it closely for confirmation with the move down that we've seen the high. I wish I could say emphatically that the high is in and you should now mortgage the house and double short this market. But I can't (and besides, I wouldn't).

The fact that I'm feeling confident but uneasy about the high being in place (primarily due to the kind of pullback I've seen so far) is a good sign. Usually when I'm confident about a reversal I get bitten by something unseen. So I'm cautiously bearish out of a healthy respect for what could still happen in this market.

Pushing my unease aside, I like the setup across the board for reversals. I like the weekly candles and I like where the indexes/sectors stopped and how some leading indexes are leading the way back down. I like trading fast and strong moves in the market, no matter which way it goes and in a bear market the moves to the downside can be real money makers. The setups are there this week and if Friday is a down day, especially a strong down day, then I think we'll have a more definite answer to the question about whether or not we've seen the top. If Friday bounces back up, especially a high bounce, then next week will require caution on both sides.

I think we're moving into a period where you'll want to short the bounces rather than looking for dips to buy. I think the dipsters are going to find catching falling knives is an unhealthy pursuit. By this time next week (or as early as tomorrow) we'll know better whether or not you'll want to continue selling rallies. Good luck and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish to 1158
- bearish below 1119

Key Levels for DOW:
- cautiously bullish above 10,800
- bearish below 10450

Key Levels for COMPQ:
- cautiously bullish above 2350
- bearish below 2276

Key Levels for RUT:
- cautiously bullish above 673
- bearish below 643

Keene H. Little, CMT