Market Stats

The stock market quickly moved from overbought last week to short-term oversold yesterday. Today's bounce was not unexpected, especially since there's still hope that the Fed will do something to save us (with more drug money). The day started with a gap up and rallied higher, putting in a high shortly before the FOMC announcement at 12:30. Following the announcement the market sold off, with the indexes retracing about 50%-62% of the morning rally but then Uncle Ben said some soothing words in his afternoon press conference and pushed the market back up near its highs for the day. I see a little more bounce potential on Thursday but then the a-b-c bounce off Tuesday's low could be followed by more selling.

This morning we received some jobs data from Challenger, Gray & Christmas and from ADP. The Challenger Job Cuts report showed +12.6% increase in the announced job cuts compared to a year ago. The good news is that it's down considerably from last month's +211.5%. Most of the nearly 43K job cuts will come from government (mostly state level) and financial agencies. Total job cut announcements for the year are running a little ahead of last year at this point, which of course is not encouraging when thinking of economic growth.

The ADP report sounded decent -- payrolls rose 110K -- but of course that's not nearly enough to handle just the growth in the working-age population. It's also a drop from September's upwardly revised +116K. Compounding the problem is that the growth came entirely from the service industries while the manufacturing industries actually lost 4K (and those are the higher paying jobs). Small and medium-sized businesses added 58K and 53K, respectively, while large businesses shed 1000 jobs.

This afternoon we got the much anticipated (cough) results from the mighty Fed with the FOMC announcement mid day and then the Bernank blessed us with a press conference. No surprise, the Fed will hold rates close to zero until at least mid-2013 (why even give a date that far out?). The Fed said that growth had strengthened somewhat in the third quarter but that "significant downside risks" remain. Charles Evans, the president of the Chicago Fed, was the only one who favored more easing.

The market barely reacted initially to the statement while it waited for the Bernank to assure us that everything is fine, problems are contained, inflation is only transitory...let's see did I miss anything? Even though inflation is showing up everywhere and at higher levels, he's trying to convince us otherwise. In his words, "inflation appears to have moderated since earlier this year" and it will settle down over coming quarters. It's that transitory thing.

Along with some disappointment that the FOMC didn't announce some more drug money for the market, the IMF announced it would hold back any further loans to Greece pending the outcome of Greece's referendum announcement. The double disappointment resulted in a stock market selloff to a mid-afternoon low and then consolidated a bit while waiting for soothing words from the Bernank. Once Bernanke started talking, the market rallied back up this afternoon to test the morning highs. The amazing thing to me is that the market still listens to him, as if he has any clue what he's talking about and any control over the outcome.

The FOMC announcement included a downgrade in their growth projections for the economy, looking for a significant drop in 2012 and 2013. At the same time it significantly increased its unemployment rate forecast. The 2011 GDP forecast is now 1.6%-1.7%, 2012 is 2.5%-2.9% and 2013 is 3.0%-3.9%. These numbers are down from their previously lowered numbers: 2011 - 2.7%-2.9%; 2012 - 3.3%-3.7%; 2013 - 3.5%-4.2%. They're now forecasting the unemployment rate to be 9%-9.1% this year and 8.5%-8.7% next year, declining thereafter. Inflation is expected to be 2.7%-2.9% this year, dropping below 2% next year and beyond.

This is laughable actually -- the Fed couldn't see the side of the barn in front of them as the financial difficulties in 2007 stared them in the face. And yet they think they can forecast numbers for next year, let alone for 2013 and 2014? I suppose they have to try. I think the more accurate prediction from them for 2012 and 2013 should read "we hope to see growth without causing hyper inflation from our policies."

Last week's strong rally, adding to the already strong bounce off the October 4th low, was all about the excitement over Europe getting a fix for it debt woes. While it was rallying so strong, especially last Thursday following the agreement on a plan for the plan (well, at least between Merkel, Sarkozy and a few bank heads) I was wondering why all the excitement. What was really solved?

John Mauldin did a really nice job in his October 29th letter ("Let's Just Change the Rules") explaining a possible reason the market rallied so hard. When the agreement was announced overnight last Wednesday, causing a huge gap up and rally on Thursday, my immediate reaction was "REALLY?" What could possibly be so bullish about the announcement of a definite plan to produce a plan that had no substance supporting it (like money, commitments, agreements, etc.). Mauldin offered a couple of thoughts that made a lot of sense and I'll try to summarize.

He basically referred to the rules being rewritten for the bond holders. Merkel and Sarkozy gave the banks an offer they couldn't refuse (either take the 50% loss on Greek bonds or take a 100% loss with a default). Basically the Merkozy pair told the banks it was their choice to have a pencil stuck in one eye or both. The banks chose one eye. At any other time a 50% loss (and it won't stop there) would be considered a default but this "agreement" avoided the classic default. An unintended consequence with the CDS market followed, one that could curtail future bank lending.

By not defaulting, the owners of insurance, through the purchase of CDS contracts (Credit Default Swaps), would not be able to collect. The sellers of the CDS contracts would typically short banking stocks or a market basket as a hedge against paying off the CDS (with the assumption that a default would cause the banks' stocks and stock market in general to decline). Once the seller of the CDS contract realized they would not have to pay off the CDS contract they no longer needed the short hedge.

The short covering that resulted simply fed into the other hedge fund short covering and normal buying that was going on in the market (especially into the end of the month). It's interesting that a melt-up in the market is never investigated like a melt-down. The HFT with their algorithms joined the party and the market blasted off to the upside. It wasn't because everyone was so happy Europe solved the problem; it was because the default risk was suddenly removed which triggered the initial short covering. It basically fed on itself until it flamed out last Thursday.

Then Greece turns around and hits the reset switch. The plan to develop a plan got dropped into the toilet and suddenly a Greek default was a clear possibility. All the short covering that was done last week was reversed again as the sellers of the CDS contracts had to short a lot of stock to hedge their commitment. This resulted in a reversal of the euphoric rally off last Wednesday's low. Not that it necessarily helps you trade this whacky market but it does help to understand where some of this volatility is coming from.

The danger now is that buying insurance through the CDS market may not be of interest to a lot of bond holders. They pay a lot of money for the insurance and then the EU leaders turn around and rewrite the rules, making your insurance contracts worthless. You have to take at least a 50% haircut and yet cannot make a claim on your loss. Why buy the CDS contract? Another unintended consequence that makes the financial system less stable, not more. If a bank is holding other sovereign debt and does not insure that debt then the bank is at greater risk than before in the event of a sovereign default. It will take down the financial system even faster.

If the CDS market is destroyed in the process, because people do not want to risk spending money on insurance that will be cancelled at the whim of some bureaucrat, banks will be less interested in lending money. Why take the risk if you can't reliably counter the risk? In a tightening credit market rates go higher. The problem here is that rates could be pushed higher than they normally would and that exacerbates the sovereign debt problem. Do you see how people messing with the system in the name of protecting it actually make it worse?

Look at what's happening to the spread between Italian bonds and German bunds. The widening spread is making it more difficult, and expensive, for Italy to borrow money and the recent spike in the past few days is telling us money is tight for Italy. The break above resistance near 4% is likely very important. Whether it's Italy, Spain, Portugal or Ireland, they're all in the same boat and paying off their debts is being made more difficult by the EU leaders. As painful as it will be, the market needs to self correct and can only do so if the bozos get out of the way.

Italian-German Bond Spread, chart courtesy bloomberg.com

With that we'll jump into the regular charts. A topping pattern that I've pointed out before (comparing the 2007 and 2011 tops) appears to be playing out so far. What's interesting about this pattern is that it had played out the same way back during the large topping process in 2000-2001. Note in the chart below how the neckline of a H&S top started from the previous high just before the left shoulder (although admittedly the H&S pattern in 2000 is a bit funky looking. But regardless of the topping pattern, each trend line started from the previous high prior to a steeper pullback. After the trend lines were broken and price plunged lower, price came back up for a retest of the broken trendline. It was not a pretty time to be a bull after the retest of those lines. It's hard to see at the right side of the chart (better seen in the next chart) but SPX just tested its latest broken trend line.

S&P 500, SPX, 2000-2007-2011 tops

Moving in closer to just the topping pattern in 2011, the weekly chart below shows the trend line starting from November 2010 and formed the H&S neckline across the lows in March and June 2011. Last week's rally brought SPX back up to the broken trend line. History doesn't always repeat but the setup is uncanny and dangerous for bulls. If history does repeat we are about to sell off sharply into the end of the year in a strong 3rd wave down.

S&P 500, SPX, Weekly chart

The daily chart below shows the test of the broken H&S neckline and a strong decline as it got slapped for trying to give it a kiss goodbye. As depicted, there is the possibility for another push back up for at least another test/minor new high (as it did in October 2007) but that would be just a guess right here. At the moment it looks like we should be thinking about shorting all bounces.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1275
- bearish below 1215

Not only did SPX achieve a retest of its broken H&S neckline but it also achieved a few Fib projections in the 1280-1287 area. A drop back below its 200-dma near 1274 was the first indication on Monday that the rally attempt was not going to hold. A rally back above 1275 would be a bullish statement but for now I don't believe it will get there. Two equal legs up for the bounce off yesterday's low, for an a-b-c correction to the impulsive decline from last week, would be at 1254.03. That's right on top of the 50% retracement of the decline. Tuesday's gap would also be closed 1253.96. So any bounce up to 1254 tomorrow that fails to hold will be an outstanding shorting opportunity. I'd even be tempted to put a MOAP on top of that one (which really belonged to last week's test of the broken neckline).

S&P 500, SPX, 60-min chart

The DOW's pattern is the same as SPX but the upside target area for the bounce is not quite as tight. Two equal legs up for its bounce off yesterday's low is at 11990, a little above its 200-dma at 11973 and just below round-number resistance at 12K. A 50% retracement of its decline is at 11957 and it would close Tuesday's gap at 11959.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 12,150
- bearish below 11,630

NDX has had a very different pattern than the others but it too looks like it completed a bounce pattern off the August and October lows. It bounced off its 200-dma yesterday and ran into resistance at its 20-dma yesterday and today (2324 today). It might get a little higher bounce tomorrow morning but as with the others I'd look to short it.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 2386
- bearish below 2287

Last week the RUT stalled at its 62% retracement of its May-October decline, at 766.63, and just shy of its 200-dma near 778. At yesterday's low it almost reached down to its 20-dma, near 708 at the time. It also stopped short of its 38% retracement of the October rally, near 705. So there were some eager bulls who wanted to buy the dip in the RUT, hoping for the outperformance in the expected year-end rally. The bulls could be right but at the moment I'm betting against them (it takes two sides to make a market).

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 760
- bearish below 712

Looking closer at the RUT's pattern, it has a setup similar to the one shown above on the SPX 60-min chart. But this one has an even nicer setup. It's almost too pretty (for a bear) and that actually worries me a bit. When the setups are obvious they're usually obviously wrong. So strongly consider that possibility if you wait for the short play to set up here. BTW, one possibility is that the bounce has finished and we will not get an extra pop higher tomorrow to complete the setup shown below. That's because the 2nd leg of the bounce off yesterday's low met the minimum requirement by achieving 62% of the 1st leg up at 732.96 (the late-day high was 733.56). But if the market can push a little higher tomorrow, two equal legs up is at 740.77. A 50% retracement of the decline is at 740.94. Tuesday's gap fill would be at 740.84. A retest of its broken uptrend line from October 4th is near the same 740.80 area in the first hour of trading. Tight correlation like that is not common and when it is you need to pay attention -- it will be either the best shorting opportunity you're likely to see or else it will blow up in the bears' faces. But if 741 holds and price starts to roll over, short it and use a stop just above the bounce high.

Russell-2000, RUT, 30-min chart

As pointed out last week, the banking index, BIX, was heading for its downtrend line from February and would likely have trouble with it at least on the first test. It had big trouble with it and broke down from a potential rising wedge pattern this week. If the rising wedge is the correct interpretation, it will get retraced quickly as the BIX heads for new lows. Stay away from the banks (I use them for a market proxy -- follow the money -- only).

Last week I thought the TRAN might be able to make it up to just above 5000 so that it could test both its 200-dma and June low. It did that the next day on Thursday but this week retraced the euphoric rally off Wednesday low. As with the broader market the TRAN now looks lower, even if it's to be just a deeper pullback before heading higher again in December.

Transportation Index, TRAN, Daily chart

In a true case of follow the money, the dollar has been leading the stock market around by the ring in its nose, except that it goes in the opposite direction. When the dollar rallies, stocks fall and vice versa. It's a very tight correlation at the moment. The dollar pulled back from a very strong 2-day rally, one that completely retraced the decline from October 18th. So it's not tick for tick between the dollar and stock market since SPX would be below 1190 if it followed the same move as in the dollar. But the dollar found support in its pullback at its 50-dma and 20-dma and 50% retracement of the August-October rally. It could pull back a little further but the shape of its pullback (descending wedge) points to the possibility that it's ready to resume its rally from here, which would be immediately bearish for the stock market. So watch the dollar.

U.S. Dollar contract, DX, Daily chart

Since the euro and the dollar are counter to each other and the stock market is counter to the dollar that puts FXE (euro ETF) in synch with the stock market and is another one you could watch for direct correlation with the stock market -- use it to help see a move in the stock market as real or not. FXE left a nasty looking bearish kiss goodbye against its broken uptrend line from June 2010, which was broken in September. This is a chart only a euro bear (dollar bull) could love.

Euro currency ETF, FXE, Daily chart

Gold's bounce pattern off the September low continues to look like a correction of the August-September decline, in a bear flag pattern, but has a little more upside potential to the top of a flag pattern, currently near 1785. There is also quite a bit of price congestion in the 1770-1800 area so it's an area to watch for failure of the bounce, to be followed by another leg down. Large flag patterns like this are typically at the halfway point so the downside target will be near 1400.

Gold continuous contract, GC, Daily chart

Silver started down earlier than gold and therefore has a slightly different wave count for the move down but the flag pattern since the September low is the same and has the same message -- the decline should continue once the correction has completed. The initial downside target for silver is near 20.

Silver continuous contract, SI, Daily chart

Oil has been bumping its head against the top of a wider down-channel since October 25th and just below its 200-dma at 94.86 and 50% retracement of its May-October decline, at 94.89. The 94.86-94.89 level is going to be tough to crack, especially if the stock market will be heading lower. It would obviously be bullish above 94.90 but I think the higher-odds move will be a selloff from here.

Oil continuous contract, CL, Daily chart

Tomorrow's economic reports include the unemployment claims, the preliminary release of the Productivity and Unit Labor costs. The Fed uses these numbers as part of their model in determining whether or not higher inflation is a risk (and therefore whether additional easing policies are available). Factory orders and ISM Services will be released after the open. Depending on whether or not we've got more important news out of Europe overnight, these reports may be ignored.

Economic reports, summary and Key Trading Levels

The bulls have their work cut out for them here. Last week's highs were at very important levels and unless they're quickly recaptured we have a bearish setup in front of us. As reviewed in the first couple of charts of SPX, the analog pattern between the highs in 2000, 2007 and now 2011, and especially with the retest of the broken necklines from below, sets us up for a strong decline from here. Think about the decline in 2008 and the next one could be worse than that. We might be perched on the edge of the cliff here.

Bullish sentiment has switched rapidly to excessively bullish. I've even been surprised by a trading group that I belong to in how bullish the group has become. These are people who have traded the markets for decades and they're getting swept up in the bullishness of the market (strong market breadth, big retracement, end-of-year expectations, etc.). I could be completely wrong in doubting them but doubting them I am. I think this is a very dangerous market right here and could collapse in a few "flash" crashes. That's not a prediction but it is the risk and I implore those who feel bullish about the market to at least consider the downside risk and protect yourselves appropriately.

For those who like to play the short side, if I'm correct, you're about to have some serious fun. You do not need to play large positions and in fact you should not. This is a very volatile market and it's easy to get whipped out of trades. Play smaller and consider playing with no stops with put options. Buy plenty of time (at least 3 months out and plan on getting rid of them within a month) and a few strikes OTM. Buy only what you can afford to lose (how much would you lose on a stock trade and use that amount for a put option). As you make money on the plays you can the slowly leverage up to a larger position. That's just one idea but the bottom line is that risk management is far more important that profit objectives. You can't make a profit if you lose your trading capital.

If we get an early bounce Thursday morning look for the setups I showed on the SPX and RUT charts. If the short play sets up we can then see how it's looking next week to see if another bounce into December looks like a good possibility or if instead a stronger selloff is coming.

Good luck and I'll be back with you next Wednesday at which point we'll have a better idea about whether or not the bears are taking control again.

Key Levels for SPX:
- bullish above 1275
- bearish below 1215

Key Levels for DOW:
- bullish above 12,150
- bearish below 11,630

Key Levels for NDX:
- bullish above 2386
- bearish below 2287

Key Levels for RUT:
- bullish above 760
- bearish below 712

Keene H. Little, CMT