Market Stats

The rally from November, and especially from December, has many (if not most) proclaiming we're in a new bull market. They base this of course on the stock market and its rally. There are many indicators showing price is not matched by strength indicators, which is at least a caution flag at the moment. Earnings do not support a stock market rally. Slowing economies, including China and Europe, do not support a stock market rally. So why is it rallying so strong? This is what has many, bulls and bears alike, wondering what's going on.

Because most of the rally since December has occurred in the overnight futures it may have been more short covering than actual buying and that would leave a big air pocket beneath us. There's been a lot of speculation as to why the market has rallied in the face of weakening momentum and such low volume. Many credit the liquidity push by the central banks, with much of the European money making it into the stock market and much of that going into the relative safety of U.S. stocks and bonds. With an election year in the U.S. it has many believing the Fed will continue to pump money into the economy (and stock market) until the November election and then worry about draining liquidity after the election. The theory is that Bernanke and his cohorts, not to mention a slew of politicians, would like to keep their jobs and creating more money is the way to do it, inflation be damned.

While I do not doubt the validity of newly created money making its way into the stock market I think the rally in the last couple of months could be more a result of large institutions covering their hedge short positions, which would explain the overnight rallies in the futures, creating the morning gaps. Other than those gaps there hasn't been much for the bulls to crow about. And that's what makes the market vulnerable to a disconnect to the downside.

To understand what might be happening, we need to understand that the major industrialized nations continue to go through a deleveraging process, which follows a huge increase in a credit-based economy that peaked in the mid 2000's. If the central banks could stop this deleveraging process (and it is a process that will take many more years) we would not have had the credit freeze and market crash like we did in 2008. It will likely happen again and I think it will be within the first half of this year. It will be part of the process of showing the Fed's impotence (which is part of a bear market cycle where the trusted institutions, such as governments and central banks, lose the faith of their supporters).

Part of what caused the credit freeze is that the banks themselves did not have enough cash. This is of course what the Fed and other central banks are trying to rectify right now with all their money printing. But the banks are so highly leveraged (30:1 and more) with very weak asset prices (which they're carrying on their books at make-t0-believe values) and any demands for cash combined with a further drop in the value of their assets will create a situation where the banks are going to again have to sell a lot of those assets at deflated values, which will include more of their stock (at lower prices). When leveraged 30:1 it only requires about a 3% drop in the value of their assets to wipe them out. This is basically what happened in 2008 and the Fed doesn't have the power to stop it from happening. They simply can't produce enough money to overwhelm the credit destruction. History is quite clear here -- never before, not once, has a country inflated it's way out of over indebtedness.

One way the banks control their risk is to hedge their assets with short positions, usually in the futures market. So what happens when customers (retail, business or other banks) need to withdraw large sums of money? To come up with the cash the bank has to sell assets and if they no longer have an asset then they no longer need a hedge on it. Covering the short futures position creates buying demand and that could be a lot of what we're seeing in the overnight equities futures -- a gap up in the morning but no follow-through buying, hence the stair-step move higher that we're seeing.

In theory a run on the banks could result in a stock market rally, but only if the banks were the only ones selling and covering their short positions. I think the larger picture says asset sales would be joined by other people and institutions and could result in a self-reinforcing cycle. But the point is the current stock market rally could be more a result of what the banks are doing and not necessarily from the helping hand of the Fed under the market. It's certainly a different time and it makes it that much more difficult to figure out what's happening.

Clearly the market has become very overbought and bullish sentiment, by various measures, is extreme. We're seeing long-term bears throwing in the towel and big money saying they're jumping in long with an expectation for higher prices. Todd Harrison at Minyanville wrote an interesting piece this morning about many "smart" investors declaring now is the time to get fully invested in the stock market. Even "Dr. Doom" Roubini himself announced it's time to give up being a bear and get bullish (I can't help but wonder what he might really be up to).

But as Harrison correctly noted, many of the big names in money management were declaring it was time to bail in December. Looking at a chart of the stock market since the December 19th low one could say "smart" money made a bad call then and it's therefore questionable how smart their call now is to get 100% invested, which is what Blackrock's CEO Larry Fink is now recommending. The moniker "smart money" might not be accurate to use anymore. Or are they in fact pretty smart with these calls?

Bullish sentiment is through the roof and by most measurements, such as bullish percentages and numbers of stocks above their 50-dma (at levels of previous major market highs), we have a market that is much closer to an important top than a bottom. So the timing of the calls by "smart" money seems questionable. It would be purely guesswork on my part but some of these large money managers might have an agenda to get people to help them at market turns. If smart money can get the retail crowd to sell at the bottom, with big money buying it from them at low prices, it works to panic out the retail traders ("sell everything NOW!"). Then at the top when most are feeling bullish, smart money declares it's the best time to buy for a further rally. The retail crowd then buys the inventory from the smart money managers at top prices. Hmm, smart money indeed.

Now I know I'm just being cynical (wink) because I know we have smart money managers who are only looking out for the best interests of the public when they announce their predictions on CNBC so I'm sure my guessing is completely wrong. There's a reason why I tell traders to stop listening to CNBC. You will be wrong at the turns by listening to them and based on this theory, the calls to buy here is your signal to do exactly the opposite.

By the way, one smart market analyst, John Hussman, predicts a 25% market decline this year as the economy slips into a recession. That would drop the S&P 500 from 1350 down to about 1010, which was the June 2010 low. In an article in moneynews.com, author Forrest Jones did a good job summarizing Hussman's opinion about the market, why analysts miss the turns (like the retail crowd) and how a decline in spending (the American public is not in the mood for more government spending) will "help" the economy into a recession. As for his prediction for a 25% decline, I'll show a similar projection with the kind of pattern that I think is playing out.

Moving to the charts, my best guess on the wave pattern for the major indexes is a big A-B-C pullback pattern from the July highs (which will be part of a larger corrective pattern for a decline over the next 18 months or so). The current rally has pushed above the July highs but in what's called an expanded flat correction this is what is typically seen. It's one reason why people get so bullish during the b-wave correction that makes a new high but then get scared out of their positions in the next leg down, the c-wave, which is typically very strong and nearly straight down. The c-wave typically projects to 162% of the a-wave and I'll show those projections on the weekly charts reviewed tonight.

Starting with the DOW's weekly chart, an a-b-c decline from May to August (for wave A), has been followed by a double zigzag bounce (two a-b-c's separated by an x-wave, and labeled w-x-y) to the current high in wave B. Two equal legs up for the two a-b-c moves (waves w and y) that make up wave-B is at 12912, which crosses the broken uptrend line from July 2009 through the August 2011 low this week. It makes for a very good setup to complete the rally and start back down. A 162% projection for the c-wave down is to about 9200, although I'm showing a decline to the 50% retracement of the 2009-2011 rally at 9673, which would also be a test of the June 2010 low.

Dow Industrials, INDU, Weekly chart

The DOW's daily chart below shows how it has reacted to the broken uptrend line when tested on January 26th and again last Friday and this week. The May 2011 high at 12876 is of course resistance as well and the 12912 projection is only 9 points above Tuesday's high. As noted on the chart, the new highs are showing bearish divergence on MACD while RSI has reached a level not seen since the May 2011 high. That's not a good combination for those being enticed to buy into this rally here.

Dow Industrials, INDU, Daily chart

Key Levels for SPX:
- bullish above 12,912
- bearish below 12,500

On the SPX daily chart below I'm showing a tight parallel up-channel for the rally from late December that's inside a rising wedge pattern, the top of which is the trend line from the December 5th high. Since last Friday SPX has been pressed up to the top of its parallel up-channel and its rising wedge. If the bulls can at least keep the bears at buy (with a continuation of the dip buying), there is obviously upside potential to the May high near 1370. It takes a break below 1300 to confirm the high is likely in place.

S&P 500, SPX, Daily chart

Key Levels for DOW:
- bullish above 1353
- bearish below 1300

Looking closer at the leg up from the end of January, I've outlined in bold a smaller rising wedge pattern within the larger one shown on the daily chart above. Based on the wave relationships in the move up from January 30th there are two price projections, at 1350.61 and 1351.60, which I've been watching for a possible high. Today's high at 1351 is "there." A drop from here tomorrow that breaks this morning's low near 1342 would indicate the high is probably in. If it pushes a little higher Thursday morning watch for a test of the top of the rising wedge near 1353. If it can push higher than 1353 it could head for the next price projection near 1360.

S&P 500, SPX, 30-min chart

There's another reason why SPX 1353 could be an important level to watch. The October low was near 1075 and two circles around on the Sof9 chart (720 degrees) is 1353 and it therefore "vibrates" off 1075, which is interesting since it could encompass the entire correction to last year's decline.

Gann Square of Nine chart (lower section)

A look at the weekly charts for the two tech indexes shows us an interesting setup here this week. It's a setup for a reversal but the bears are going to have to jump on it. Starting with the Nasdaq, there is an uptrend line from March 2009 through its July 2010 low that is potentially important here. That uptrend line was broken last August and tested at the October 27th high. It reacted from that touch as if it tested an electric fence. Now it's back for another test and obviously higher up. So far it hasn't had the same bearish reaction but with the market being so overbought and with the bearish divergence on RSI I'm thinking the bears could have a golden opportunity here. The 162% projection for the c-wave in the A-B-C pullback pattern from July points to a strong decline to the June 2010 low, near 2060.

Nasdaq, COMPQ, Weekly chart

The weekly chart of the NDX shows two price projections that are of interest. The first is a projection to 2528.31 for two equal legs up from its August low (wave-w equal to wave-y). That level was achieved last Friday. The 2nd projection is a 127% extension of the July-August decline, at 2547.32, and is a common reversal Fib level when it's the b-wave of an expanded flat correction. When the b-wave (the move up from August) extends beyond the start of the a-wave (the July-August leg down) it tends to get most feeling very bullish because of the new high. But then the c-wave (the next wave down) creates a bull trap and the frantic selling from the disappointment creates the strong c-wave down. A 162% of the a-wave gives us a downside projection near 1900 assuming it will start down from near here. That downside projection lands on top of the 38% retracement of the 2009-2011 rally (and would likely be a test of the 200-week MA). The only thing the bears need is for the market to start back down.

Nasdaq-100, NDX, Weekly chart

Key Levels for NDX:
- bullish above 2550
- bearish below 2500

The RUT has pushed up to its broken uptrend line from 2009-2010 and is just shy of a price projection at 833.91 where it has two equal legs up from October (last Friday's high was 833.02 and it has not been able to exceed that, showing weakness relative to the others and possibly our canary in the coal mine). Of all the indices this one could still easily be considered as having a 1st wave down last year and a 2nd wave correction for the October-February rally. But whether it's a c-wave or a 3rd wave move down from here, both point to strong selling that should easily break below the October low. Caveat emptor.

Russell-2000, RUT, Weekly chart

Key Levels for RUT:
- bullish above 834
- bearish below 800

The banks have been the beneficiaries of the hype and hope that Greece will get its next bailout and avoid bankruptcy (at least for now). With that being priced in, and with BKX pushed up against resistance, I can't help but wonder if the next word we hear is a failure to reach an agreement with Greece. Technical setups for a reversal in the market are usually just waiting for a catalyst to set off the reaction. BKX has nuzzled up to its broken neckline along the lows from November-December 2009 and August-September 2010, which was broken in August 2011. This is the first time it's been back up for a test of the line and has been stalled at it since Friday. Today it hit the projection at 45.27 (with a high of 45.28) where the 5th wave of the move up from November is 62% of the 1st wave. It's a very good setup for a reversal back down from here. Now waiting for the catalyst.

KBW Bank index, BKX, Daily chart

Like the RUT, the TRAN is starting to show some relative weakness and that could be a heads up. Today it closed slightly below its uptrend line from October but found support at its 20-dma at 5277. A break of that level on a closing basis would be the first intermediate sell signal. This follows a near hit on its price projection for two equal legs up from August (wave-w = wave-y)

Transportation Index, TRAN, Daily chart

The dollar's decline from January 13th has been supportive of the stock market rally but it might be close to finishing its pullback if the larger pattern is still bullish. After breaking its down-channel form January 13th, it has pulled back for a back test of its downtrend line. With today's low at 78.51 it also came within 6 cents of hitting a 50% retracement of its October-January rally. That could be setting up the next rally leg, which should be a strong one if the larger bullish pattern is correct.

U.S. Dollar contract, DX, Daily chart

As the dollar prepares to rally (maybe) it's looking like gold could be ready to start its next leg down. Last week it had bounced up to its broken uptrend line from October 2008 and this week it looks like it's trying for another test but so far it's a lower high following Friday's and Monday's decline. A break below 1712 would indicate the probable start of the next leg down, which should quickly break below the December low near 1524 (1400 downside target for now). Notice the heads up for gold bears with the break of the uptrend line on RSI. A break above 1770 and holding above its broken uptrend line would be bullish.

Gold continuous contract, GC, Daily chart

Silver has been struggling with its broken uptrend line from October. A rally above the 50% retracement of its August-December decline, at 35.21, and its 200-dma, at 35.36, would be bullish. Otherwise it too is looking like a setup to start its next leg down, and should decline well below its December low.

Silver continuous contract, SI, Daily chart

Oil's pattern remains a mess and I could argue for either direction from here. Flip a coin. While I show a decline from here, after back testing its broken uptrend line from December, which is based on a dollar rally setting up (potentially), I can see a strong possibility for another leg up to at least 105 before topping out (based on the choppy pullback pattern from January 5th. A drop below its 200-dma at 94.77 would be a bearish heads up and below its December low at 92.50 would confirm the top is already in place. A drop below the October low near 75 would then be the likely move. Keep in mind that oil tends to trade the same direction as the stock market, regardless of underlying funnymentals.

Oil continuous contract, CL, Daily chart

It's been a quiet week for economic reports and that continues for the rest of the week.

Economic reports, summary and Key Trading Levels

A review of major stocks and indexes shows prices pushed up into significant resistance. At a time when the market is overbought, overloved and with waning momentum (and low volume) and bullish indicators at extremes not seen since May 2011 and October 2007, I think it's a time for extreme caution by the bulls. Let the rest of the retail crowd take the inventory off the hands of "smart" money. From here I'd rather miss additional upside opportunity and be safely in cash. We might not be far from getting some sell signals and getting short could pay off nicely. Just expect spikes back up to knock the bears back and make it difficult to play the short side. Big money wants the market to themselves and wants retail traders out of the way. Even the government players are going to want to frustrate the bears and keep them away from the market.

I'll finish with one last chart of the VIX to show it's could be very close (one day) from breaking out of its descending wedge pattern. One down day could do it and a buy signal on this would of course be a sell signal for the stock market.

Volatility index, VIX, Daily chart

The market could certainly continue to levitate higher, even if it's only 10 points on the DOW each day (for the headlines -- "DOW" to new multi-year high!"). But the longer this remains propped up on a lack of fundamentals, especially if it's a result of more short covering than anything else (as discussed at the beginning of this report), the more at risk the market is for a sudden disconnect to the downside. A quick drop back down to the December low would mean more than 1100 points off the DOW before the bulls know what hit them, all the while holding on because they just know the market will come back.

Good luck and I'll be back with you next Wednesday.

Keene H. Little, CMT

In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying