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Newsletter

Daily Newsletter, Wednesday, 09/20/2006

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Volatility Pause

The post Fed market showed a return of volatility but that should not surprise anyone. The Dow had reached 11628 prior to the announcement but that faded to 11581 immediately after the news broke. As post Fed volatility goes that was very tame. The Fed did not surprise anyone with their pass but according to the statement they retained their tightening bias. At this point they appear all bark and no bite after the recent housing news and drop in energy prices.

Dow Chart - Daily

Nasdaq Chart - Daily

The FOMC meeting was the big news for the day and traders pushed the indexes higher ahead of the announcement on feelings that the Fed decision was already in the bag. The positive markets also benefited from oil falling to $60 as the October crude futures expired. The Dow hit 11628 and only -52 points below its five-year high at 11670. The S&P did set a new five-year high at 1328.53 and the highest level since February 2001. The Fed did little to dampen the bull's expectations and although they changed the statement slightly it was still business as usual with signals the economy was still slowing rather than crashing. They acknowledged the economy was continuing its slow growth "partly reflecting a cooling of the housing market." They indicated they still expected inflation to moderate over time due to falling energy prices, prior rate hikes and softening demand. However, they also maintained their tightening bias saying that "some inflation risks remain."

Essentially the markets reacted to the hawkish talk rather than the Fed's dovish actions. One of their statements, "The risks continue to be weighted mainly toward ... heightened inflation pressures." That was the exact language they used back in November 2000 only seven weeks before a 50-point rate cut. The bond market is already pricing in a rate cut and several other sectors are beginning to follow suit. The Fed is using its only current weapon, the tone and structure of their statements, to keep the markets on edge. This is typical Fed tactics that has them trying to talk rates up rather than actually raising them once conditions begin to weaken. Talking the rates up keeps the bond groupies unsure of which way to play and delays corporate decisions due to uncertainty. By using this tactic at this time of the cycle normally indicates the next move will be a cut in early 2007. The Fed will not want to hike rates before the November elections to avoid any political accusations. Given the current economic conditions there are no changes in the Fed stance expected until early 2007. This suggests the Fed is really done and this should be a green light for the markets into Q4.

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The Mortgage Applications Survey this morning showed that new purchase applications fell -3.0% but refinance applications rose by +9.5%. This is a very good sign that homeowners are moving out of their broken ARMS and into new mortgages rather than sell the homes. Several mortgage bankers were interviewed on CNBC recently and all of them claimed the majority of ARM loans were made to good credits with less than a 75% loan to value. This would appear to throw cold water on the worries that adjusting ARMS would cause a catastrophic repossession wave. However, 27% of the mortgage applications reported this week and 41% of the dollar volume was new Option ARM loans. Given the likely direction of interest rates over the next two years that may not be a bad decision. Own ARMS at the top of the rate scale and fixed interest loans at the bottom. Several readers in the real estate, homebuilding sectors have emailed me that they are seeing signs of a rebound beginning. Let's hope they are right.

After the Fed meeting the yield on the ten-year note fell to an intraday low of 4.71, which was also a new five-month low. Bonds are definitely pricing in either additional economic weakness or the next Fed move will be a rate cut or both. Falling rates will help the housing sector and this is a good reason the housing sector may be starting to see a bottom form.

The markets at these levels may not be as bullish as many think. There are some problems beginning to appear in the fundamentals. For instance Think Equity reiterated their sell on Dell today. They feel Dell will prewarn in October due to falling unit sales and lower margins from the current PC price war. Because Dell is such a big factor in the sector the analysts are assuming Dell will do everything possible to keep sales from slumping. That means Dell will slash prices even further while advertising heavily. This will force companies like Hewlett Packard to cut prices to remain competitive thereby lowering their profits. The outlook for computer sales in Q3 are not good despite CDW saying their component volume was higher. The sharp rise in gas prices took a lot of money out of the pockets of consumers and high dollar tickets like computer sales are sure to have suffered. That could produce a rebound in Q4 but the critical back to school computer buying period has passed.

After the bell Silicon Labs warned that Q3 sales would be significantly below prior estimates. They are now predicting $113M to $116M compared to $122-$127 in prior estimates. Over the last week we have seen Maxim Integrated Products (MXIM), Xilinx (XLNX) and Microchip (MCHP) also warn. This has prompted the SOX to show weakness over the last couple of days and removed some support from the Nasdaq. That support was not missed given the +30 point jump today.

On the stock front Oracle jumped +1.80 or +11% after reporting strong earnings on Tuesday. Sales jumped +30% to $4.59 billion and earnings rose +29%. Oracle bought back 67 million shares in the prior quarter and said they would buyback another $1 billion in shares in each quarter of 2007. ORCL hit a new 52-week high at $18.29.

Morgan Stanley (MS) posted a +59% jump in earnings to $1.85 billion or $1.75 per share beating estimates by +37 cents. The stock jumped +$2 on the news but gave back some of its gains after posting a cautious forecast for the next quarter. However, analysts said that the recent improvement in trading conditions could negate that cautious stance.

Google continued its Yahoo related decline losing another -$6.81 to $397. After the Yahoo warning on Tuesday analysts started ticking off reasons why Google could see a slowing of revenue like Yahoo. While most believe Google is better positioned than Yahoo nobody wants to bet against an earnings warning until the smoke clears.

October Crude Futures Chart - Daily

Oil prices fell to $59.95 intraday on the expiring October contract before rebounding at the close to $60.46. Today was the final trading day for the October contract and the last chance for anyone holding longs to jump ship. Crude inventories fell by -2.8 million bbls in the report released this morning. That is the 3rd consecutive week for declines over 2 million bbls. On the surface it would appear bullish for prices for inventories to fall but it was a factor of several different things. Refinery utilization was very strong and raw crude was being turned into refined products. Secondly, the hurricanes in the Atlantic may not be threatening land but they are creating havoc with shipping. Imports have been delayed as ships slow their crossing speeds waiting for the storms to move further north. For the same three week period distillate inventories rose by an average of 4 million bbls per week. That includes heating oil and jet fuel. It is simply a matter of lowered demand after summer ended and no refinery problems.

Oil prices are expected to rebound slightly on Thursday as traders roll into the November contract at what is considered very strong support at $60. This rebound could be only temporary with the end of the quarter only 7 trading days ahead. Funds happy to show positions in energy over the last couple years may not want to show big positions after the recent drop in prices. This could cause oil and energy stocks to trade lower next week. Or, it is entirely possible that funds who missed the last rally will want to pick up a few positions at what could be seen as cheap prices.

Before anyone succumbs to the constant drivel about the end of the oil boom on stock TV and the investment press you probably should know the facts. Over the last three years oil prices have dropped -20% or more seven times. Each time it was the end of the proverbial energy boom if you listened to the press. This time around oil supplies are at highs not seen in years and +12.9% over the five-year average despite the three weeks of draws. Excess supplies were stocked in advance of the hurricane season when it was reported to be a strong one like we saw in 2005. Supplies were also hoarded on geopolitical concerns around several different events. None ever impacted supplies. Events never came to pass and now all those supplies have to be burned off. It is not a problem since winter heating oil demand will take care of the excess later this year. I would just not expect any booming bull market for several months unless Chavez cuts off oil supplies to the devil as he called Bush in a UN speech today or Iran does something stupid on the nuclear front.

Tomorrow we will get the natural gas inventory numbers and another strong injection is expected of nearly 100 BCF. This would bring supply levels to something in the 3,200 BCF range and just below the all time high of 3,327 BCF hit in 2004 and just under what is seen as the maximum capacity of 3,500 BCF. We are already starting to see gas against gas competition where those with remaining storage capacity are taking gas from the lowest bidder to add to their storage. This will eventually cause a bidding war among suppliers and prices could dip below $4 per unit. Gas consumption will not rise again until cold weather begins to appear around Halloween making the next five weeks a potentially rocky road for gas prices. Since gas and oil tend to trade on a parity basis per BTU it means oil could be dragged lower over the same period. Current estimates by multiple analysts seem to be congregating in the $56-$58 range for a low if $60 does not hold. Several people have said OPEC will support $60 and we have nothing to fear. That may well be the case but if Saudi cut exports tomorrow it could take 45-60 days before the current surplus in the channel was reduced and prices firmed. I would believe we have a better chance of seeing bargain hunters support the price over the next couple of weeks than we have of seeing OPEC come to our rescue.

The Thunder Horse news barely even dented the decline in oil prices. BP said on Tuesday that its Thunder Horse platform in the Gulf would be offline until mid 2008 due to a failure in the undersea components repaired after Katrina nearly destroyed the platform. It had been expected to return to service this year. Thunder Horse produces 250,000 bpd of oil and 200 million CF of gas. Having that platform offline for an additional 18 months is a severe blow to US production but the news only caused a brief blip in prices. They claim you are only supposed to buy stock when there is blood in the streets. $60 oil could be seen as that threshold but corrections tend to take on a life of their own and it may take some time under $60 for the real buyers to appear.

We saw this week how trading in denial of the facts can be very costly. The collapse of the Amaranth hedge fund after losing $5 billion in natural gas futures is a prime example. The traders at Amaranth put on extensive positions in expectations of a rise in gas prices when inventory levels were climbing weekly to those highs I reported above. This did not happen overnight and anybody doing their homework would have seen it coming. I have been reporting for two months of the impending gas crunch and the record levels of inventories. Amaranth bet on the historical cycles and the record warm winter and lack of hurricanes nearly put them out of business. They sold their remaining energy positions to Citadel and JP Morgan today. We do not know if those positions were longs or shorts or the sales price. Since JP Morgan is their broker and responsible for their trades it could have been a leveraged position JP Morgan took to offset margin problems. Either way JP Morgan and Citadel will probably be liquidating portions to bring their risk back into balance. Their exit from the position imbalance over the last couple of weeks could have been a major driver of the decline in prices. $5 billion in natural gas positions is huge and according to reports today much of those were acquired in the OTC market rather than under the watchful eye of the CFTC. Regardless of where the positions were held or acquired when you need to dump $5 billion in the futures market you are going to make waves. The risk now and until the end of the quarter is what this will do to other hedge funds. If investors become scared of a similar event at their favorite fund there could be a run on deposits with investors placing orders to withdraw their funds. This would also pressure those currently long energy positions. Also, hedge funds may want to lighten the load ahead of the quarter end to eliminate the appearance of being too heavily invested in energy even if their investors are not placing withdrawal orders. These concerns should keep pressure on the energy sector for the next week. Even if you did not invest in Amaranth directly you may be an investor. Many mutual funds invest in hedge funds as a way to spice up normal stock returns. Even investment banks invested in Amaranth including Deutsche Bank, Goldman Sachs, Bank of New York and companies like 3M and many retirement funds. As these companies reevaluate their investment objectives and risks it could cause yet another ripple in other hedge funds like Amaranth. Nobody wants to wake up on a Monday and find out their fund lost $5 billion.

When I swapped days with Linda this week I thought I would have plenty to write about after the FOMC meeting. Instead the meeting was mostly a footnote to the day with indexes hitting new highs. My problem today is picking a market direction. If you remember my September Fed meeting table from the Sunday commentary there was a pretty strong case for a normal September decline to begin within 3 days of the meeting. Nothing has changed in our chances even with the S&P at new highs. That high was 1328.53 but the close was right back at very strong resistance at 1325. This is a critical inflection point just like 1290 was on the downside. Above this level we could see massive short covering and a fair amount of buy stops. A failure at this level could begin a September decline that could take us back to 1290 or maybe as low as 1265.

The market outlook is bright given the Fed pass, probably for the rest of the year, and a slowing but not crashing economy. Money coming out of energy stocks is flowing into techs, drugs and healthcare. Mortgage rates are falling and gasoline is under $2.50 in some states. It appears to be a perfect scenario for a year-end rally. The only problem is the normally weak Sept/Oct period just ahead. I visualize a wagon train on a plateau overlooking the promised land on the far horizon. Unfortunately there is a large Indian village in the valley below between them and the land they seek. Can they sneak around the village quietly and hope they are not noticed or do they just race down the hill with guns blazing in hopes of breaking through before the Indians can mount a credible attack?

I relate this to the market like this. We are at a plateau at S&P 1325 after fighting our way across a wasteland that stretched from May 10th until now. Just when victory appears to be in our grasp there is one more hurdle to cross. I have spoken recently of the lack of conviction by the bulls. Despite today's rally it was it was less than convincing. The broader averages of the Russell, NYSE Composite and Wilshire 5000 are still struggling with resistance although the charts are improving. On the flipside the bears are not showing any conviction either. They can't seem to mount a credible sell off despite being at resistance highs. Will the buyers charge out of the gate tomorrow morning with guns blazing hoping to rout the bears waiting at 1325? Or will the bulls be content to hold the high ground and take a few round of incoming fire while they wait for the October earnings cycle to give them conviction? What is an investor to do with these circumstances ahead of a normally weak calendar period?

SPX Chart - Daily

SPX Chart - 30 min

We need to let the market tell us what to do next and not rely on our biases. I personally want to short 1325 but that may be the wrong decision based entirely on prior years of historical data. It is simply very hard for me to ignore the potential for an end of quarter dip. On the other hand the indexes continue to creep higher even without conviction and I would hate to miss a breakout over 1325. It could be powerful if the dominoes fall correctly. We have been using 1290 as our long/short indicator for several weeks with great success. I believe it is time to change. Since 1325 is so critical we will use it as our pivot point but hedge it slightly given the close at 1325 today. I am going to suggest a range of 1315-1330 as our key. If you are not already long tonight I would look to go long over 1330. That is well above the 1325 congestion range and would indicate a breakout in progress. I would buy a dip to 1315 but change to a short/flat bias under 1315. That gives us a neutral zone of sorts and a clear game plan for the next couple of weeks. Odds are good we are NOT going to just hold at 1325. We should either breakout or breakdown and either move could be strong. It would be hard to go wrong with a DJX spread of the 116 put and 117 call for a net cost of $2.20 using the October options. By expiration Friday on October 20th the odds are very good one of those options will be well into the money. Once a direction appears close the side that is out of play and ride the other until the trend changes. As always keep your eye on he charts and not on the market chatter.
 


New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
None None None

New Calls

None today.
 

New Puts

None today.
 

New Strangles

None today.
 


Play Updates

In Play Updates and Reviews

Call Updates

Beazer Homes - BZH - close: 39.65 change: -0.24 stop: 38.49*new*

Homebuilders, as a sector, continued to under perform. The DJUSHB index lost 1.1% today. Shares of BZH performed a little better with a 0.6% loss on declining volume. It looks like BZH wants to move higher and is resisting attempts at profit taking but if shares don't follow through higher soon the stock might see a retest of its lows. Some of the short-term technical indicators are starting to turn over into bearish signals. We would wait for another move over $40.50 or $41.00 before considering new call positions (remember, we said "over" these levels. BZH actually hit $40.50 today on an intraday spike). Our target is the $46-47 range. We do not want to hold over the November earnings report. Please note that we're raising the stop loss to $38.49.

Picked on September 18 at $ 40.75
Change since picked: - 1.10
Earnings Date 11/02/06 (unconfirmed)
Average Daily Volume = 1.2 million

---

Cymer Inc. - CYMI - close: 43.84 chg: +0.53 stop: 41.95

Tech stocks led the way higher on Wednesday with software rushing to the lead on ORCL's positive earnings news. The semiconductor stocks were the worst performing tech sector with a +0.39% gain (SOX). Shares of CYMI managed to out perform its peers (+1.22% today) but CYMI remains under resistance at its 100-dma and the $45.00 level. We're not suggesting new plays at this time. Our target is the $47-48 range.

Picked on September 06 at $ 42.55
Change since picked: + 1.29
Earnings Date 10/24/06 (unconfirmed)
Average Daily Volume = 1.0 million

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Hartford Finc. - HIG - close: 86.85 chg: +1.07 stop: 84.45 *new*

Today's rally in HIG, following yesterday's intraday reversal higher, looks like a new entry point to buy calls. We're going to raise our stop loss to $84.45. Our target is unchanged in the $91.50-92.00 range. We do expect some resistance in the $89-90 region. We do not want to hold over the early November earnings report.

Picked on September 12 at $ 86.29
Change since picked: + 0.56
Earnings Date 11/02/06 (unconfirmed)
Average Daily Volume = 1.4 million

---

Manpower - MAN - close: 60.79 chg: +0.51 stop: 58.99 *new*

Yesterday's intraday bullish bounce higher in MAN saw some follow through this morning. Yet the rally ran out of steam under the stock's 100-dma. This is not a good sign when you consider the S&P is hitting new five-year highs. We are raising our stop loss to $58.99, which is under the simple 50-dma. Readers can watch for another bounce from the $60 region as a potential entry point but enter new positions cautiously.

Picked on September 12 at $ 60.28
Change since picked: + 0.51
Earnings Date 10/18/06 (unconfirmed)
Average Daily Volume = 900 thousand

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Mettler Toledo - MTD - close: 64.50 chg: -0.57 stop: 61.99 *new*

It's decision time for some of our readers. Today's action in MTD is bearish. The stock has produced another failed rally in the $65.00-65.60 region. We expect that shares will pull back toward broken resistance and what should be new support in the $62.00-62.50 region. Our more conservative traders may want to exit early right here to avoid or minimize any losses. You can always jump back in if there is a bounce from the $62.50 level. We are not abandoning the play just yet but we are raising the stop loss to $61.99. Our target is the $68.00-69.00 range. Please note that we normally try to avoid playing stocks with average volume this low so traders may want to consider this a higher-risk play. We do not want to hold over the late October earnings report.

Picked on September 13 at $ 63.66
Change since picked: + 0.84
Earnings Date 10/26/06 (unconfirmed)
Average Daily Volume = 169 thousand

---

Omnicom - OMC - close: 91.28 chg: +0.40 stop: 89.75

We remain somewhat cautious on OMC. The stock did bounce today but the rally stalled out at its 10-dma, now acting as short-term resistance, directly overhead. We don't see any other changes and we're hesitant to suggest new plays at this time.

Picked on September 10 at $ 90.97
Change since picked: + 0.31
Earnings Date 10/24/06 (unconfirmed)
Average Daily Volume = 1.1 million

---

United Ind. - UIC - close: 54.61 change: +1.01 stop: 51.77

Defense-related stocks took advantage of the market's rally. The DFI index added 1.2% and closed near its highs for the session and appears to be breaking out higher from its recent trading range. Shares of UIC, which had fallen unexpectedly yesterday, managed a bounce (+1.88%) but volume continues to come in low. We are not suggesting new positions at this time.

Picked on August 27 at $ 51.77
Change since picked: + 1.83
Earnings Date 08/01/06 (confirmed)
Average Daily Volume = 198 thousand
 

Put Updates

Caterpillar - CAT - close: 65.88 chg: -0.68 stop: 67.36

Isn't it interesting that the DJIA is trading near new multi-year highs and the S&P 500 is trading at new five-year highs but shares of CAT are slipping lower. There was no participation in the market's rally today, which is definitely a sign of relative weakness in CAT. We are still waiting for a breakdown under $65.00 to open the play. Our suggested entry point is a trigger at $64.59. The P&F chart points to a $48 target. If triggered our short-term target is the $60.25-60.00 range.

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/20/06 (unconfirmed)
Average Daily Volume = 5.2 million

---

EOG Resources - EOG - close: 60.99 chg: -0.91 stop: 64.15

Volume on EOG's sell-off is creeping higher. The stock lost another 1.4% following a 2% drop in crude oil, which was on top of yesterday's 3.3% decline in oil futures. We are not suggesting new positions at this time. We still see the biggest risk here as the Iran-vs.-West conflict over its nuclear program. Our target for EOG is the $57.50-55.00 range. The P&F chart points to a $48 target.

Picked on September 06 at $ 63.85
Change since picked: - 2.86
Earnings Date 10/31/06 (unconfirmed)
Average Daily Volume = 3.3 million

---

Express Scripts - ESRX - close: 83.94 chg: +1.17 stop: 82.51

There is no change from our weekend update on ESRX. We are still sitting on the sidelines waiting for a breakout in ESRX. The stock has been trading sideways in the $80-85 range for six weeks. Taking into account that the next four weeks are usually a very bearish time period for stocks odds are definitely growing in favor of a breakdown. We're suggesting a trigger to buy puts at $79.85. If triggered our target is the $75.50-75.00 range.

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/25/06 (unconfirmed)
Average Daily Volume = 1.6 million

---

Johnson Controls - JCI - close: 71.31 chg: +0.33 stop: 74.16

A relatively widespread rally in the market today helped JCI bounce for a 0.4% gain. We are not suggesting new positions at this time. More conservative traders may want to adjust their stop toward last week's high (73.60). More aggressive traders may want to keep their stop above $75.00 or the 50-dma (near 74.42). Our target remains the $68.50-67.50 range. The P&F chart is more bearish with a $56 target.

Picked on August 22 at $ 72.96
Change since picked: - 1.65
Earnings Date 10/19/06 (unconfirmed)
Average Daily Volume = 1.3 million

---

Jacobs Engineering - JEC - cls: 75.54 chg: -1.76 stop: 80.15 *new*

There was no slow down in JEC's sell-off on Wednesday. The stock lost another 2.2% on strong volume marking its fifth decline in a row. The lack of participation in the market's rally is definitely bearish. We're lowering our stop loss to $80.15. More conservative traders may want to lock in some profits right here since JEC might try and bounce from round-number, psychological support at the $75.00 level. This would not be a good spot to consider new plays. JEC is starting to look a little oversold and due for a dip. Our target is the $72.50-70.00 range.

Picked on September 18 at $ 79.45
Change since picked: - 3.91
Earnings Date 11/02/06 (unconfirmed)
Average Daily Volume = 416 thousand

---

Joy Global - JOYG - close: 34.81 change: -2.08 stop: 37.51

Look out below! JOYG failed to join the major market indices and their rally higher today. Instead the stock produced a failed rally at the $38 level this morning and plunged through support at $36.00 and the $35.00 levels. It was our suggested trigger to buy puts at $34.95 so the play is now open. Our target is the $30.50-30.00 range.

Picked on September 20 at $ 34.95
Change since picked: - 0.14
Earnings Date 11/30/06 (unconfirmed)
Average Daily Volume = 2.6 million

---

Las Vegas Sands - LVS - close: 65.26 change: -0.35 stop: 70.05

LVS is still under performing the broader market. The stock lost another 0.5% today after its morning bounce failed. We don't see any changes from our previous updates. Our target is the $60.50-60.00 range. We do not want to hold over the early November earnings report.

Picked on September 19 at $ 65.99
Change since picked: - 0.73
Earnings Date 11/01/06 (unconfirmed)
Average Daily Volume = 2.2 million

---

Nucor - NUE - close: 48.74 change: +0.60 stop: 50.01

The major indices may have been hitting new relative highs but that failed to help NUE breakout over resistance in the $49.50-50.00 region. We are still waiting for a breakdown under support near $46.00. Our suggested trigger to buy puts is at $45.95. If triggered our target is the $40.50-40.00 range. The P&F chart has a relatively new triple-bottom breakdown sell signal with a $41 target. We do not want to hold over the mid October earnings report.

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/19/06 (unconfirmed)
Average Daily Volume = 4.2 million

---

Steel Dynamics - STLD - close: 51.46 chg: -0.36 stop: 52.05

STLD under performed the S&P 500 on Wednesday and continues to edge lower following Monday's failed rally. We're still on the sidelines waiting for a bearish breakdown under support. Our suggested entry point to buy puts is at $49.40. If triggered our target is the $45.15-45.00 range. We do not want to hold over the mid October earnings report.

Picked on September xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/19/06 (unconfirmed)
Average Daily Volume = 1.5 million
 

Strangle Updates

None
 

Dropped Calls

None
 

Dropped Puts

None
 

Dropped Strangles

None
 


Trader's Corner

Five Chart Patterns to Pay Attention To

I received a SUBSCRIBER E-MAIL by way of a follow up question on my Trader's Corner musings of last week about the Head & Shoulder's (H&S) bottom price pattern that had been traced out in the S&P and Dow Indices. This article is found in your 9/13 saved Option Investor Daily e-mail (you do save them!?) or can be seen online by clicking here.

I've been talking about the 'minimum' upside objectives implied by the H&S bottom for some time in my weekend online Index Trader column and lo and behold the OEX hit that target (612) today. And, speaking of 'lo', Dr. Andrew Lo of MIT did some sampling and testing work to see what technical patterns, if any, had a significant predictive value. He and his colleagues found 5 actually worthy of following up on based on having statistical significance. And, that was the Subscriber question: what are the other 4 patterns that have shown to have a predictive outcome well above a chance or a random result?

The 5 chart patterns worth following once they form are:
1. The Head & Shoulder's (their conclusion was on the H&S TOP pattern, as the H&S bottom doesn't act quite as reliably, although its quite good)
2. The Double Top
3. The 'rectangle' top
4. The 'rectangle' bottom
5. The 'broadening' formation

THE HEAD & SHOULDER'S
The Head & Shoulder's (H&S) bottom is sometimes called the 'inverse H&S', as it's the reverse pattern to the three top pattern of the H&S Top. The H&S bottom pattern consists of a low (left shoulder), a lower and final low (the 'Head') and a secondary low that's in the area of the FIRST low. The measurement for a 'minimum' objective is the distance from the lowest low up to the 'neckline' added to the 'breakout' point. The distance traveled can be of course MORE THAN the minimum objective. The distance traveled after the breakout above the downward sloping neckline can be LESS than the measured objective also of course, but this is less common than the objective at least being achieved or exceeded.

The foregoing description is demonstrated by the markings on the S&P 100 (OEX) chart below:

Often in a prolonged and powerful advancing wave or movement like this, the market may be 'climbing a wall of worry'. Factors exist that keep investors and traders from getting bullish in the extreme and this is seen in my 'sentiment' indicator above; i.e., the lowermost chart of the CBOE Equities Call to Put ratio.

OTHER INDEXES AND OTHER PATTERNS:

The S&P 500 (SPX) chart next will show both the possible H&S bottom minimum upside target AND the possibility that this could be a DOUBLE TOP, which is #2 of the top-5 most reliable chart patterns suggested by Dr. Lo's study:

A 100% retracement of a prior price swing, that doesn't continue on in the same direction but instead reverses direction is a double top, or double bottom, chart pattern.

In the case of SPX below there exists the possibility that a double top could be setting up. Trader's are aware of this of course and may well sell into the prior top area. With a possible double top, it's necessary to not jump to conclusions too fast, as it can take a few days (or weeks, in the case of the weekly chart) before it becomes clear as to whether there will 1. just be a shallow pullback, then a push to a NEW high or 2. a sharp reversal and/or significant retracement of the prior/recent price swing.

Sometimes traders, myself included, especially when this pattern presents itself ALONG WITH an 'overbought' extreme such as seen below with the 13-day RSI, will make a trade based on an 'assumed top', which is to assume that a top has been made and take out puts with a 'tight' stop just over the most recent price peak. If the trade works out, if the stock or index HAS formed a double top (or double bottom) the risk (to just over the prior high) is quite SMALL relative to the 'reward' potential of even a nominal retracement of the prior advance; e.g., 33-40%.


GOLD BUGS BEWARE:

Regarding Head and Shoulder's top patterns, there is major one that has formed in the Philly Gold and Silver stock Index (XAU) on a weekly chart basis. You see this chart below, shown as a weekly line (close-only) chart. You'll note that the top forming the 'right shoulder' (RS) doesn't have the simple one peak look of the left shoulder (LS).

This is fairly common and simply makes this last and final top of the variety that's sometimes called 'complex' as in a complex right or left shoulder. The idea is the same however; i.e., the second peak (RS) is in the approximate same area as the first top (LS) and can't get to a higher high. After this kind of pattern, the next move is usually down, sometimes piercing the upward sloping 'neckline' of the H&S top pattern. A measuring rule of thumb is suggested here, which is for an eventual 'minimum' target on the downside, to around 100. Stay tuned on this outcome. Those gold bugs don't give up easily these days!


RECTANGLE TOPS AND BOTTOMS:

These two patterns are #3 & #4 of the top-5 predictive chart patterns according to this one (M.I.T.) study.

The next chart of the S&P 100 or OEX during late-2003/early-2004 outlines what is not the most classic rectangle bottom, which usually has 3 or more tops and 3 or more bottoms in the same approximate area. However, in the example below, the 3rd top and 3rd bottom were experiencing 'compression' as the price range narrowed in.

The time span is typical for a rectangle top or bottom: 6 months or more in the case of a daily/weekly chart time frame. There is a very low 'failure' rate to this pattern when prices break out to the upside. The average rise after prices pierce the upper line is around 46%, with the most likely rise to be 20%. The 'classic' price target, once the upper line of the rectangle is pierced is for a move EQUAL to the price distance between the upper and lower lines of the rectangle.

The 588 eventual upside objective, implied by the 'classic' measurement of a move equal to the height of the rectangle once prices broke ABOVE the top of the pattern, was of course eventually met but not until this year.

THE RECTANGLE TOP
This is the reverse of what you see above, with a final rally hitting a top, followed by a decline, then another top in the same area (a 'double top'), another bottom in the same area as the low end of the first pullback and so on. Eventually, there is a breakdown BELOW the lower end of the rectangle top, followed by a new down 'leg'.

I'll show this pattern in my next week's Trader's Corner along with the more elusive 'broadening' formation, #5 in the top-5 chart patterns destined for trading success. And on that note, wishing you GOOD TRADING SUCCESS in the meantime!

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for answer in Trader's Corner articles to Contact Support with 'Leigh Stevens' in the Subject line.
 

Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Leigh Stevens, and all other plays and content by the Option Investor staff.

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