What a week! The debt wreck continued to weigh on the global markets and one analyst said the amount of risk being priced into the market was like "pricing for a financial Armageddon." The battle of Armageddon is generally seen as an end world event where the forces of good and evil come together in a final apocalyptic catastrophe. With literally no bids for most commercial paper the financial sector was completely grid locked with the major averages in free fall on Thursday. Banks had closed up shop and boarded the doors in anticipation of an impending mortgage massacre. The Fed was injecting liquidity on a daily basis but the patient had failed to revive. There were faint signs of a pulse but it was very erratic. On Friday before the open the Fed went bear hunting and cut the discount rate by -50 points to 5.75% and seemed to indicate there were more cuts to come. That perfectly timed move caught millions of shorts off guard and the Dow gapped opened with a +320 point spike. That was the 3rd largest opening gain in history following a +385 point gap on 12/3/99 and a +331 point gap on 10/28/99.
Dow Chart - Daily
Nasdaq Chart - Daily
The only economic report for the day was the first reading on Consumer Sentiment for August. The headline number fell to 83.3 from the final 90.4 in July. This initial reading was the lowest level since August of 2006 and well below the 96.9 high seen back in January. The present conditions component dropped from 104.5 to 97.7 and the expectations component fell to 74.1 from 81.5. The collapse of the mortgage market, falling house prices and constant triple digit declines in the stock market were the main concerns. The only positive was the firm labor market even though new job creation has slowed. Falling gasoline prices failed to provide any support to sentiment. It is unlikely sentiment will rebound any time soon even if the stock market posts a recovery.
The economic calendar for next week is the thinnest I have seen in months. The only two reports with any material market interest are the Chicago Fed National Activity Index (CFNAI) on Monday and the Durable Goods report on Friday. Those are not normally market movers and should not have any impact next week as long as the numbers come in even close to expectations. Traders will be entirely focused on the global markets after some massive drops last week and the anticipation of further action by the Fed.
Many analysts had been calling for the Fed to cut rates to provide support for the financial sector. Their move on Friday was not a normal rate cut and the Fed's target overnight rate is still 5.25%. This is the rate banks charge each other to borrow money. The rate they cut was the discount rate from 6.25% to 5.75%. This is the rate the Fed charges banks that borrow directly from the Fed. This is called the "discount window" where the Fed will loan on various types of collateral at a discount to face value. The discount window is normally considered the last stop on the way to the cemetery for troubled banks. It is normally used when banks can't borrow from other banks due to credit and stability concerns. It is the loan of last resort and normally a sign of weakness. The Fed took an unusual action on Friday of hosting a conference call with the major banks and telling them that using the discount window this time would not be seen as a sign of weakness. The Fed realizes the credit markets have ceased to function and are trying to jump start the lending process by providing cheap loans. By offering to be a friendly lender at a reduced rate they are expressing confidence in the system and the economy. They changed the terms for any loans to 30 days and said the loans were renewable at the option of the borrowers. The Fed said they would continue to accept a broad range of collateral including home mortgages and related assets. The Fed said the terms would remain unchanged until the Fed had determined that market liquidity had improved materially. With the discount rate still +50 points over the target Fed funds rate of 5.25% there are many analysts that expect the Fed to cut the discount rate once again to 5.25%, possibly as soon as this weekend. This kept a bottom under the market all day on Friday.
The Fed is also expected to cut its Fed Funds rate from 5.25% to 4.75% possibly as soon as the Sept-18th meeting if not before. The Fed said the economy had slowed suddenly and the risk of a recession was now their primary concern with inflation no longer a major threat. The Fed said downside risks to growth had increased "appreciably." The Fed said it was "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets." Also, "Financial market conditions have deteriorated and tighter credit conditions and increased uncertainty have the potential to restrain economic growth." The Fed funds futures are now indicating as many as four rate cuts over the next four meetings. The anticipation of some continued Fed action was a prime reason the markets failed to sell off into the close on Friday.
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It was clear the Fed went bear hunting Friday morning due to the timing of the rate cut announcement. S&P index options expire at the opening print on the S&P on OpEx Friday. Not at the close or not 30 min after the open but at the opening print for each stock in the index. If there are order imbalances as there were on Friday the opening print can be substantially higher than the prior close. By announcing the rate cut before the market opened it created serious upside pressure on that opening print and options that were in/out of the money at Thursday's close of 1414 were either seriously out of the money or seriously underwater when the S&P opened at roughly 1440 on Friday. The bears were strongly short going into Thursday's close and expected a big payday when the options settled at Friday morning's open. There were 1.2 million expiring S&P puts and only 330,000 calls. The +25 point difference between the open and the close created some serious pain and apparently the Fed planned it that way. If they were not targeting the shorts in order to relieve some selling pressure they could have announced the move 30 min after the open or at any time during the day. Instead they planned the announcement to produce maximum amount of pain for shorts and by the wording of the announcement make them think twice before loading up on shorts again. For the bulls it was perfect timing after a +340 rebound on Thursday. Shorting was heavy at the close and those shorts were nuked at the open. There were persistent rumors that some small trading firms would be forced to close because of the hit they took at the open. Uncle Ben proved he knew how to play hardball and the market wandered the rest of the day not knowing how to react.
There was a +75 point swing on the S&P from Thursday's low at 1370 to Friday's close at 1445. That is a major move in any market and that was typical for the major indexes rebounding from Thursday's low. At that low the final two indexes, Dow and S&P, finally joined their brethren in falling more than 10% since their recent highs. That is the textbook definition of a normal correction. There is always the question of not closing at that -10% level but I think everybody got the message. The Dow and S&P immediately rebounded along with the other major indexes once that -10% level was hit. The table below lists the point/percentage decline from the recent highs in each index. Note that housing and brokers have declined around 30%.
In my opinion the major drop on Thursday was caused by the redemption notices received by hedge funds on Wednesday August 15th. I wrote about this two weeks ago as a potential hazard in our immediate future. With hedge funds blowing up almost daily and many announcing redemption halts the urge to exit non-performing funds was very strong. August 15th was the notice deadline for withdrawals on Sept-30th. Reportedly the redemption requests were hitting record levels and funds were forced to sell anything with value to offset those assets they could not sell in the grid locked credit markets. That means anything with accrued profits including commodities like oil, copper, gold and stocks in those sectors. The result of everyone hitting the sell button at once was volume of nearly 12 billion shares across all markets and another new volume record. It was also a capitulation event with down volume 12:1 over up volume in the morning session. Once that -10% level was reached just before 1:PM the tide turned and buyers rushed in to snap up the bargains. The funds are not done selling but with the Fed's rate cut help we are a lot higher today than Thursday's lows. Hedge fund followers said that 60-70% of the positions targeted for liquidation had been unwound by Friday. They were also suggesting that they would not be in a hurry to close the remaining 30% or so since they have several more weeks to raise the cash. Friday's triple witching OpEx probably helped since a favorite tactic to close positions is to sell in the money covered calls with expectations of having the stock called away. For instance you could have sold the Goldman Sachs $170 August call (GPY-HN) for $10 at Friday's open. GS closed at $175 with the call premium adding another +$5 to your total sale. There were over 8,000 of those calls traded on Friday. If they are not exercised in the option lottery then that $10 premium is just extra profit when they sell the un-called stock on Monday at $175. Multiply that across thousands of hedge funds and thousands of stocks and you can see where that adds appreciably to their total returns. That makes Monday settlement day and odds are good there will be a lot of called stock hitting the market for sale. According to Merrill there were 5400 hedge funds in 2005 with assets of $625 billion. Today there are over 10,000 hedge funds with assets of $9 trillion but actual equity of only $1.7 trillion. Leverage is the name of the game and they play it well. When the music stops that is a lot of sellers hitting the market at the same time.
Another one bites the dust. First Magnus Financial Corp, the 16th largest mortgage originator in the country, closed its doors on Thursday. 5000 employees were sent home and some said a bankruptcy filing is expected. Subsidiary's Charter Funding, Great Southwest and Frost Mortgage will also likely close. First Magnus originated over $30 billion in loans in 2006.
Countrywide hopes to avoid a repeat of that scenario by being very open to the market and taking down all the credit lines it has available. On Thursday CFC exercised its $11.5 billion in open credit for operating purposes. That credit line was from a consortium of 40 banks and it was a surprise to most when they exercised the entire line all at once. Reportedly there were some hectic phone calls from banks who suddenly saw the money disappear at the same time there were bankruptcy rumors circulating about Counrtywide. That would be a bankers worse nightmare to have an unused credit line suddenly drawn down only to have the company file bankruptcy shortly thereafter.
Countrywide claims it has long-term credit lines in excess of $58 billion that will enable it to weather the storm through 2008. Moody's claims this is true with equity lines available through 2008. There are mixed views from the major brokers on Countrywide's survivability. BAC upgraded CFC to neutral while Merrill cut them to sell on their bankruptcy risk. There is some discussion on whether Countrywide can actually make it through 2008 with only $58 billion in remaining credit. They originated $36 billion in loans in July alone. In order to stretch their available funds they plan on cutting way back on the number and principal amount of loans they are going to fund. Reportedly they are only going to originate loans that fit the federal agency guidelines and can be sold to Fannie and Freddie. Those loans will only be written to excellent credits and with no funny terms. They will also not write jumbo loans. Those are loans over $417,000 and not acceptable for Fannie or Freddie. There are different views on how much that will impact their origination capability. Some analysts claim $12-$14 billion a month is not currently agency qualified paper. Other analysts said these restrictions would lower originations to less than 50% of the loan volume they have been generating. That would still equate to $20 billion a month but it will be an enormous hit to earnings. Margins will plummet and there is the possibility of major layoffs. I personally believe Countrywide will survive and eventually thrive in whatever mortgage market evolves out of this debt wreck.
Countrywide Chart - Monthly
While Countrywide changes to its new model they plan on funding most of the mortgages out of their bank, which gives them other equity options including using customer deposits and even the Fed discount window. The Countrywide bank has assets over $107B but those assets are under pressure. There has been a run on deposits this week as rumors of a Countrywide bankruptcy were discussed in the news. Countrywide issued a video statement trying to reassure customers their deposits were safe. That had little impact and customers lined up outside the branches to withdraw their funds. It was taking as much as 90 minutes per person to withdraw funds and they quoted 48 hours to process a wire transfer. It is going to be a rocky road for CFC over the next six months but eventually the credit markets will ease and lenders will go back to business as usual but that business format will likely be significantly changed.
The Fed discount rate cut was being called a Countrywide bailout in disguise. By accepting mortgage paper as collateral and changing the loan terms to renewable 30-day terms this would allow mortgage lenders to use the discount window to warehouse loans until they were eventually sold into the secondary market. While Countrywide could benefit from this in the short term the discount scenario is only a short term fix and one that could end up backfiring if the Fed changed the rules again several months down the road. Also, only a portion of Countrywide's mortgage paper would fit the Fed's strict requirements for collateral.
The biggest problem for the mortgage market remains the coming flood of ARM resets. There have been numerous sets of numbers making the rounds but I believe those put out by Gary Shilling may be the most accurate. The following table shows the number of ARM loans that will reset over the coming 16 months. The biggest portion will reset from January through June of 2008 resulting in massive additional foreclosures and additional pressure to the credit system and home prices. Once past that hurdle the housing sector could begin a slow rebound. The biggest fear today and one the Fed appears to be waking up to is the possibility of those resets pushing us into a recession. Foreclosures, lack of loans, slowing home sales and falling home prices will continue to pressure the economy for at least another year.
Mortgage Reset Table
Senators Dodd and Frank are pushing to have the portfolio caps on Fannie Mae and Freddie Mac raised by +5% each to give loan originators an outlet for their loans. These government-sponsored agencies are responsible for keeping the mortgage market healthy by providing an outlet for new loans. Many feel the new cap won't be approved because of existing problems inside these agencies. The senators want to push the approval through and worry about the continued cleanup later.
Greed is good and it is greed that will eventually rescue us from the current debt wreck. The problem today is nobody wants to buy any form of asset backed security (ABS) including RMBS, CMBS, CDO or CLO. Those are all leveraged asset backed securities of some form that began as mortgages and consumer loans. With the rating agencies backing off their original AAA ratings and defaults rising sharply nobody knows what they are really buying and how much it is really worth. So, until that problem is resolved nobody is buying anything. Some of these loan packages are selling for pennies on the dollar when they do trade because buyers view it as a crapshoot since nobody can apply a true value. Eventually the true value of the instruments will begin to appear and even the lousy ones will find buyers. If you can be reasonably assured of getting 35 cents on the dollar for a package of loans then distressed debt hedge funds will be perfectly willing to bid 25 cents and take the debt off the market. The majority of the debt will eventually return to near face value and begin trading again. Until this valuation and sorting process is completed banks and funds will be overly cautious of buying debt, any debt. Since nobody really knows who owns what, and the true value of whatever they own, the banks don't want to loan money to other banks and funds that may have millions of dollars of skeletons on their balance sheet at vastly over rated valuations. The problem will be resolved only with the passage of time and the careful revaluation of all existing asset backed securities. Once value can be determined greed will return with a rush and a buying frenzy will appear.
Techs tried to buck the trend over the last week but even Hewlett-Packard's blowout earnings on Thursday failed to really push the bar higher. HPQ reported earnings that beat the street and posted a +16% jump in revenue but the stock only gained +95 cents on Friday. They also guided significantly higher but it did not seem to help. HPQ is on track to break $100 billion in revenue for the year for the first time.
On the flip side Dell Computer finally announced the result of its year long accounting probe and admitted employees cooked the books for years to meet earnings targets. They are going to restate earnings and the amount is trivial compared to their size but it is not the end of the problem. The SEC as well as Federal prosecutors have subpoenaed records and will be making life miserable for Dell. The company warned on Friday that earnings were going to suffer due to the restatements but investors bought the stock hoping the end was in sight. Dell rose +39 cents.
Financials helped lead the rebound on Thursday with some of the majors seeing percentage swings for the week in excess of 20%. This is huge volatility as investors ran from the banks only to see new buyers jump into the void they left. CFC saw a 27% swing from low to high for the week. Bear Stearns swung 24%, WM 24%, LEH (the firm with the most subprime exposure) 23% and FNM 17%. For example BSC hit a low of $101.25 on Thursday and a high of $125.45 on Friday. That was the second $25 swing in the last two-weeks.
BSC Chart - Daily
September Crude Oil Chart - Daily
Oil stocks bounced sharply on Thursday afternoon and Friday after crude fell from Wednesday's high of $74.23 to hit $70.10 on Thursday only to rebound to $72 at Friday's close. The hedge funds were forced to sell crude positions to raise cash and the appearance of a hurricane in the Gulf was the only thing that kept crude from falling below $70. Hurricane Dean is headed for the Gulf on Monday and is currently expected to hit south Texas and northern Mexico. The current track could vary several hundred miles once Dean bounces off the Yucatan Peninsula on Monday. That bounce could be just enough to point it towards northeast Texas and Louisiana and right across the oil patch. It could also turn it westward and more into Mexico. Whichever way it goes there is significant risk to oil facilities of some sort. Corpus Christi and the current bulls eye has three major refineries and represents 5% of our refining capacity. If Dean veers just a little to the north to the Houston area there are nine refineries representing 14% of our total capacity. If it turns toward Mexico it will impact the major Mexican oil fields with daily production of 3.2 million barrels. Over 1.5 mbpd of that production is exported to the U.S. and would be sorely missed. The oil patch offshore from Louisiana produces 1.4 mbpd and large volumes of natural gas. Many platforms are already shutting down and personnel are being evacuated to the coast. Oil prices are likely to rise on Monday as we wait to see which way Dean will track and where the destruction will appear. If Dean weakens from its projected Category 4 strength or veers into a less damaging area for production the price of oil will plummet. I believe we are either looking at $75 or $65 by the end of the week. Summer gasoline demand is behind us and there is added crude supply coming to market over the next 90 days. Inventory levels are already at decade highs and without a direct hit by Dean I believe the remaining funds will dump their crude positions to raise cash. Those still holding longs probably thought on Friday, "If we just hold two more days we could be rewarded with a direct hit." In the greater scheme of September 30th fund redemptions two more days is nothing.
Hurricane Dean Wind Patterns
Hurricane Dean Tracking by Day
Snap back, dead cat bounce or the beginning of a rebound? It all depends on whom you talk to. The Dow rebounded from its -10.6% decline to 12519 to close +560 points high at 13079 on Friday. That is a significant rebound but we were extremely oversold. Without a new Fed move next week we could have a tough time stretching that rebound. There is very strong resistance just over 13500 and just reaching that level would extend the rebound to nearly +1000 points. It would be very tough to crack that resistance after a +1000 point run.
The Nasdaq broke support of the 200-day average at 2500 and continued to plunge to 2400 in only 2-days. The rebound was equally impressive returning to close just over 2500 once again. Like the Dow the Nasdaq has very strong resistance between 2550-2600 and it could be a tough uphill battle.
Dow Chart - Daily
S&P-500 Chart - Daily
The S&P-500 is the clearest chart with strong resistance at 1455-1480 and that would be on top of a +75 point rebound. That was a huge +5.4% rebound in only two days. I would love to see this rebound continue but I fear the bulls will need some help.
That help could come from Asia next week. The Asian markets are also under pressure with Japan losing over -5% on Friday. If those markets rebound following our Friday gains then some of our negative sentiment could evaporate. The Fed could also make some more comments suggesting they were ready to cut rates again and that would be supportive to the markets.
I fear that we could see some more fund liquidations next week but hopefully they would be offset by the dip buyers coming back to the market. There are no material economic reports and earnings are over for the quarter. This is normally one of the worst weeks in the market as the summer comes to a close. Let's hope reality is better than the historical trend. TrimTabs reported that in the week ending on Wednesday stock mutual funds saw massive outflows of $19.86 billion. Obviously hedge funds were not the only funds seeing massive redemptions. These withdrawals accelerated the market drop and show exactly how negative investor sentiment has become. This contrasts with the record $11.8 billion that flowed into ETFs in the week ended August 10th. Those inflows helped power the Dow to a +500 point rebound from August 6th-8th. Once that rebound ended late on August 8th at 13700 the outflows of nearly $20 billion in the following week pushed the Dow to a new 3-month low.
There is an old market adage that cautions "Don't fight the Fed." Normally that is true but not necessarily true in short term reactions. When the Fed embarks in a long-term adjustment like the series of rate cuts that took rates down to 1% or the 17 consecutive hikes that brought it back to 5.25% the adage is true. It does not mean next week will automatically be an up week just because the Fed lowered the discount rate. Normally a change in the discount rate is ignored with only the Fed funds target rate getting the attention. As next week progresses we will see dozens if not hundreds of analysts get their 5 min of air time to voice their opinion of the Fed's next action. These sound bites will be played over and over interspersed with any Fedspeak hitting the wires next week. The next FOMC meeting is September 18th and that is a long way off to be betting on a rate cut regardless of how many sound bites you are forced to endure.
When all the hype is stripped away the market next week will be at the mercy of the funds still liquidating for redemptions. As each day passes those will decrease in number and buyers will begin to prevail. That will of course depend on whether this is a run of the mill 10% correction or something else entirely. I am concerned about the dire language in the Fed statement about the state of the economy. If they believe "downside risks to growth have increased appreciably" then we may be looking at an entirely new ball game. They would not make that statement if they did not want to warn us that conditions have changed significantly. The Fed is the master of understatement and that is not a comment we should ignore.
I would be a bargain hunter next week with an exit plan in place if the market rolls over again. A new failure would be one of two things. The first option would be a potential retest of the lows leading to a real rally into Q4. The second option would be a return to a bear market with a failure at SPX 1375. Remember, a dip under the 200-day averages is normally negative and a sell signal for funds. The S&P at 1445 is still nearly -10 points under its 200-day at 1454. The Dow and Nasdaq may have rebounded to close slightly over their 200-day levels but only by the slimmest of margins. There is still risk in the market regardless of how many TV commentators are screaming buy.
Russell-2000 Chart - Weekly
Russell-2000 Chart - 60 min
Remember the Russell. The small cap Russell-2000 closed at 786 and just below
major resistance at 800 and its 200-day at 805. The Russell has been weaker than
the other averages and as a sentiment indicator for funds it is not yet
suggesting any real strength. For the purposes of determining market direction
next week I want to use the Russell instead of the S&P. I would be a buyer over
800 or on a dip back to 740. In the middle I would retain a bearish bias. Until
the funds begin
to move back into the Russell the correction is not over. Until
then everything else is just noise.
Play Editor's Note: All of the major market averages have produced a bullish reversal pattern over the last few sessions. However, that does not mean that stocks will go straight up from here. There is still a good chance that we will see some profit taking on Monday and Tuesday. There is an even better chance that we will continue to see volatility. Just because we add some bullish plays to the newsletter tonight doesn't mean you need to buy them on Monday morning. Be patient and be cautious. Yes, stocks are still oversold and could easily bounce but we're still in the worst two months of the year for stocks and the credit crisis hasn't been completely ironed out yet. If you cannot be actively monitoring your positions you may want to just sit out of the market for the next few weeks. Right now one of our biggest challenges is stop loss placement because the rebound from Thursday's low has been so strong.
Amazon.com - AMZN - cls: 75.02 chg: +2.23 stop: 69.95
Why We Like It:
BUY CALL SEP 70.00 ZQN-IN open interest= 908 current ask $7.20
Picked on August 19 at $ 75.02
Freeport McMoran - FCX - cls: 76.90 chg: +3.83 stop: 71.49
Why We Like It:
BUY CALL SEP 75.00 FCX-IO open interest=1403 current ask $6.30
Picked on August 19 at $ 76.90
Goldman Sachs - GS - cls: 175.00 chg: +5.15 stop: 167.45
Why We Like It:
BUY CALL SEP 170 GPY-IN open interest=2572 current ask $13.60
Picked on August 19 at $175.00
DJ Transports iShares - IYT - cls: 85.43 chg: +1.79 stop: 82.45
Why We Like It:
BUY CALL SEP 85.00 IYT-IQ open interest= 65 current ask $5.80
Picked on August 19 at $ 85.43
Sears - SHLD - cls: 137.24 chg: +3.47 stop: 134.85
Why We Like It:
BUY CALL SEP 140 KTQ-IW open interest=3603 current ask $6.30
Picked on August xx at $ xx.xx <-- see TRIGGER
L.B.Foster Co. - FSTR - cls: 37.31 chg: +1.30 stop: 33.90
Friday morning's market gap higher helped push FSTER to a new all-time high at $39.16. Unfortunately, the stock was unable to hold its rally above resistance near $38.00. The stock was still able to close up 3.6% and on strong volume. We remain bullish on FSTR here but it's up to the reader on where they want to initiating new positions. You could wait for a new rise past $38.00 or look for another dip back toward the 10-dma near $36.00. Conservative traders may want to raise their stop loss toward Thursday's low ($34.60). We have two targets. Our first target is the $39.90-40.00 range. Our second target is the $42.00-42.50 zone. Please note that this remains an aggressive, higher-risk play.
BUY CALL SEP 35.00 FQD-IG open interest=148 current ask $3.90
Picked on August 14 at $ 37.33
Intuitive Surgical - ISRG - cls: 199.13 chg: +9.50 stop: 205.51
There are no surprises here. We warned readers that ISRG was very volatile and that if the markets bounced on Friday that ISRG would probably challenge resistance at the $200 level, which is exactly what occurred. This remains a very aggressive, higher-risk play due to both the market volatility and ISRG's volatility. The $200 level and the 10-dma, both overhead, should be resistance. However, if the markets continue to bounce we would expect ISRG to bounce with them and stop us out at $205.51. If you're suddenly feeling conservative then we suggest you strongly consider exiting early now to cut your losses or adjusting your stop loss toward the $200 level. We are not suggesting new positions at this time although a failed rally under $200 would technically be a new entry point for put plays. Our target is the $181.00-180.00 zone.
Picked on August 15 at $194.50
Penn National Gaming - PENN - cls: 56.18 chg: +0.69 stop: n/a
We are giving up on PENN. The stock gapped higher back in June after it was announced that Fortress Investment Group (FIG) and Centerbridge Partners would pay $67.00 a share in an all-cash deal to buy PENN. PENN was given 45 days to solicit higher bids and there was a lot of speculation that multiple bidders might appear driving the stock higher. We suggested an aggressive and very speculative play on a potential bidding war that never appeared. In recent weeks several analysts have upgraded the stock confident that the deal would get done and that PENN would climb to the $67 buyout target price. Yet so far the stock price has continued to languish suggesting that the market does not believe the deal will get done in its current format or price. We are no longer willing to wait and our suggested August options have expired.
Picked on June 17 at $ 62.12
As I've been doing every few months all year long, it's time to follow up on my series of articles on the corrective fan principle. Did the corrective fan principle correctly predict the end of the rally? If so, what does it have to say about the current state of the markets?
For those who have not read my previous articles on the corrective fan principle, that principle's evidence concluded that the rally off last summer's low ended in February.
Oh, yeah? the last article in the series asked. That article was written in June and included the following chart, complete with the original annotations written in June.
Annotated Daily Chart of the SPX in June:
If the rally ended in February, why did the SPX reach higher right into July? the article asked. My conclusion at that time was that the "possibility exists that the entire post-February rally" was similar to the SOX's rally in early 2006. When seen in hindsight, that early 2006 SOX rally had been nothing but the setup for a prolonged choppy period that eventually resolved, rather dramatically, to the downside. Traders needed to plan how they would address such a development on the SPX, too, the article concluded because it was possible that the last leg of the SPX rally wasn't truly "rally" but merely a setting up of the eventual decline.
I hope some did plan.
So, for the benefit of those who haven't read the previous articles, what is the corrective fan principle? The principle, expounded upon by Martin J. Pring in TECHNICAL ANALYSIS EXPLAINED, suggests that any trending move establishes three separate trendlines. The first sharp move up from a low or down from a high tends to be too steep to be maintained. Prices fall through the first ascending trendline or break up through the first descending one. A less steep second trendline is established. Prices bounce from that trendline for a while, too, but it's also too steep to be maintained. A third trendline is established.
When that trendline breaks, the principle suggests that the trending move is kaput. In the case of a rally such as the one off last summer's low, the SPX break of that third trendline in February suggested that either a period of disorganized trading or else a downtrend would follow.
What we've gotten so far is a period of disorganized trading, in my opinion, followed by a possible beginning of a decline that will be organized along the corrective fan. The climb to test all-time highs was accompanied by poor breadth. It climbed the underside of the trendline defining rally support.
Can the corrective fan principle tell us something about when the downtrend since late July will end?
Let's take a look. This chart was snapped Wednesday, August 15, after the close of trading, and I wanted to keep it and my further comments so you can test those conclusions and see if you agree. I'd be the first to tell you not to trust anyone else's conclusions if they don't fit yours, even if that "anyone else" is me. So, let's test this chart I snapped Wednesday evening and the following commentary, also originally written Wednesday evening.
Annotated Daily Chart of the SPX:
As the chart notes, it's possible that the first descending trendline, red on this chart, has been formed and broken to the upside. If that trendline is a valid or true trendline, then it should now serve as support on any downside tests, as it had twice done before the late-day test on Wednesday, August 15, when this chart was snapped and this commentary first written.
What does all this mean? First, let's address what it does not mean. While it's possible to draw a trendline and even two, and to find supposed corroboration through using the RSI, we're not sure that these are valid. It's still possible that markets are just churning in a disorganized manner without a clear downtrend in place, although many would dispute that as a possibility. The drawing of two trendlines on a chart, particularly when one has as awkward a fit as that first one does, does not prove that a new downtrend exists.
However, the other possibility, of course, is that a new downtrend has begun, replacing the rally that has now concluded, and that the two trendlines drawn above may ultimately prove valid. If so, the breaking of the first too-steep descending trendline does not mean that prices can't go lower than they have. Wednesday proved that. Just as prices could climb the underside of a rising trendline during the prolonged rally, they can slide down along the topside of a descending one. That first descending trendline can provide support for every daily close until the descent is over, but prices could be sliding lower all the time. Still, if it's a valid first trendline, we do at least know that it should now serve as support on pullbacks.
The descending blue trendline has only two touch points so far, and so is not yet well established. I wouldn't trust it yet, but would consider it a possible candidate for the second of the three descending trendlines that form the corrective fan in a downtrend. Until it's better established, it's still possible that the choppy trading behavior will establish a second trendline with a slope a little less steep. Even if RSI predicts or corroborates an immediate break up through that blue trendline, it may not yet be well enough established to provide support on pullbacks. However, if it is tested a bit more and continues to provide resistance, and only then is broken to the upside, complete with RSI corroboration, it's likely that prices will either bounce from it or slide along it on future tests.
If a new descent is forming and organizing itself along Pring's corrective fan, we've still got at least one more descending trendline to form, sometime after the second one is broken to the upside. That's not happy news, of course, but we'll take a look now and then and see what's developing.
For now, look for the red trendline to form support on daily closes on descents, even if that support is a sliding-lower one. Consider the possibility that resistance will hold at the blue descending trendline, at least until RSI breaks through its own blue descending trendline. When that happens, watch for price to break up through its blue trendline, if it's not happening concurrently with the RSI breakout. RSI sometimes anticipates a move or predicts it, but do remember that any signal that moves ahead of a price break can sometimes give false signals, too. For now, though, it will likely be the best signal you'll receive of a short-term or intermediate rally, on the way to forming the third and final trendline. Don't get too fooled by any such rally, as new lows could still result.
That concluded the commentary that I had written as of Wednesday night, so let's update it and test the conclusions that were written then. To ensure that I'm not just editing this to fit my supposedly already written commentary, the next chart will be the one included in Thursday night's Wrap, with the commentary that written Thursday night, so that you can double check it and make sure that I'm not just editing to fit what has happened as of Friday.
Annotated Daily Chart of the SPX as of Thursday's Close:
How did Thursday's action fit with the corrective fan theory? Although the red trendline, one with a fit that I still find suspect, was pierced intraday, it did indeed form support on the daily close. Perhaps it's valid?
Even if it is, Thursday's action again proved that although prices have now broken above the first of the three trendlines and that trendline appeared to hold as support on daily closes, prices can and did slide lower along that trendline. The breaking of subsequent trendlines to the upside will not necessarily mean that prices will move higher.
However, as I noted Thursday evening in the OptionInvestor, when prices pierce this trendline during intraday periods, short-term bears should consider the possibility that prices will bounce back to or above that trendline by day's close. The other admonitions about watching RSI, also included in the annotations on the last chart, remain valid for now, too.
Let's check back in a few weeks.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda
Piazza, and all other plays and content by the Option Investor staff.
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