I (Keene Little) will be filling in for Linda for this evening's Market Wrap. What the market giveth the market taketh away. One of the strongest one-day rallies this year, on Tuesday, has been pretty much been given back after yesterday's and today's selling. Interestingly the big cap techs (Nasdaq-100) have given back less than the others (but only marginally) while the small caps completely erased Tuesday's gain and did a retest of Monday's low right at the end of the day (and got a predictable bounce off that low). The big cap techs got washed out pretty good coming into this week so it's not surprising to see a little less selling in the NDX.
One look at the table above says it all--ugly day today and in fact uglier than the indices might otherwise say. Yes they were down but with the DOW down -121 on the day I'd say that's in the noise area with its increased volatility lately. The S&P 500 was down a greater percentage and gave up almost 20 points on the day. But the market internals were strongly negative with new 52-week lows hammering new highs better than 5:1. Decliners beat out advancers almost 3:1 and down volume swamped up volume 4:1. Those numbers reflect some strong selling that was not necessarily reflected in the big indices.
Today, November 15th, was the last day for withdrawal requests for hedge funds. Jim had mentioned this in his weekend wrap and suggested we could see some strong selling this week from that. So today's selling might have finished if that was a big reason. Considering the steep decline in the market the past month, after it had done a retest of the July high, there were probably many traders who waited until the last minute to withdraw funds as they hoped the market would bounce and get them out at a better price. After yesterday's selloff and inability to add to Tuesday's rally I'm sure many decided to just pull the plug and get some of their money into safety. It would be interesting to see if money market funds increased this week. I suspect they have.
As I had mentioned yesterday, opex can exacerbate these kinds of moves because traders are forced to make hedges to their positions. If they were shorting stock again today to protect short put positions (such as sold puts on SPX which settle tomorrow morning) then that selling pressure just added to the normal selling. And if they no longer need, or want, those short positions tomorrow morning we could see a reversal again back to the upside. Traders got a workout this week.
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As I'll show in the charts I'm thinking we will see a reversal back to the upside on Friday. Opex Friday's are typically pretty boring days so we could get an initial flurry of buying followed by a drop off in volume as the market flattens out. But as long as Thursday's lows hold then I think we could be due another rally leg above Wednesday's early-morning high.
Before getting to the charts we'll review today's economic reports:
CPI and Core CPI
As I had reported yesterday for the PPI numbers, the year-over-year comparisons are now starting to show an increase in inflation due to the drop off of the September and October 2006 declines. So for this October the y-o-y CPI was +3.5% (and +3.6% for all of 2007 so far) and core CPI is +2.2% y-o-y (and +2.3% annualized for the year so far). Neither number is Fed friendly in their inflation battle.
One thing boosting the core rate was a +0.5% gain in rent costs. This could be a little more worrisome for the Fed as housing costs are something they watch a little more closely. The increase in rents may be due to more people renting now that it's harder to get into a home (or more sadly, for those who may have lost their home). Any further pressure on rents could put more pressure on the Fed.
CPI, 1991-2007, courtesy briefing.com
The chart shows CPI heading higher this year but core CPI (blue line) has been trending lower. The Fed watches PCE (Personal Consumption Expeditures) more closely but obviously they would not be happy if the core rate starts following the CPI higher.
Unemployment Claims, 1991-2007, courtesy briefing.com
The chart shows unemployment claims remain at the low end of their range over the past 17 years which is a good sign for the economy. Unfortunately it's a lagging indicator so any uptick in claims will probably already be felt in other areas of the economy.
NY Empire State Index
The outlook for the companies was not as good as it was in October. The index fell 20 points to 30.5. The future new orders and shipments indexes also fell sharply. The capital expenditures index fell several points to 19.1 and most companies expect to have higher cash levels over the next year (not good for technology and other capital expenditures).
Philadelphia Fed Index
The worrisome number is the 6-month outlook as shown in the table of recent numbers for this index:
Philly Fed Index, July-November 2007, courtesy briefing.com
I highlighted the November outlook and you can see it's significantly lower than previous months. This is of course worrisome as business leaders who lack optimism about the future will tend to pull in spending and this matches what the NY index showed. The lack of capital expenditures could add to a slowdown in consumer spending and it's not a good sign for our economy in the future.
Getting to the market, other than more of a pullback from yesterday there's really not a lot to add to yesterday's charts but let's see what they look like:
DOW chart, Daily
The wave count that I'm considering here, more clearly seen on the 60-min chart, is an a-b-c upward correct off Monday's low. Tuesdays strong rally would be wave-a and the pullback since that rally would be wave-b. That means we need wave-c to the upside and it should rally back above Tuesday's high (shown in dark red on the chart). A 38% retracement of the October-November decline (13442) or 50% (13587) is what I would expect to see from here. If the DOW were to rally higher than 62% (13731) it would be a break of its downtrend line from October and I think would be telling us some bullish things (shown in green).
On the flip side, a break of Monday's low at 12975 would look bearish. There's one caution about that though--if we are getting a b-wave pullback it can undercut the previous low and not negate the possibility for a wave-c up to follow. It could end up being a head fake break which would mean a bear trap in this case. If you see a new low but it's not confirmed with some of the market internals (you'd see some bullish divergences) then beware the bear trap.
DOW chart, 60-min
Today's pullback undercut the bottom of the parallel down-channel from the October high but essentially closed on it. These channels can be amazing how much they capture price movements which is why I keep them on the charts until it's much older than this one. Shown in pink, a slightly larger bounce now followed by new lows would be a bearish breakdown and I'd be looking to short it. But if a rally starts on Friday then I'd be looking to buy the dips since the upside potential is at least the 13450 area.
SPX chart, Daily
SPX held above the new uptrend line from August and I believe finished its decline at today's low (I show why on the 10-min chart below). I show the potential (in dark red) to rally up to its downtrend line from October, near 1525, but that could be a stretch. But a rally back up to 1500-1510 would be a typical move from here if a move up in wave-c is the next move.
SPX chart, 60-min
Assuming we see a rally on Friday, the downtrend line from October 31st, currently near 1477, will be an important hurdle for the bulls. As shown in pink, any bounce followed by a new low would be immediately bearish. But a rally above it could take it as high as the 1525 area. If it dribbles lower on Friday look for bullish divergences since a minor break of Monday's low would not necessarily be bearish.
I posted this SPX 10-min chart on the Market Monitor this afternoon before the final low in order to show why I thought 1443-1444 was a target zone to look for support:
SPX chart, 10-min
A little EW (Elliott Wave) teaching here (so skip if not interested)--as shown on the daily and 60-min charts, and discussed with the DOW charts, I'm thinking we're going to get an a-b-c bounce off Monday's low and the pullback from Wednesday morning's high is wave-b. I've been watching the decline for evidence to either negate that count or support it. First of all the sideways triangle consolidation on Wednesday fits best as a small degree b-wave since these triangles are present in 4th waves and b-wave. Since it's not a 4th wave it must be a b-wave. That set up the decline as corrective which fits the larger degree b-wave (labeled wave-(b) at today's low). From there I've got the move down labeled as a double zigzag which means two a-b-c's separated by an x-wave.
The Fib projections shown on the chart are based on Fib relationships between these wave patterns and towards the end of the day, after 1451 was violated, I said watch for support in the 1443-1444 area since there's good Fib correlation there for the end of the wave count. Today's low was right in the middle at 1443.49. That low must hold now otherwise it opens up a bunch of possibilities and potentially much lower prices. Therefore long against today's low is the recommended play here.
A break above 1466 is needed by the bulls to confirm a bottom is in. Then move to the 60-min chart and watch that downtrend line at 1477 since a failure there that then heads back down to a new low would be bearish, no ifs ands or buts.
Nasdaq-100 (NDX) chart, Daily
It's the same deal with NDX--today's pullback should lead to another push higher to complete an a-b-c bounce off Monday's low. That should complete a wave-2 correction to wave-1 down from October 31st. Once it completes the next wave down, wave-3, should see the strongest selling we've seen this year.
Nasdaq-100 (NDX) chart, 60-min
I added a Fib projection to this chart that I showed last night. Two equal legs up (for wave-a = wave-c) would be at 2120, assuming today's low holds. That would place the bounce between a 50% and 62% retracement of the decline which is pretty typical for a 2nd wave correction. If we get that kind of rally leg expect to hear Jim Cramer pounding the table on what a wonderful buying opportunity it is for a year-end rally. Believe him at your own risk as I believe it will be a bull trap (which is what makes 3rd waves so strong as those who were trapped start bailing en masse).
I haven't shown the semiconductor holders in a while so I thought an update is in order:
Semiconductor Holder (SMH), Daily chart
After breaking its down-sloping neckline in October and then retesting it on October 31st, it's been downhill for the semis since then. It broke it longer term uptrend line from October 2002 yesterday and was unable to get back above it today. It could flip-flop around this level, or bounce back up for another retest of its broken neckline as part of a sideways consolidation pattern (some bullish divergences are starting to appear), but from a pattern perspective I do not see a reason to be thinking long the semis. This could continue to be an albatross around the neck of the techs if it continues to sink lower.
Russell-2000 (RUT) chart, Daily
Different index same pattern--looking for another leg up in an a-b-c bounce off Monday's low. Assuming it can get up off today's retest of Monday's low, it could rally back up to its downtrend line from October, currently near 807. If it can get up into the area then the 50-dma and 100-dma could block any further progress. If price plays out as I've depicted in dark red you can also visualize a H&S pattern with the right shoulder need here and the neckline near 760. This would be a larger H&S pattern than the one that completed off the September-October H&S formation (for which the downside objective has not yet been achieved).
Russell-2000 (RUT) chart, 60-min
We've got some bullish divergences against the lows since November 8th so that supports a rally leg from here and that would be wave-C up to at least the 800 area if not to the downtrend line from October. As with the others, any appreciable bounce from here, to say the 780 area (shown in pink) that is then followed by a move to new lows would be immediately bearish. That kind of move would very likely break down below the bottom of its parallel down-channel.
The banks got hit hard today, down -4.4% on news that more banks are reporting more troubles with bad loans, mortgage portfolios, derivatives, etc. Barclays UK joined the un-distinguished list and reported this morning that they're writing down 1.3B pounds ($2.7B) for the 3rd quarter and October, citing downgrades from rating agencies on a broad range of CDOs (collateralized debt obligations). It says it has exposure to 7.3B pounds of unsold underwriting positions in leveraged finance (such as for LBOs which will go onto their books if they can't sell them) and another 19B pounds of exposure to its own on-balance-sheet conduits.
This continues to be an unfolding story and will likely play out for some time to come. The reason more write-downs keep occurring is because the ratings agencies are literally downgrading something new every day as the market prices these assets. One look at the ABX closing prices for last week on AAA-rated investments (these are investment grade holdings that investors like pension funds are being forced to sell because of the downgrades) shows the pain many are feeling:
ABX Closing Prices, effective November 8, 2007, courtesy markit.com
These asset-backed securities are divided up into which half year they were sold. The chart above shows the ABX index for AAA-rated securities sold in the 2nd half of 2007. Anything sold after 2005 has taken a bigger hit in value because that's when the garbage was being packaged as AAA and sold to unsuspecting investors. As the chart shows, the value sank to 90 cents on the dollar in August when the market panicked over all of this coming to light and today it's worth 70 cents on the dollar. The ones that have been downgraded are obviously faring even worse, with A-rated currently trading for 30 cents and BBB is at 20 cents.
Many holders of this garbage still haven't accounted for the actual mark-to-market value but instead carry them at their mark-to-model values (100 cents on the dollar). When a ratings agency downgrades one of these securities and someone then sells it, that can trigger a write-down for the banks and others who hold the same package. This process will take a while to undo. One thing that the market may not have been happy about today, especially for the banks, is the FASB decision to not allow a deferral of Statement 157, Fair Value Measurements.
FASB 157 requires companies to implement this new standard for financial assets and liabilities. This ruling requires companies to value their assets at fair value which means market value. It will require companies to go to the mark-to-market model and there are many who are not happy about this. In order to have their financial statements signed off by an auditor they will have to demonstrate that they've fairly valued all of their assets. This is going to be painful for those who are carrying a lot of these asset-backed securities at inflated values when compared to how the market is currently pricing them.
Financial Executives International (FEI), which is a trade group for heads of finance, treasurers and corporate comptrollers, had asked the FASB to delay implementing the 157 standard by a year but today's decision shot that request down (except for non-financial assets). There are many who have simply swept this problem under the rug in hopes the market will improve before they have to sell. Now it won't make a difference--they're going to have to value them as if they were sold today.
There's going to be more pain ahead. This problem has been compounded in the banks because of their record-low rates of reserves that they had set aside for bad loans. I reported before the summer that banks were going to take big hits to their bottom lines just to fund their reserve accounts once loans start going bad (and it didn't take a rocket scientist to know it would happen when Fido was given a loan but no way to pay it back). So the banks found some more sellers today.
BIX banking index, Daily chart
Even though banks got hit hard today I still think they're due a bigger bounce, the same as for the broader market indices that I've been showing. Obviously that's not a given and it could turn real ugly if the banks continue lower right from here but I continue to lean towards another leg up before the hard selling resumes.
However, the brokers could be pointing to a very bearish setup:
Brokers index (XBD), Daily chart
The one big bearish thing I do see setting up is what I see for the brokers. I show (in pink) the possibility for a rally up to, or above, the downtrend line from October (which would match the others) but right now there is the possibility for a very strong 3rd of a 3rd wave down to unfold (dark red arrow). If the brokers drop to a new low from here then the selling could accelerate and border on panic selling. I'll be watching this one carefully.
U.S. Home Construction Index chart, DJUSHB, Daily
It's possible the correction for the home builders is over and we'll see the next leg down begin from here. The 50-dma has been a brick wall for this index. A break below 300 would be an indication that we'll see this index head down to its 215 target next.
Oil chart, December contract (CL07Z), Daily
Another kiss of its broken uptrend line and a pullback from it. The US dollar is rallying and that could hurt all commodities if it continues. A drop below 90 would likely mean a quick drop down to 85 on its way to 80.
Oil Index chart, Daily
I think the oil stocks are also due another leg up in its bounce before it resumes its path to lower lows. After bouncing off its 100-dma it should then head for its 200-dma, at 731 currently.
Transportation Index chart, TRAN, Daily
If the broader market manages to rally I'm sure the Trannies will be doing the same. Watch for resistance at either its downtrend line from October, near 4850, or higher if it's able to get through that.
U.S. Dollar chart, Daily
The US dollar just might do it here. It just might be able to continue rallying and finally break its downtrend. It's got a little ways to go, above 76.50, to prove it but see that little poke above the RSI downtrend line. Like a little snake sticking its head above water to see if it's safe to come ashore. If it's able to break that downtrend line then it should be a heads up that the dollar will be able to break its downtrend line next.
Gold chart, December contract (GC07Z), Daily
The US dollar rallied and gold got spanked, down almost -$27 today. But it's still holding its uptrend line so the gold bulls have a chance here of saving this. Unfortunately for them the break of the RSI uptrend line says gold will likely follow with a break below 780. I show one possibility, in pink, for gold to rally back up for a test of its high while RSI bounces back up for a retest of its broken uptrend line. This is not that uncommon and in fact would be an excellent short play setup.
Results of today's economic reports and tomorrow's reports include the following:
Friday's economic reports will not likely be market moving. The capacity utilization report is used by the Fed in their inflation assessment so a big jump in utilization would spark inflation concerns but that's not expected.
Rather than show the SPX weekly chart again, since so little changed, I thought I'd show a chart of copper:
Copper chart, December contract, Weekly
Copper is a very good metal to follow as it provides a good signal for how the economy is doing. It's an industrial metal and obviously used a lot in homes so the reduction in home building has caused a reduction in requirements for the metal. But the price recovered significantly off the January low and was a result of global demand. That was a good sign for growing economies. But now we have an expanding bullhorn pattern and at highs this is a bearish pattern. It's setting up a reversal. Also notice the bearish divergences at the highs as compared to the 2006 high and even the 2007 highs. We may have seen the last high for copper and a break below 2.90/lb. would be a signal the top is in and a slowing in the global economy. That would obviously be a bearish sign for the stock market as well.
So I'm looking for a rally on Friday but I wonder how much it will be able to rally since opex Fridays aren't known for big moves. But it occasionally happens. If the market just trades sideways and consolidates most of the day it will look bearish and I would expect lower prices from there. The short term bullish scenario requires a strong rally and to start from the open. Anything less would have me on the sidelines watching to see what's happening. I don't recommend a short play here only because I'd be worried about a bear trap with a minor new low for the week and then a reversal. You'd need to be able to watch the market intraday in case that happened. We all know what v-bottoms can do to short positions.
If your trading horizon is longer than a trade that lasts for only a day or two then the long play setup is not for you. We have to see some resistance overhead broken before I'd be comfortable recommending a long play. But if we get the bounce back up to the DOW 13500-13600 area then I'd look for a short entry or two since you'll be able to keep your stop relatively tight.
I'll be back on Wednesday to see how this sets up. Good luck in your trading.
PACCAR - PCAR - close: 47.67 change: -1.36 stop: 50.81
Why We Like It:
BUY PUT DEC 45.00 PAQ-XI open interest=461 current ask $2.00
BUY PUT JAN 45.00 PAQ-MI open interest=291 current ask $3.00
Picked on November xx at $ xx.xx <-- see TRIGGER
Express Scripts - ESRX - close: 64.82 chg: +0.59 stop: 61.14
ESRX continues to show relative strength. The stock posted a 0.9% gain in the face of a widespread market sell-off. While the stock's trend remains bullish we would be hesitant to open bullish positions in anything at the moment. The P&F chart is bullish with a $97 target. Our short-term target is the $69.50-70.00 range. FYI: ESRX is also on the newsletter as a current strangle play.
Picked on November 13 at $ 64.67
Gilead Sciences - GILD - cls: 43.65 change: -0.26 stop: 41.74
Biotech stocks managed to out perform the markets largely thanks to gains in GENZ and AMGN. Shares of GILD spent the session trading sideways. We would not be surprised to see another test of support near $42.00 and its 50-dma. Our target is the $47.00-48.00 range. There might be some resistance near $44.00 and its 10-dma near $45.00.
Picked on November 13 at $ 43.11
Goodrich Corp. - GR - close: 71.81 change: +0.29 stop: 67.90
GR out performed the markets today with a minor gain. Today is the second day in a row that traders bought the dip near $71.30. The intraday "low" of $71.16 looks like a bad tick somewhere. Our conservative target is the $74.90-75.00 range. Our more aggressive target is the $78.00-80.00 range. The P&F chart is bullish and points to a $99 target. FYI: GR is due to present at the Aerospace and Defense conference on Thursday, November 29th, 2007 at 11:30 a.m. ET.
Picked on November 05 at $ 71.05
L-3 Comm. - LLL - cls: 111.20 chg: +0.55 stop: 107.99
Good news! LLL did not see much follow through on yesterday's reversal. Taking a step back the trading over the last several days is starting to look like another bull flag pattern. Don't be surprised to see another pull back into the $109-108 zone. The new trend of lower highs (top of the flag) is near $113. We're not suggesting new positions at this time. LLL has already hit our first target in the $114-115 range. Our second, more aggressive target is the $118.00-120.00 range. FYI: The P&F chart's bullish target has risen from $133 to $139.
Picked on October 29 at $108.10
Las Vegas Sands - LVS - cls: 114.55 chg: +0.83 stop: 108.89
LVS popped higher this morning and then spent the rest of the day digesting those gains. More importantly there was no follow through on yesterday's bearish reversal pattern, which is a good sign for the bulls. We remain wary and would hesitate to open new positions. LVS has already hit our initial target near $117. Our secondary, aggressive target is the $121.00-122.50 zone.
Picked on November 08 at $111.60
Northrop Gruman - NOC - cls: 81.76 chg: -1.32 stop: 79.99
The trading in NOC continues to turn more bearish. A breakdown under $81.50-81.00 would look pretty negative even though NOC looks like it should have significant support at the $80.00 level. Watch for signs of a bounce before considering bullish positions. Our target is the $89.00-90.00 range. The P&F chart shows a bullish catapult pattern with a $92 target.
Picked on November 06 at $ 84.48
ExxonMobil - XOM - close: 84.49 chg: -1.82 stop: 82.99
XOM has been kind enough to give us another chance to buy the dip near technical support at the 200-dma. Of course the stock's failure to fully rebound off its first bounce from the 200-dma is bearish. Readers will definitely want to wait for signs of a bounce first (like a bounce over $86 again) before considering new positions. However, keep in mind that the stock is in a short-term bearish channel. Our target is the $92.50-95.00 range. More conservative traders may want to lock in some gains near $90.00.
Picked on November 13 at $ 86.75
(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)
Borg Warner - BWA - cls: 99.98 change: +0.43 stop: n/a
BWA popped higher this morning on its announcement last night that the company would provide a 2-for-1 stock split. Unfortunately for shareholders the rally faded quickly. Tomorrow is our last day and we're not expecting any miracles. The intraday high for the November $100 calls was about $3.20. The options we suggested for a strangle were the November $100 calls (BWA-KT) and the November $90 puts (BWA-WR). Our estimated cost was $4.50. Due to our lack of time we are adjusting our target to breakeven at $4.50.
Picked on October 23 at $ 95.67
Express Scripts - ESRX - cls: 64.82 chg: +0.59 stop: n/a
Tomorrow is our last day for this strangle on ESRX. We're adjusting our exit price to $1.00. That way a decent rally past $65.00 could help us salvage some capital. Nimble traders will want to play it by ear tomorrow. The options we suggested for a strangle were the November $65 calls (XTQ-KM) and the November $55 puts (XTQ-WK). Our estimated cost was $1.95.
Picked on October 21 at $ 59.65
Monster Worldwide - MNST - cls: 36.80 chg: -0.88 stop: n/a
Tomorrow is our last day for this strangle on MNST. The options we suggested for our strangle were the November $40 calls (BSQ-KH) and the November $35 puts (BSQ-WG). Our estimated cost was $1.75.
Picked on October 23 at $ 37.22
Corrections in the market tend to be of a certain amount often enough to think that market cycles spin out into the future and tend to follow certain 'predetermined' patterns. I know that the choice of such a sort of loaded word as "predetermined" raises considerable doubt with many if not most investors and traders. How can market trends be predicted: we don't know what the Fed is going to do, we don't know what OPEC is going to do, we don't know the future period!
We keep our minds busy with events, government policy, economic and earnings trends and the like and mostly, if we think of the bigger picture, tend to consider CHANGES in market direction as captive to unpredictable events and perhaps 'random' events. Heard of the 'random walk' theory of the market movement? Basically, one can't predict the market, so there's no point in trying. The gist of the random theory is that the HOLDERS of this idea CAN'T predict overall future market trends; e.g., economists, most investors and so on. Very wealthy traders, successful over many years and market cycles, seem to fly above and beyond that rule.
I'm not going to go much further in discussing this topic except to show and remind you of how corrections tend to occur in certain predetermined ways or are associated with certain conditions. There are some key ideas that are useful for making profitable TRADING decisions; otherwise, I wouldn't bother writing about how certain patterns repeat over and over.
KEY IDEAS ABOUT MARKET TRENDS, CORRECTIONS AND TREND REVERSALS:
(Any one of these key ideas should not be taken or used as the sole source of buying or selling decisions. Rather, it is often the interplay of these key factors that are telling.)
1.) Markets don't top out or bottom until traders and investors get quite or 'extremely' bullish or bearish. HOW you could or should measure those bullish or bearish extremes is unknowable to most market participants; how can you objectively measure this?
2.) At significant tops or bottoms the major stock indexes tend to measure as 'overbought' or 'oversold' on technical indicators called 'oscillators'; e.g., stochastics, MACD or RSI (Relative Strength Index). Knowing which of these indicators to use and what 'length' setting to use can be confusing; interpretation of an indicator, can be more confusing even. Sometimes, it's not the overbought (a high reading) or oversold (a low reading) EXTREMES that suggest that the market is topping out or bottoming, but failure of an underlying indicator to match price action.
3.) Retracements or 'give backs' of prior price swings tends to fall into certain pre-set patterns that can be measured and tend to adhere to certain 'fibonacci' price relationships.
There is also a tendency for the major market indexes to fall just once, or 1-2 to a few times, to a certain percentage below their 21-day moving averages and then rally. This tendency tends to be more true for DECLINES, rather than rallies, as advancing trends tend to occur from steady and REPEATED buying on the way up, whereas declines often stem from many participants dumping a lot of stock quickly which tends to get it over with faster and all at once.
I've covered points number 1 and 2 quite often in my weekend "Index Trader" columns or in this Trader's Corner column written mid-week on Wednesdays (occasionally Thursdays). Most readers of my columns I think know a fair amount about my thinking on these topics. You need only go back and read my most recent (Sat, 11/12) Index Trader column and see what I have to say about 'sentiment' (point #1) or overbought/oversold considerations (point #2) pointing to this recent top and sharp reversal. You can link to the aforementioned article by clicking here.
As to point #3 above, I got thinking about this question the other day, when Jim (Brown) was writing about the sharp rebound on Tuesday, in his Market Recap in the Option Investor Daily and said that: "You can only stretch that rubber band so far before it snaps back with lightning speed." How true, but the question I was wondering about from my own technical perspective is HOW far is 'so far'? What rules can we look at for HOW FAR down could this recent correction could have been expected to go? When was the time to cover puts and perhaps go into calls or sell puts, if we wanted to participate in an anticipated 'snap back' rally.
My experience with the following principles, trading 'rules' and technical concepts stem from trading experiences from the late-1970's on that included managing stock index funds using derivatives, some years as a financial futures and stock broker, 7 years as a UBS (then PaineWebber) senior technical analyst specializing in stock indexes, years spent as Dow Jones' global and European manager of technical analysis software services and a couple of final corporate years (on the 105th floor of the North Trade Tower) as a Cantor Fitzgerald manager and CNBC commentator.
Two things: there are applications or marking tools in most charting applications that will figure out the common fibonacci retracements and put a level line on those retracement amounts; e.g., click on a 1400 low, then on the imagined 1600 high and the charting application will show the fibonacci retracement levels. HOW to use these retracements or what are the RULES of retracements is another thing.
'RULES' OF RETRACEMENTS:
While once in a while a retracement will go as far as 75% or 3/4ths of a prior move and still RESUME the prior trend, it is more common to see a full 100 percent retracement back to the starting point of the prior move. Bottoms that are made after a 100 percent retracement have a name: double bottoms. Tops that equal a 100% retracement of a prior decline and don't go further are called double tops.
Are retracements self-fulfilling prophesies so to speak? Do traders start buying in anticipation that a decline will stop at the 50% retracement; or, at 62-66 percent? Indeed, some buying/selling will tend to come in at the fibonacci retracement levels, but can a limited number of traders willing to step up to the plate at these pre-set levels, determine the outcome and ultimate turning points of the huge US stock market? Unlikely! For reasons we won't go into, having to do with the nature of the unfolding of market cycles, 'natural' price progression, etc., the fibonacci sequences seem to reflect a natural order of things, including the unfolding of market cycles.
When I say 'cycles', I don't mean in the limited sense of repeating 'time' cycles of a 1-month, 6-day or 6-year duration. Rather, I refer to how market movements unfold based on what has come before.
I'll start with a more extreme or far-out example just to open this topic and then move to the more mundane and practical aspects of how you can use fibonacci retracements to assess where a correction may end (and in tandem, the possible use of moving average envelope lines) in helping you make better (i.e., profitable) trading decisions.
W.D. Gann, a somewhat legendary trader, active in the commodity and stock markets from the early-1900's to his death in 1955 and who is known to have made fortunes in his trading, held that the future unfolding of a market trend could be projected into the future based on a prior major high, a prior major low or, best, from the price range established by a major high and major low. Moreover, it was his belief that the two price axis of a chart, measuring price (horizontal axis) and time (vertical axis) could be EQUATED in measuring how far a future move might carry before a trend reversal set in, as well as suggesting where major resistance and support might be found in the future unfolding of a trend.
I took the weekly chart of the S&P 100 (OEX) back in 2005 and laid out the grids of the type used by Gann and even in my 'amateurish' way, without the special software that could create 'price and time squares', found much of interest in the unfolding of the OEX trend in the following 2 years. This chart is seen below:
I began drawing in the lines of this future 'grid' based on using the price range of 202 points established by the July '02 bottom at 385 and the '05 top at 587. The notations I've made on the chart give you some idea of how the unfolding trend AFTER early-2005, could have been expected to develop. The really interesting thing I found was how major trends began at the 'end' of the squares determined from the price range of 2002 to 2005. Go figure! This most recent trend reversal could be anticipated, give or take 1-3 weeks, in this current time frame.
Remember with the above chart that I started constructing this overlaying grid above on the OEX weekly chart 2 years ago and had of course no idea of how the strong continuation of the prior bull market would go or where any big corrections might develop. The above chart construction is by way of an extreme example of 'predetermined' cyclical patterns. Now on to the more practical and mundane examples of pre-determined fibonacci retracements, the use of which helped define where at least initial strong support would likely be found.
Deeper corrections, that exceed 50 percent of the prior move, will tend to go to a fibonacci ('fib' for short, no pun intended!) 62 percent or a 'bit' more, which is often 66%, as seen with the recent low in the S&P 500 (SPX) in the 1440 area. SPX is chopping around now, but has a good chance to 'base' around recent lows and rally over time, especially in December.
Note that I use the 13 'length' setting, a fibonacci number, for the Relative Strength Index (RSI) indicator. The fact that an 'oversold' (30) reading occurred in conjunction with the Index 66-66% retracements, was a tip off to collect most of your profits on S&P and DJX puts.
Whether you wished to buy calls at the 2/3rds retracement level, anticipating a bounce was another story, but it was a reasonable speculation if you bought at the 66% retracement, with a stop just under that level, anticipating a rebound back up the 'breakdown' point at 1490; a level of prior support, which, once broken, 'became' resistance later resistance; and a well-known technical analysis concept.
If there is a decisive downside penetration of the 62-66 percent retracement zone, there is potential for an SPX 'round-trip' of a 100% retracement or back to the area of the SPX August lows around 1380 or a bit lower.
The Nasdaq was the stronger index in recent weeks and resisted the decline the longest. The final sharp price break in the Nasdaq 100 (NDX), when it came, could be anticipated from the bearish 'rising wedge' pattern outlined below, the break of the steep up trendline and the 21-day moving average. However, what had been the strongest market segment would not be expected to have the DEEPEST correction, suggesting that the correction would be at most a fibonacci 62 percent; and NDX of course stopped just shy of this level but also got 'fully' oversold on the RSI.
MOVING AVERAGE ENVELOPES:
'21', another fibonacci number, is the single most useful length setting for the moving average to use for the major stock indexes in assessing how the intermediate-term trend (e.g. 2-3 weeks and more) is faring. This average can define both areas of support and resistance. In the S&P and Dow, prices tend to trade in a range that is around 3 percent above or below the key 21-day average in a non-volatile period, and ranges up to 4 percent in the S&P and Dow when the market starts showing more volatility, especially on the downside. Recent lows in the Dow 30 (INDU) have touched the 4% lower envelope line.
The August low cut seen in INDU (above) cut through the lower envelope line (at 4% below the centered moving average) but the Dow quickly snapped back. A decline to the lower envelope line, coupled with oversold extremes, tends to be a tip off in downside corrections to at least cover shorts and exit puts. Chances are that when prices reach the area of the lower envelope line especially given an oversold 13-day RSI extreme, you have garnered 90 percent of the profit you're going to make in DJX puts; e.g., assuming purchase around the time the trend reversed in early-October, or if entry was after the mid-October rebound rally failed to extend its gains above the 21-day average.
EXPANDING THE LOWER ENVELOPE TO FIND THE NEXT LOW:
The Nasdaq will tend to see highs and lows that hit extremes of 4-5 percent above or below the 21-day average, with the greatest extremes occurring on the reactions occurring after a prolonged (what me worry?!) and strong advance as was seen in August-October. If the rally was an 'extreme' so to speak (no direction but UP), the REACTION will also tend to extreme.
If the prior intraday low (mid-August) occurred at 6 percent under the 21-day average, as in the example provided by the Nas 100 (NDX) index chart below, a reasonable expectation or guess for the next low will be to expand the lower envelope to what it was at the last extreme. And, sure enough, the recent intraday and closing low was very close to the same 6 percent lower envelope line.
Envelope lines give a valuable idea of where, on a PRICE basis, a correction has reached an extreme. Do I use them alone, without assessing other patterns and tools? No, but it gives an excellent read on where a correction has a strong probability of having run it's course. This is not to say that there will be an immediate strong rally and the prior UPtrend will resume. Deep corrections of around 62-66 percent of the prior advance are showing that a serious underlying concern about the viability of the trend has set in.
GOOD TRADING SUCCESS!
Today's Newsletter Notes: Market Wrap by Keene H. Little, Trader's Corner by
Leigh Stevens, and all other plays and content by the Option Investor staff.
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