Option Investor
Newsletter

Daily Newsletter, Thursday, 11/26/2009

Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews

Market Wrap

Dubai Default

by Keene Little

Click here to email Keene Little
There would not normally be a market wrap tonight because the U.S. markets were closed for Thanksgiving. But because of the news and overseas market action I felt it might be helpful to get out a quick review of where we are and what the setup is as we head into Friday. As most of you are well aware, I've had a bearish opinion about the stock market for a while now and that bearishness has been increasing lately as the market tries to push higher but with clearly declining momentum. At the same time the level of bullishness has been increasing and is as bullish as it was at the 2007 highs. The put/call ratio and the ISEE call/put data, especially in the past week, has been pushing bullish extremes. It's a setup for failure and it won't take much for the stock market to tip over.

The overnight news out of Dubai (Wednesday night) has spooked the world markets. Dubai government said they need to reschedule the payments on their debt (almost $60B) and in essence has defaulted on their loans. This is causing a spike in credit default swaps (the same thing that precipitated the financial crisis in 2008) and the European markets dropped more than 3%, the most in seven months. A 3.5% drop in the S&P would have it dropping from its closing price of 1110 down to 1071 so that's the kind of potential our market is facing on Friday. The futures got hammered lower to their close at 11:30 AM, with ES down -24.25 to 1084.75. It could lose another 10-15 points if we get the same kind of -3.5% loss. ES found support at its previous lows on November 12th and 20th.

ES all-hours 60-min chart

The most significant question in my mind as of this evening is whether or not there will be an effort by the PPT (Plunge Protection Team, otherwise known as the President's Working Group) during the overnight hours to rescue the futures. And if they do try, will it hold after the cash market opens on Friday? These are all questions that we of course can only speculate about.

The RUT's futures (small caps) ended Thursday down -3.5% (about 20 points down) and below its November 13th and 20th lows. After Wednesday's close I was looking over the RUT charts with another trader since that index has been pointing towards bearish trouble even as the blue chips have been held up. The EW count for the move down from its high in October is a very bearish setup for a strong 3rd of a 3rd wave down--basically the kind of move that becomes a kickoff for a significant decline. If the PPT doesn't rescue the futures Thursday night/Friday morning, we could hear the starting gun for the bears on Friday morning.

I've been warning about a coming downside surprise that will be sparked from who knows where (usually from an area least expected) and a currency and/or bond crisis is the typical spark. When the dominoes start falling even our mighty Fed and PPT will not be able to stop it. Only time will tell whether or not this will be the kickoff to the downside but the risk has been elevated a notch by the overseas news and markets.

The RUT's 60-min chart was what I had laid out at the end of the day Wednesday prior to hearing about the Dubai news and it shows how a "normal" decline could unfold into early December before we get a decent bounce, maybe into Christmas before heading lower again into January. The very small break of its uptrend line from Friday, November 20th (that low has now been broken by the futures as of Thursday morning) was hinting of trouble into the close on Wednesday.

Russell-2000, RUT, 60-min chart

I've laid out a typical 5-wave move down from the November high to a low near 535 by December 9th. This is obviously just a guess but is based on a typical wave pattern using typical Fib price and time relationships. The wave-1 low in early December would be only a small degree 1st wave in a larger decline, as shown on the daily chart below as wave-i. The bounce into the latter part of December would then be followed by a continuation lower as the next bear market leg down develops.

Russell-2000, RUT, Daily chart

If the next bear market leg down is starting then a retest of the March low, as depicted on the RUT's daily chart, could happen by this coming March. Seeing the futures down hard I figured I'd better see how it might play out for the S&P 500 considering it's in a slightly stronger pattern than the RUT. I'll start out with a look at the last time we had to deal with a nasty credit contraction, deflation and a depression. After the 1929 crash the market then bounced back up in 1930 and retraced a little more than 50% of the decline before heading back down (in a hurry). As you can see in the chart below, the break of the uptrend line from the 1929 low to the April 1930 high was the start of the strong decline back down.

DOW Industrials, 1928-1932

The first leg down after the break of the uptrend line was a spike down, then a bounce and then an even stronger spike down into the middle of 1930. So the risk for our market, if it follows a similar pattern (and I believe it will) is for a spike down now to carry further to the downside before we get a bounce and then hard decline following the bounce.

As I played with a couple of ideas for how a decline might unfold I tended to be conservative, meaning I'm not showing a crash leg down as is evident on the chart above. Therefore, what I'm showing on the SPX charts below could be "less bad" than what might actually play out. Therefore take what I'm showing as only one idea--it could be worse or it might only pull back and then head higher again. This is my best guess at the moment. Starting with the SPX 60-min chart I want to show how a 5-wave move down might unfold into early December where it should find support near 1050 at its uptrend line along the lows since July.

S&P 500, SPX, 60-min chart

The 1st wave down (labeled wave (i) at 1050) would then be followed by a 2nd wave bounce into mid December and then a stronger decline in the 3rd wave. Moving out to the daily chart, that 1st and 2nd wave on the 60-min chart looks like a very small move on the daily chart. A larger degree 5-wave move down could take SPX down to the 940 area by early January. And then a larger degree 2nd wave bounce into February followed by a stronger 3rd wave down into March.

S&P 500, SPX, Daily chart

Notice the key levels on each of the two SPX charts--each gives us a heads up for the degree of trend that we're looking at. A break below 1097 (60-min chart) says the high is in for the move up from November 2nd and says we should get at least a pullback correction of that rally leg. A break below 1086 says the rally from July should now be complete and that calls for a resumption of the bear market. Now we take the move on the daily chart and move out to the weekly chart and the first thing to find is the wave-i low in January and notice that it's only the first wave of a much larger 5-wave decline. This goes back to the 1929-1932 pattern which calls for a significant break below the March 2009 low.

S&P 500, SPX, Weekly chart

A larger degree 5-wave move down on the weekly chart could see SPX drop down to the 600 area (606 is the 1996 low) by midyear next year. Then a larger degree 2nd wave bounce and then a stronger 3rd wave decline into 2011. You get the idea by now.

This is all speculative and we all know the market likes to make fools of whoever tries to predict it. It doesn't stop me from trying (smile). The message I wanted to get out tonight, and the reason for the special update, is because I want to make sure I've done everything I can do to show the very bearish potential from here. While the market probably won't lose as many points as the first leg down (2007-2009), from a percentage standpoint it could be worse. By the time the stock market found a bottom in 1932 it had given up 90% of its value from the 1929 high. If you think you can ride out the bear market (buy and hold mentality) you need to be aware of the potential risk in doing that.

There's plenty of time between this afternoon and Friday morning and anything can happen, including news that Dubai says they've figured out how to make their payments (we could bail them out since it's "only" $60B). That would spark some serious short covering after Thursday's decline. Needless to say, we could see some significant volatility Friday morning.

Trade carefully if you do otherwise sit on the sidelines and watch the show. If you're long the market and want to protect positions you will have some tough decisions--bail quickly, wait for a bounce (which might not come), leg out or all out? These are the tough decisions and there's no right answer. Only in hindsight will you know the right answer. Good luck. If you follow the Market Monitor we'll watch and react together.

Keene H. Little, CMT


New Option Plays

No Plays Today

by Jim Brown

Click here to email Jim Brown

In Play Updates and Reviews

No Play Updates Today

by Jim Brown

Click here to email Jim Brown