Option Investor

Daily Newsletter, Thursday, 09/04/2008

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Table of Contents

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

Market Wrap

New Era for Earnings

Market Wrap

The market started the trading day in the hole and then kept digging it deeper. It was a steady decline with only minor bounces along the way and by the end of the day the DOW was down nearly -345 points (-3.0%) while the techs and small caps lost a little more than that in percentage terms. It was not a pretty day for the bulls and at this rate it's looking like September might live up to its reputation as a bad month to be long the stock market. Volume was heavier than we've seen in a while (the volume numbers in the table above are wrong) so it confirmed the selling. The other market breadth numbers in the table also confirm the bearish day we had.

The market closed at its lows so we'll have to see if there was a little capitulation into the close which could set up a reversal tomorrow (it's been common to see strong moves right into the close get reversed the next day). That's just a guess of course but it's something to watch for. From the price pattern I also see the possibility for a quick move in the morning, perhaps as a reaction to the morning's economic reports, and then a reversal for the day. I'll review all that in tonight's charts.

Analysts are forever arguing about the value of the stock market and part of the reason for all the choppy price action we've had this year is the tug of war between the bulls who believe the market is undervalued and the bears who believe the market is overvalued. Most market fundamentalists use company earnings as a gauge for whether the market is fairly valued or not. The price of the stock compared to its earnings, the P/E ratio, is widely used by many and the P/E ratio for an index, such as the Dow Jones Industrial Average (DJIA) and S&P 500, gives us an idea as to the overall valuation of the market.

Over the years we've seen this measurement get skewed by analysts trying to make a case for their argument. Earnings have been forward looking and backward looking (trailing) and obviously that makes a big difference in the 'E' portion of P/E. Most times the analysts using P/E ratios like to use the one that best supports their particular argument although the trailing earnings is the most commonly used.

The average P/E ratio for stocks over the past 100 years is 14-16 (depending on whether geometric or arithmetic mean is used). As the following chart shows, the P/E ratio of the S&P 500 rose from a low of about 7 in 1980 to a high of about 37 in 1999:

S&P 500 P/E Ratio, 1943-2002, courtesy lowrisk.com

Anything over 20 is considered expensive and that's where the market has been since 1996, even after the 2000-2002 bear market. The next chart shows the period from 1999:

S&P 500 P/E Ratio, 1999-2008, courtesy marketgauge.com

The data is current through August 29, 2008. This chart shows stocks stayed expensive throughout the previous bear market cycle and in fact got more expensive (earnings dropped more than price). A secular bear market cycle will eventually return the P/E ratio to below 10 as earnings improve but public appetite for stock ownership wanes. As stock prices continue to fall, even while earnings improve, that's when the P/E ratio will get back to below 10 (to set up the next secular bull market cycle) and it sets up for another secular bull market.

But here's a question for you--what happens if earnings drop to a negative number? Anything divided by a negative number is a negative number. But the P/E ratio is always a positive number because within the index there are always some companies who report losses but the majority report at least some earnings. Right? Um, well, maybe not. Take a look at the DOW earnings chart:

S&P 500 P/E Ratio, 1943-2002, courtesy agorafinancial.com

This chart runs from 1929 through August 2008. For the first time in the history of the DJIA its total earnings have dropped into negative territory, and not by just a small number! It took about 50 years, from 1929 to 1979 for the DOW earnings to climb higher than $100, another 20 years to climb to about $850 and less than a year to drop to -$108. This is simply unprecedented. The DOW earnings have dropped nearly $1000 in one year!

We know that banks have been taken behind the wood shed and severely beat about the head and shoulders for losing so much money in the past year. I am simply amazed at how banks so creatively and consistently learn how to lose money. It's usually the financial sector that gets the market into trouble. At any rate, we know about the banks' negative earnings (and they're huge). But other companies have been hurt bad by the same bad investment scheme perpetrated and foisted off on others by the banks. AT&T went from positive $4B net earnings to reporting a loss of $11.3B because of huge losses in "Investing Activities". Can you imagine telling your spouse that you would have made money for the year except for your "investing activities" and that you therefore had to mortgage the house to cover your expenses, and that the mortgage company is now coming after your house? You'd be lucky to still have a bed to sleep on.

Verizon did one better--they went from a positive $2B in net earnings from their operations to reporting a $17.5B loss. It's no wonder the DJIA now has total earnings in negative territory. It's not just the banks who are having to write down the value of the bonds and alphabet-soup derivatives they own. On top of these losses we haven't even begun to see the write-downs that are coming from bad credit card and auto loans (that were also repackaged, blessed and sold as bonds). Add in commercial loans that will start defaulting as we head deeper into recession and you can understand why I've been pounding the table that we're not even close to a bottom in all this.


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The credit creation since 1980 drove the credit market from about 130% of GDP to about 350% today (excluding unfunded liabilities). This led to the unprecedented inflation in most asset classes. The collapse of the credit market, which has only just begun, will also collapse the value of most assets (gold included). We've got a generational change upon us and most will miss it before it's entirely too late to save their investments. It's September; do you know where your investments are?

So now the P/E of the DJIA is in negative territory. Theoretically it means any price for the DJIA is too much. They should be paying us to take their stock off their hands. Interesting times we have in the markets these days. Have I mentioned before that I think we're in a secular bear market and that the next couple of years are not going to be good times to own stock? OK, just checking.

After today's pummeling the bulls have got to be wondering if the September/October swoon is upon us. As I'll review on the charts, some key levels were broken to the downside which says the bears are back in control of the ball. There will always remain bullish possibilities so I'll review those levels as well. On to the charts.

S&P 500, SPX, Weekly chart

As I'll point out on the daily chart below, SPX broke below the key downside level of 1261 today and that negated a bullish price pattern that had the potential to see a rally into September opex. But on the weekly chart I'm still showing the possibility for a rally over the next couple of weeks as part of a larger a-b-c bounce off the July low. Notice that SPX is nearing the longer-term uptrend line from 1990, currently near 1225. If the market manages to bounce off a higher low than the July low at 1200 there would be many proclaiming a successful retest of the low and they'll be calling for a rally into the end of the year. I'll review that potential if and when it looks like we're getting a bigger bounce. I'm showing it as a potential move but the higher-probability move is a break below 1200 and a strong decline into next year, as depicted in dark red on the chart. We could see the 5-year 2002-2007 rally retraced in a period of about 18 months.

S&P 500, SPX, Daily chart

The longer-term uptrend line and the horizontal line across the 2005 highs/2006 lows crosses this week near 1220-1225 so that's the support level to watch if the decline continues tomorrow. I show a bounce off that level and then a turn back down from the 1261 level and declining into the end of the month (dark red). If it plays out that way and you see SPX stalling at 1261 you'll want to be aggressively short the market. Any bounce back above 1261 would be a heads up that the bulls are getting stronger and above 1300 would have me looking for a rally into opex and up to about 1350-1360.

Key Levels for SPX:
- cautiously bullish above 1300
- bearish below 1261

S&P 500, SPX, 120-min chart

The break below the shelf of support at 1261 obviously hit a lot of stops as the decline picked up speed from there. The price pattern would look best with a small consolidation and then another new low in which case watch for possible support around 1220-1225.

Dow Industrials, INDU, Daily chart

As with SPX I think the higher-probability direction for the DOW is down (dark red) but there remains the potential for another rally leg this month and if it were to rally from here I'm showing the projection to 12215 where the bounce off the July low would have two equal legs up (pink A-B-C bounce). If the DOW can rally back above 11500 I'd start to think more seriously about that potential but in the meantime I think it's safer to short the rallies rather than buy the dips.

Key Levels for DOW:
- cautiously bullish above 11718
- bearish below 11340, confirmed bearish below 11125

Dow Industrials, INDU, 120-min chart

I've been watching the move down from August 11th to see if the DOW would stop near 11211 where it had two equal legs down from the high which is also at the bottom of a small parallel channel for the pullback. If it reverses right back up tomorrow then this pattern could still be bullish (bull flag). Otherwise if the DOW drops below the channel, and especially if the bottom of the channel then acts as resistance, it would be bearish for much lower lows to come.

Nasdaq-100, NDX, Daily chart

A slightly larger parallel down-channel from the June high has been drawn for NDX's decline. Two equal legs down from June is at 1678.82 so watch for support if it gets down there. Note that today it broke down below the longer-term uptrend line from October 2002. NDX broke the trend line back in July but only on an intraday basis. Today's solid break and close below it is a bearish statement. The March lows near 1679 should be next.

Key Levels for NDX:
- cautiously bullish above 1913
- bearish below 1815

Nasdaq-100, NDX, 120-min chart

Another parallel down-channel, similar to the one shown on the DOW's 120-min chart, shows how NDX firmly broke below it today. Yesterday it dropped below it and retested it in the afternoon, closing slightly below it. The gap down this morning was a clear signal it was a bearish break. I'm showing a bearish wave pattern that calls for the move to stair-step lower into opex.

Russell-2000, RUT, Daily chart

The RUT is the lonely index that has not broken down yet. The key level at 716 remains intact but the bulls will need to do some serious buying tomorrow to get this turned around. A break below 716 would confirm today's break of its uptrend line from July. Notice it closed on its 200-dma and the 50-dma is about 7 points lower near 711. I think the higher-probability move from here is much lower.

Key Levels for RUT:
- cautiously bullish above 739
- bearish below 716

Banking index, BIX, Daily chart

We've got another parallel down-channel but this one is longer term from the high in October 2007. The BIX consolidated over to the top of the channel but appears ready to turn back down. The wave count I have on this chart is very bearish and calls for a hard decline from here. But if the bulls can continue the buying and drive the index above 200 we should see a rally at least up to its 200-dma before rolling back over.

I have a slightly different wave count on the chart of the brokers but it looks essentially the same:

Broker index, XBD, Daily chart

Like the banks the brokers consolidated near the top of its parallel down-channel and the wave count I'm using in this chart calls for a decline to kick off now. One other possibility, shown in pink, is for a drop back to 140 to be followed by a rally leg into October before tipping back over. I'll be watching the 140 level for support but have my doubts about that scenario.

U.S. Home Construction Index, DJUSHB, Daily chart

The bounce off the July low looks complete as of Tuesday's high. Similar to what I showed for the brokers, we could see one more down-up sequence to finish the corrective bounce off the July low (pink). A break below 268 would negate that possibility.

Transportation Index, TRAN, Daily chart

The Transports continue to be a very good indicator for how confused the market is right now. This index is chopping up and down and looks like a lost child at a carnival--not quite sure to look for his parents or go play on the rides. The pattern created by the uptrend lines from January can be thought of as an expanding wedge which is a bearish reversal pattern. These typically take a long time to play out and have very whippy price action. I think we'll see the key level at 4720 break soon.

U.S. Dollar, DXY, Daily chart

The mighty US dollar is showing no mercy on the dollar bears. After consolidating briefly at its downtrend line from 2002 the dollar took off for the upside. But notice the bearish divergence at the new high compared to the mid-August highs. This should be confirmation that a 5-wave move up from July is completing. I do not expect to see it tag the $80 area before first pulling back (green). It takes a drop back below 74.30 to tell us new lows are likely coming for the dollar.

Oil Fund, USO, Daily chart

Oil is trying to hold onto its uptrend line from August 2007 but after retesting it yesterday and today it closed below it. It looks like it should head lower to the Fib projection (and bottom of a support zone) near $69. A push back above $104 would have me thinking a little more bullishly about oil.

Oil Index, OIX, Daily chart

Oil stocks may be completing a 5-wave move down from May--notice the bullish divergence at this new low. A typical correction of the decline would be back up to the 875 area by mid November. If it instead continues lower there is an alternative wave count (pink) that calls for these stocks to stair-step lower into the end of the year.

Gold Fund, GLD, Daily chart

Gold, like oil, is trying to hold onto its uptrend line although for gold its a longer-term line from July 2005. It might be in the middle of a larger a-b-c bounce pattern that will take it back up to the 87-88 area before tipping back over. Otherwise look for gold to stair-step lower with an initial downside target near 60.

Economic reports, summary and Key Trading Levels

After today's ADP employment report showed a loss of 33K jobs last month, and expectations for a larger loss of jobs (-70K) in tomorrow's report, the market may have priced in the bad news today. If the number comes in better than -70K we could see a relief rally. Conversely if the jobs number comes in even worse, and the unemployment rate ticks higher, we could see more sell stops getting hit in a hurry. It could make the first hour of trading a little trickier than usual. The price pattern suggests to me that the initial direction of trading in the morning will get reversed so look to fade the initial direction.

On Tuesday I showed a chart of the 10-year yield and pointed out potential support at 3.6%. Today's decline in TNX got it down to 3.63% and the downside projection (for two equal legs down from June) is at 3.62%. Close enough for government work? We'll see and of course TNX could simply continue heading lower (dark red on the chart below). But it's worth keeping an eye on this chart into next week:

10-year Yield, TNX, Daily chart

If yields are going to rise over the coming months we should see support come in here. The a-b-c pullback from June should lead to a push to new annual highs probably before the year is out. That would indicate that inflation is not abating and the Fed would be raising rates to combat it (and follow the 10-year as they always do). But I've been of the opinion we'll see rates decline, shown in dark red. I think the slowing economy and the flight to safety (buying bonds drives up their price and yields down) will be a factor this year. But regardless, keep an eye on what rates do here since the stock market and TNX have been more in synch than not. If TNX continues to drop I highly suspect stocks will also be continuing to drop. That correlation may not hold much longer but until it breaks it's worth watching.

The stock market is now bearish with the break of some key downside levels. Therefore play defense--short the rallies or use them to lighten up your holdings. By the way, the moment you think you can't sell now because the market has dropped too much, that's the moment you're in trouble. That's the slippery slope of hope--hoping every day the market drops lower that the bottom is here and your stock portfolio will recover. That hope will be the destruction of more peoples' accounts than I care to think about. Have firm stop levels in place at this point and honor them. Your only loss potential in getting out is future gains. Staying in could cause serious and painful Real losses. Protection of capital is far more important right now than return on capital.

The bears are running with the ball and it takes a break now of some key upside levels to tell us the bulls have taken the ball back. That upside signal will leave plenty of time and money to be made on the long side (for a trade only). Longer term position traders should be flat and/or short. Traders should be looking for bounces to short, take your profits on declines, rinse and repeat. Trade with the trend which is now down. Long plays are counter-trend.

Just keep in mind that bear markets are the toughest to trade. Emotions run high and that means volatility increases. I strongly suspect we're going to see a couple of 300-point DOW days, in both directions. Trade carefully, take profits often and look for crisp setups and honor your stops. Volatile price action can destroy a trading account in a heartbeat.

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

Key Levels for SPX:
- cautiously bullish above 1300
- bearish below 1261

Key Levels for DOW:
- cautiously bullish above 11718
- bearish below 11340, confirmed bearish below 11125

Key Levels for NDX:
- cautiously bullish above 1913
- bearish below 1815

Key Levels for RUT:
- cautiously bullish above 739
- bearish below 716

Keene H. Little, CMT
Chartered Market Technician

New Plays

Most Recent Plays

Click here to email James
New Plays
Long Plays
Short Plays
None CS

Play Editor's Note: Concerns about a global slowdown and the possibility of another round of write downs for the financial sector have banking stocks looking weak. We are adding some bearish plays on a couple of foreign banks. A few more stocks you might want to check out are: BCS, IRE, ITU, and MTU. I would also keep an eye on Wachovia Bank (WB).

New Long Plays

None today.

New Short Plays

Credit Suisse - CS - cls: 44.93 change: -2.36 stop: 47.51

Company Description:
Credit Suisse Group is a major money-center bank based on Zurich, Switzerland.

Why We Like It:
A global slowdown is bad news for the foreign banks. Shares of CS have seen the recent bounce reverse. We're suggesting shorts right here. Another potential entry point would be a failed rally in the $46-47 zone. More conservative traders or those who want to see more momentum might want to wait for a new relative low under $44.15 before initiating positions. Our target is $40.10. Aggressive traders could aim for the July lows around $38.50.

Picked on September 04 at $44.93
Change since picked: + 0.00
Earnings Date 00/00/00 (unknown)
Average Daily Volume: 1.2 million


ICICI Bank - IBN - cls: 30.64 change: -1.89 stop: 33.25

Company Description:
ICICI Bank Ltd. is a large money-center bank based in India.

Why We Like It:
This is an aggressive entry point for bearish plays in IBN. The stock could have support at its 50-dma near $30.40, possible support at $30.00, and it still has a short-term trend of higher lows. However, if the world markets are truly worried about global growth and the credit crisis still has another round or two to go then IBN could easily retest its lows. We will try and reduce our risk with a stop loss above Wednesday's high. Our target is the $26.00-25.00 zone.

Picked on September 04 at $30.64
Change since picked: + 0.00
Earnings Date 10/13/08 (unconfirmed)
Average Daily Volume: 4.4 million

Play Updates

Updates On Latest Picks

Click here to email James

Long Play Updates


Short Play Updates

Alcoa - AA - close: 28.56 change: -1.24 stop: 32.05

Our entry point in AA did not pan out the way we expected. Instead of bouncing back to resistance and then rolling over shares of AA only bounced to $30.18 before quickly reversing. The stock ended the day off 4% and at new multi-month lows and on strong volume. Our suggested entry point for shorts was $30.35. We may have to re-evaluate an entry point but we're going to stick to our plan for now. More aggressive traders may want to pile on the bandwagon now. If triggered our target is the $27.05 mark. The Point & Figure chart is bearish with a $17.00 target. The latest data listed short interest at just 2.7% of the float. FYI: I think our biggest risk in shorting AA would be any buyout or acquisition news. Over the past few months I've heard some analysts speculate that AA might be a target but at this point it is just speculation.

Picked on September xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/07/08 (unconfirmed)
Average Daily Volume: 12.8 million


Expedia - EXPE - close: 17.82 change: +0.36 stop: 18.35

Shares of EXPE managed to buck the down trend today after getting a "buy" rating and a $25 price target from an analyst firm this morning. The stock rallied to $18.06 before failing at its 10-dma. This looks like another entry point for bearish positions. We have two targets. Our first target is $15.10. Our second target is $13.50. Be sure to take some money off the table at our first target since the $15.00 level might be round-number support. The Point & Figure chart is bearish and forecasts a $9.00 target. FYI: The latest data listed short interest at 5% of the 205 million-share float. That is just under three days worth of short interest.

Picked on September 03 at $17.25 *triggered
Change since picked: + 0.57
Earnings Date 11/06/08 (unconfirmed)
Average Daily Volume: 4.2 million


Genuine Parts - GPC - cls: 41.50 chg: -0.74 stop: 44.01

GPC followed the market lower. The stock broke through its 100-dma and closed near its lows for the session, which is normally a bearish sign for the next day. The move under $42.00 looks like another entry point for shorts. Our target is the $38.50 mark. More aggressive traders may want to aim lower. The P&F chart is bearish with a $28 target. We don't see any significant levels of short interest.

Picked on August 31 at $42.42
Change since picked: - 0.92
Earnings Date 10/17/08 (unconfirmed)
Average Daily Volume: 1.1 million


Hologic Inc. - HOLX - close: 19.18 chg: -0.82 stop: 21.05

HOLX also suffered some steep selling with a 4% decline and a new three-week low. The MACD on the daily chart is near a new sell signal. We had listed a trigger to open bearish positions at $19.60 so the play is now open. We have two targets. Our first target is $18.15 near the August low. Expect a bounce when HOLX nears $18.00. Our second target is the $16.55 mark.

Picked on September 04 at $19.60 *triggered
Change since picked: - 0.42
Earnings Date 11/06/08 (unconfirmed)
Average Daily Volume: 5.5 million


Kimberly-Clark - KMB - cls: 61.27 chg: -0.92 stop: 63.51

KMB displayed some relative strength by only losing 1.4% versus a 3% drop in the S&P 500. It looks like the stock has produced a bearish double top pattern but we're waiting on a little more confirmation. We are suggesting a trigger to short KMB at $60.75. More conservative traders may want to use a stop loss above last Thursday's high of 62.84. If we are triggered at $60.75 our target is the $56.00 mark. We do not see any significant short interest. The Point & Figure chart is bearish with a $54 target.

Picked on August xx at $xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/22/08 (unconfirmed)
Average Daily Volume: 2.6 million


Merck - MRK - close: 34.17 change: -0.50 stop: 36.85

MRK traded lower but still hasn't broken through the $34.00 level yet. We're not suggesting new bearish positions at this time. Our target is the $32.00 level. More aggressive traders may want to aim for $30.00. The P&F chart is bearish and points to a $23 target. We don't see any significant amounts of short interest.

Picked on August 31 at $35.67
Change since picked: - 1.50
Earnings Date 10/22/08 (unconfirmed)
Average Daily Volume: 17.8 million


Rockwell Autom. - ROK - close: 43.79 chg: -2.40 stop: 50.05

ROK was hit hard by the market-wide sell-off. Shares lost more than 5% and broke through potential support at the $45.00 mark and its 50-dma. The stock closed near its lows for the session, which is bearish for tomorrow. Our target is $43.00. More aggressive traders may want to aim lower ($41-40). Short interest is at 2.2% of the float. In other news today ROK announced that it would present at the Morgan Stanley Global Industrials CEOs Unplugged Conference in Laguna Niguel, California, on Wednesday, September 10, 2008.

Picked on August 31 at $47.21
Change since picked: - 3.42
Earnings Date 11/06/08 (unconfirmed)
Average Daily Volume: 1.7 million

Closed Long Plays

Monster Worldwide - MNST - cls: 19.15 chg: -0.73 stop: 19.11*

MNST was not immune to the market sell-off today. Shares broke their short-term trend of higher lows and dipped to $19.06 intraday. Our recently adjusted stop loss was $19.11.

Picked on August 20 at $19.11
Change since picked: + 0.04
Earnings Date 10/23/08 (unconfirmed)
Average Daily Volume: 3.1 million

Closed Short Plays


Today's Newsletter Notes: Market Wrap by Keene H. Little and all other plays and content by the Option Investor staff.


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