Market Stats

Recent data shows short sales in the stock market have dropped to a 6-month low. The short interest on the S&P 500 stood at about 8.8B shares of the end of July and has continued to drop since then. In the last two weeks of July the short interest dropped 12% according to Bloomberg which is the fastest decline since September 2008. If you look at the chart of the stock market you'll see that October and November were not kind to investors following that low short interest level.

From a contrarian perspective the current drop in the short interest level, combined with the extreme level of bullishness that we're currently seeing (by all measurements, whether it's put/call ratio, bullish/bearish advisors or daily sentiment index), says we should be very wary about expecting more upside for the market. But these measurements are not timing signals. You've heard it many times--the market can remain irrational far longer than you and I can remain solvent trying to fight it. There's a reason "the trend is your friend" is a popular way to trade. Stick with it until it's broken and you'll get the most out of the move (and hopefully keep most of what you made).

I am not a momentum trader but instead like to look for turns in the market. The challenge with this approach, especially at market tops, is that you can be early and fighting the trend. That's clearly been the case with this rally and my attempt to find the top. But as happened back in October 2007, the longer the top takes to form the harder the break seems to be. And as far as the trend goes, SPX really doesn't break its uptrend until it breaks the uptrend line from March which is currently sitting near 930. That would mean giving up about 80 points (about 800 DOW points) before deciding to cut and run on your long positions. That's a lot to give back. Hence my effort to identify the turns.

For those who have tried, with me, to short this market it's been a real struggle as the market continues to rally in the face of weakness. A top often takes longer to form than a bottom and if you're trying to short the market by buying put options it requires buying a lot more time than you think you'll need. You then have the option (no pun intended) to ride out whatever rally the market makes or jumping out and trying again at a higher level. But at least you won't get killed with time decay. So be sure to consider this before buying puts.

Back to the data on short interest, the sector experiencing the strongest rally lately is the banking sector. A 12% decline in the short interest for the whole market in July was dwarfed by the 31% decline in the short interest in financial stocks to about 2B shares. Short interest in Citi (C) dropped 72% to 343M shares. The people in the Fed, Treasury and SEC have all made it clear they do not like short players and think they're harmful to the market. I have little doubt they've engineered the buying in the financial stocks. It makes me wonder if the Harry Shultz letter warning of a bank holiday on August 26th is something well known by these people and are trying to get the banks as high as possible before it happens. But without shorts there will be little buying power when the market starts back down and that's why a significant drop in the short interest is bearish for the market. It's a matter of when, not if, the market will sell off hard.

I want to look out a little ways tonight and look at several weekly charts in addition to the normal daily charts I show. With the market holding up as well as it has been I want to review upside potential if it continues its climb, as it has been, in the face of waning momentum, extreme bullishness, low volume and Fib resistance (all the reasons why I'm looking for a top but frustrated that the market doesn't seem to care much about all the reasons why it should sell off). I've been bearish for a while with this rally and clearly too early. So in fairness to the bulls who won't let go (thanks in large part, I'm sure, to the Fed's intervention in the markets which includes money given to the primary banks to "invest" in the stock market).

Starting as I usually do with the SPX weekly chart, the first important Fib level is the 38% retracement of the 2007-2009 decline, at 1014. This is where price has currently stalled and this week's candle, which is hard to see because I compressed the chart a bit, is looking like a hanging man so far. That candle, if it finishes Friday near the current level, at Fib resistance would be bearish but obviously it would need a down week next week to confirm it.

A price projection at 1032, which is difficult to see because it's behind the broken uptrend line from 1990-2002, is where the 2nd leg up for the rally from March would achieve 62% of the 1st leg up. The broken uptrend line from 1990-2002 is near 1040 (this line stopped the rally back in November 2008 which then led to the low in November). So if the bulls can keep the rally alive we could see SPX make it up to the 1030-1040 area.

S&P 500, SPX, Weekly chart

The next upside projection is 1121-1133 which is the 50% retracement and where the bounce off the March low would have two equal legs up. I have a hard time seeing that level of bullishness from here but price is king and a rally above 1040 would open up that possibility.

The daily chart shows a parallel up-channel for price action since the March low and as depicted in pink we could see a rally up to the top of the channel by the end of the month where it crosses the 50% retracement at 1121. I don't believe there's enough strength to drive it up that high but it doesn't matter what I believe. We need to respect that possibility as long as the bulls (with the help of the Fed) are holding onto this market.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1018
- bearish below 925

The 60-min chart shows the fanned uptrend lines from July 10th through each of the lows since July 29th. Based on the current price pattern I'm showing some price projections for the next leg up if that's what's coming. The first, near 1014, matches the 38% retracement shown on the weekly and daily charts. Then there is 1021.40 and 1034. The intersection of trend lines is near 1040 by next Tuesday. At each of those levels I would be wary of a possible top. The latest uptrend line through Tuesday's low has now been tested a few times and therefore traders consider it important. A break below it, currently near 1005, would be a bearish heads up than a high might have been made. But it takes a break below 992 to confirm that. So the market is bullish until it's not.

S&P 500, SPX, 60-min chart

For the DOW I'm showing an a-b-c wave count for the bounce off the March low and the DOW has achieved a potentially important target at 9400. The 2nd leg of a bounce (wave-c of an a-b-c bounce) will typically achieve 62%, 100% or 162% of the 1st leg up. That projection is shown at 9399 (hard to see behind the red price depiction). Close to that level, at 9422, is the 38% retracement of the 2007-2009 decline. Therefore it's a setup for a reversal back down if it rolls over from here.

Dow Industrials, INDU, Weekly chart

The next upside projection is in the 10205-10334 area where the bounce off the March low would have two equal legs up and is the 50% retracement. A rally up to this level in the face of all the bearish signals I'm getting seems a stretch but price is king and we need to continue to respect the upside potential as long as support holds.

As shown on the daily chart, the bounce off the March low has the shape, so far, of a bearish rising wedge. The DOW has been held down by the top trend line along the highs since May-June. A rally out the top of it, so above 9425, would clearly be bullish. Right now it's looking like a bearish setup but they haven't proven they have what it takes to end this rally.

Dow Industrials, INDU, Daily chart

If the rally breaks and the bears take over the ball we could see a drop down to the uptrend line from March, which will be near 8700 by the end of the month. From there traders would need to be prepared for another rally leg or a full breakdown.

Key Levels for DOW:
- cautiously bullish above 9425
- bearish below 8600

On the NDX weekly chart I've been showing a Fib time relationship between the highs and lows since its October 2007 high. The week of July 12th was a low within the rally from March. There of course Fibonacci numbers between 21 weeks and 34 weeks (1,2,3,5,8,13,21,34,55) but I'm sticking with 21 and 34 (and 55) for now because of the relationship we've seen so far. Therefore the next date, 21 weeks from the week of July 12th, is the week of December 6th. There are some cycle studies pointing to the end of November as an important turn date so that ties in. I'm depicting a low of some kind during that week but that's clearly just a guess at this point.

Nasdaq-100, NDX, Weekly chart

Currently NDX has stalled near its 50% retracement of its 2007-2008 decline (1629.05). Slightly higher is its downtrend line from October 2007 which crosses the trend line along its highs since May-June next week near 1680. So that makes for a good upside target for now if the market does not break down from here. Whether from here or after a pullback to its uptrend line from March we could see another rally leg up to the 62% retracement at 1773. It takes a break below its uptrend line near 1510 to say a more important high is in.

The daily chart shows more clearly the intersection of the two trend lines next week near 1680 and that would make for a interesting setup for a possible top to its rally. The retest of last week's high is leaving a clear bearish divergence on the oscillators so the bulls need to keep the rally alive otherwise those divergences are warning of topping action here and now.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1630
- bearish below 1485

The RUT pattern and Fib targets are similar to the others. The 2nd leg of the bounce up from March achieved its first target of 62% of the 1st leg up once it tagged 578.12. Slightly higher at 597.60 is its 50% retracement of the 2007-2009 decline. I show, in pink, a price depiction for a continuation of the rally through the fall to a high of 643-658 where the rally from March would have two equal legs up, it would tag its 62% retracement and it would hit its downtrend line from October 2007-September 2008. Again, I have my doubts the market will be able to rally like that through the fall but I can't argue with price. I'm watching for evidence of a high being put in but so far there's no hint of a breakdown.

Russell-2000, RUT, Weekly chart

I don't show it on the daily chart below, but similar to the SPX daily chart there is a parallel up-channel, the top of which is near the 643-658 area by the early September. Another possibility, if we get a pullback but haven't seen a longer-term top yet, is for the uptrend line from March to hold and then another rally leg into September/October. That would certainly get a lot of bears leaning the wrong way into the historically weak period of the year. A break of the uptrend line, near 520, would suggest a longer-term high is in place.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 578
- bearish below 520

The rally in the financials since mid July went parabolic as the shorts couldn't cover fast enough. Price is now either consolidating for another run higher or is already in a topping pattern. Looking at the financial sector SPDR, XLF, a cleaner finish at this point would be another push up to the Fib projection at 15.27 into the end of the month. But as with the broader market there is the risk that the rally will fail at any time and a drop below 12.40 would signal the top is in (and then it would be time to start figuring out what kind of drop to look for).

Financial Sector SPDR, XLF, Daily chart

The price pattern for the bounce off the November low for the home builders has achieved an a-b-c-d-e rising wedge pattern and therefore is set up for a reversal back down. There was a minor throw-over above the top of the wedge yesterday and a close back inside today. That's a sell signal by this pattern. But if price presses higher I would expect to see the Fib projection at 315.51 to get tagged. The bottom line here is that this is a very bearish pattern until proven otherwise since it calls for a complete retracement back below the November low.

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

The weekly chart of the transports shows the rally has now reached the top of a parallel down-channel, the level of the 1999 and 2005 highs and almost to the 50% retracement of the 2008-2009 decline (3835). Today's candle is a hanging man against this resistance level so it's a setup for a reversal. A down day on Friday would confirm the signal in which case today's high would then establish the stop level for short plays. The IYT is the transportation ETF.

Transportation Index, TRAN, Weekly chart

The daily chart of the TRAN shows another Fib level at 3807 which is where the 2nd leg of the bounce off the March low would achieve 62% of the 1st leg up. That and the 50% retracement at 3843 makes a tough Fib resistance level to deal with. A rally above 3850 would mean the next Fib target, and the top of its parallel up-channel from March, near 4300 would likely be the upside target. A drop below 3400 would be a bearish heads up that a high has been made and below the uptrend line from March, currently near , would confirm the high.

Transportation Index, TRAN, Daily chart

UUP is the U.S dollar ETF and since it has options it makes a good trading vehicle. I like the setup for the dollar to make an important bottom, which it has either already done or should be close to doing. The wave count looks good for an end to the decline from March and the bigger A-B-C pullback from October 2008 looks good for a continuation of the rally that will take it above last year's high. Today's bounce looked like a correction so it might have a little lower to go and therefore being long the dollar has some risk of seeing last week's low taken out (23.04). There is also a downside Fib projection at 22.40 that it might drop to. A rally above 24 would say an important low has been made. With only 3% bulls, according the Daily Sentiment Index at, the dollar is ripe for an upside reversal.

U.S. Dollar, DX, Daily chart

If the dollar rallies it will put downward pressure on stocks and commodities and that's why I'm watching the dollar closely here. The rally in the stock market since March has been largely helped by the decline in the dollar so a reversal in both looks close. The inverse relationship between the dollar and commodities might not hold in the future but so far it is and therefore watching what the dollar does could help answer where gold and oil could be heading next.

There's been little change from last week's update on both gold and oil. For gold I have the key levels to the upside and downside still at 978 and 927, respectively. As I mentioned last week, each is on the cusp of a big move so a break of one of those levels should lead to a good trade. While the dollar looks potentially bullish and therefore I'm leaning short on gold and oil, a continuation of the decline in the dollar could spark a stronger rally in commodities.

Gold continuous contract, GC, Daily chart

A retest of the June highs for oil is leaving a bearish divergence on the oil chart. That in combination with what I see as a bullish setup for the dollar has me leaning towards the short side on oil. A break below 62 is needed to confirm the high is in but a break of the uptrend line from March, currently just below its 50-dma at 67.72, would be a bearish heads up. A continuation higher from here, above 74 would be bullish for a potential run up into the high 80s into September.

Oil continuous contract, CL, Daily chart

Tomorrow morning's economic reports could move the markets if the CPI data comes in either much stronger or weaker than anticipated (basically flat). Industrial production and the Michigan Sentiment numbers could also cause a big move if there is a surprise. But there seems little that's bothering the bulls at the moment even after a bad reaction to economic news. Once that changes we'll know we're dealing with a different market.

Economic reports, summary and Key Trading Levels

The following chart of business inventories, which declined more than expected, and sales, which declined more than expected, shows how dismal the picture is. Since 1999 we haven't seen anything like the current decline and as long as sales (the blue line) continues to outpace the decline in inventories there will be no build cycle in inventories. This is essentially what business leaders have been telling us and yet the market analysts keep insisting that we've seen the bottom and therefore the rally off the March low is justified. It's not and market participants will soon be forced to wake up and smell the coffee. Those who are long the market will then need a stiff drink instead.

Business Inventories and Sales, courtesy

I could go into the litany of reasons why the stock market rally has been built on nothing more substantial than hope. It's also been helped by a strong intervention from the Fed (feeding the primary dealers billions of dollars to then "invest" in the stock market). But you've all heard it before from me so the only thing I can do is warn those who are bullish to be very careful now. With bullish sentiment at October 2007 levels we know that those who want to be long the market are now long. Shorts have been shoved out of the market and that removes any buying pressure once the market starts down (the bears won't believe it and won't try to sell it down). This is exactly what sets up hard declines and the law of unintended consequences by the government to force shorts out of the market will backfire on them.

But the sentiment numbers are not good for market timing. It's only good for a warning. The rally into October 2007 went much longer, even if only marginally higher, than I thought it would go. We're now getting a mini version of the same thing but in this case I don't think it will go months. I think weeks at best.

Consumer credit continues to fall, down almost every month this year and even after the rally from March. Today's sales numbers only reinforce the idea that the consumer, the driver behind GDP, continues to retrench and save rather than spend. The Fed wants the banks to lend but they're too afraid to do it. Consumers and businesses are too afraid to borrow more. The velocity of money (how rapidly it grows through lending) continues to shrink, which is deflationary regardless of the fact that the Fed is pumping money like crazy into the banks.

Mortgage lending continues to shrink and foreclosures continue to grow. The combination is deadly for the home market. The chart of the home builders above is bearish and the bad news will soon take over and drive their stocks to new lows.

The Cash for Clunkers program gave a lift to the auto manufacturers by having people who would not normally have bought a car now go out and do so. They borrowed money they probably can't afford to pay back (ready for more loan defaults and a flood of cars back onto the market?) and we'll see auto sales shrink even further once this program is finished. Feel good now, feel pain later. That's all the government has been able to accomplish.

But these problems fall into the fundamental camp. We don't trade fundamentals (well we do but it's not a good timing tool). We trade the charts where price rules. Right now we remain in a bullish price pattern but those patterns warn of a possible top here or very close to here. I showed on most of tonight's charts a lot more bullish potential and that has to be respected. Whether I believe in that potential, the market cares not one whit. I show the setups for reversals as a warning to those who are long the market and for those who, like me, try to catch the turns. But without a break of the key downside levels noted on the charts we have absolutely no confirmation that a high has been made.

If you try to trade the turns you must recognize the risks. Trade small until the market proves your trade is correct and then start adding to it. Depending on your risk tolerance you can let the market move against your position or instead jump in and out as you attempt to catch the top. Or wait for a break of the trend and then start looking for short entries. There is no right or wrong way to do it. But risk management is key no matter which way you try.

As of tonight I see a couple of charts ready to reverse from here and a couple that look like they could press marginally higher before they're ready for a reversal back down. Waiting for breaks of the key levels to the downside, considering some are relatively close, is a more conservative way to try shorting the market rather than pick a top. One concern, and something we've seen in previous declines, is that the declines are often started with gaps to the downside and it's hard to get aboard. Bear markets are hard to trade and this one is not going to be any different.

Good luck next week as we head into opex and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1018
- bearish below 925

Key Levels for DOW:
- cautiously bullish above 9425
- bearish below 8600

Key Levels for NDX:
- cautiously bullish above 1630
- bearish below 1485

Key Levels for RUT:
- cautiously bullish above 578
- bearish below 520

Keene H. Little, CMT