Market Stats

Todd and I switched nights this week so he'll be writing Thursday's Market Wrap.

There were a lot of guesses as to why the market sold off today. Market pundits are paid to come up with a reason for why we get the buying and selling. Sometimes the same piece of news will explain both sides. My argument is much simpler--the market sold off today because traders sold their positions.

That's said somewhat tongue-in-cheek but in reality it really is that simple. The market moves on emotions rather than news. We've seen far too many instances where the market reacts "strangely" to what is perceived initially as either bullish or bearish. When traders are ready to sell they'll sell regardless of the news. If traders sell the "good" news (or "less bad" news) we say they "sold the news" after buying the rumor. If they buy bad news we say they're climbing the wall or worry. This is a reason why I don't try to make market prognostications based on what I think the news will be or what the economy might look like down the road. The economy and stock market will simply reflect social mood.

We've had a lot of hope in the past several months that the bad times are over and that we're starting the next bull market leg up. Despite the plethora of bad news that the economy is not improving ("less bad" is not improving since the hole is still getting deeper but at a slower pace) we've had one of the strongest rallies in history based purely on hope.

A Slowing Decline

The credit market continues to shrink, home foreclosures are climbing, unemployment is expected to get worse, commercial real estate is starting to collapse, banks are folding, etc., etc., but investors are being told that this is a great buying opportunity. Hope feeds bull markets and despair feeds bear markets. When despair about the future starts to overwhelm hope we'll get the sellers stepping back in. We may be on the edge of that tipping point now.

There is plenty of information that shows how much liquidity has made it into the markets in an attempt to get money into the monetary system and to boost investor moral. Again, hope is a commodity that the Fed has been buying double fisted with all the money they can create. But the Fed is not THE market and it's only been a matter of time when a collective social mood shift back to the negative side overwhelms even the mighty Fed.

The liquidity push by Greenspan sparked the final stages of the credit bubble which spawned the housing bubble and we're experiencing the after effects of that bubble (which has a ways to go before being deflated). They're trying again to re-inflate the credit bubble but there are few takers. The banks don't want to lend and consumers/businesses don't want to borrow. Massive insider selling by corporate executives, compared to insider buying, tells us company heads don't feel very good about the future prospects of their company stock prices. Under these conditions it's highly unlikely they'll have their companies take on more debt (which is only done when they're positive about the future and borrow to gear up for it).

What I don't know at this point is whether today's decline is part of what will become a significant decline into the fall or will be just a pullback that leads to another rally leg into September. For one who wants to short the market to take advantage of a market downturn I dislike the fact that so many are expecting a pullback to SPX 950 or a decline into September/October to set up the next buying opportunity. When too many expect something it often doesn't happen. We might only get a small pullback and rally into September (shown on tonight's charts) to fool most of the people. Then when everyone is convinced we won't have a decline into the fall the market will collapse.

The other side of that coin is that SPX 950 will not hold as support. Again, with so many expecting that to be solid support and a terrific buying opportunity I have to wonder, if we get there, whether a bounce off that level will be a huge bull trap. We can only guess at this point as we peer into our crystal balls. I've been saying for a while now that we need to play this market one leg at a time since the longer term (next 6 months) is far too difficult to know. I like to use key levels on my charts as a way to help identify the higher probability moves.

Last Thursday I presented a few weekly charts in an effort to give a little longer-term perspective on where the market could head into the end of the year. Currently I'm probably one of the more bearish analysts out there and even among us OIN writers. I think you get a great cross section of opinions just from us and that's healthy. If we all start to agree on where the market is going you can almost take it to the bank that we're all wrong. I say that somewhat in jest but in fact we writers have seen that happen time and again, particularly on the live Market Monitor.

So our hope is that you read the various opinions and simply use the information you glean from us as part of your own research and decision making for your personal trades/investments. Only in hindsight will we know who might have been closer to figuring out what their crystal ball is telling them. My "style" of analysis relies quite a bit on EW (Elliott Wave) patterns and from these price patterns I can identify key levels to the upside and downside that will support either a bullish or bearish scenario.

I use the "hand" symbol on the charts and in combination with the finger (not that one) pointing either up or down with the price level identified next to it, I'm hoping you will have enough information to help you decide whether to trade that direction or get flat. Always remember that a flat position is many times the best. You might not make money with it but you'll surely save yourself from a loss when the market's probable direction, in your opinion, is not clear enough to justify a trade.

Coming into today's trading the futures were down sharply after dropping steadily during the overnight session. Asia was down despite some good news out of Japan about their GDP growth for the 2nd quarter. This followed last week's reports out of France and Germany. The market has sold off on these pieces of good news. The Chinese market got hit hard again last night (-5.8%, following Friday's -2.9%) and that market is giving signs of a breakdown in progress. I've been recommending a short play on the Shanghai index for the past three weeks.

Why do we care about the Chinese market? First, we're a global economy and it's not just the U.S., being such a large market, which drives the world markets. We're all inexorably linked and when one sneezes everyone else soon catches the same cold. It comes back to the social mood thing. Fear is contagious. The Shanghai index experienced a bubble top in 2007 and dropped about 73% into its November 2008 low (bottoming before our March 2009 low). It has now dropped about 17% from its August high (which retraced about 38% of the 2007-2008 decline). Today's decline sharply broke below its 50-dma and the question for us whether or not the Shanghai index may be acting as the canary in the coal mine. The fact that their market has rolled over should raise more than a few eye brows in this country.

The chart of the Shanghai index with an overlay of the SPX shows the sharp drop today through its 50-dma. It has also broken its uptrend line (not drawn on the chart). It's hard to see the SPX pullback behind the SSEC price but so far it's relatively minor. The question now is whether SPX will follow SSEC lower and also break its 50-dma and uptrend line from March, both currently near 946. That's an important level to watch if the bears continue to rule this week.

Shanghai index, $SSEC, with SPX, Daily chart

Not a lot has changed since my last update on Thursday, which included some weekly charts for a longer-term perspective, but looking a little closer at the daily charts will shows us what to watch for this week. The SPX weekly chart has a fresh red candle from today's price action but obviously the week is still young. But a red candle this week, after last week's small hanging man at Fib resistance, would complete a candlestick reversal pattern. As depicted with the dashed line, we could see a pullback to its uptrend line near 946 followed by another rally leg to the 1100 area in September. What could drive it there I do not know (other than more government money (our money) thrown at the market in hopes of holding it, and consumer sentiment, up). But don't argue with price no matter how bullish or bearish you feel about this market.

S&P 500, SPX, Weekly chart

Friday had finished with a lot of bullish sentiment, especially after another one of those end-of-day stick saves with the jam up into the close. Call options were flying off the shelf while put options were feeling very lonely. Word on the floor was that the dip last week was an excellent buying opportunity. The sideways price consolidation had many traders leaning over the bullish side of the boat and today it tipped over on them. The gap down opening was followed by more selling and by mid morning the trading day was essentially over.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish above 1018
- bearish below 940

If SPX finds support at or above its uptrend line from March, currently near 940, and then makes it back above 992 we will very likely see a continuation higher to new highs (pink). The first upside target, assuming it finds support at 940, would be near 1037 (62% projection for the 2nd leg up from the July low) and then close to 1100 (two equal legs up from July).

The wave count into Friday's close was a potentially very bearish setup and I had suggested taking a few puts home over the weekend in case we saw immediate selling out of the gate on Monday. It was a setup for a 3rd of a 3rd wave down which are often accompanied with gap moves, as this morning's was. Now the pattern calls for at least one more leg down on Tuesday to complete a 5-wave move down from Thursday. The downside target for that is 965-970 (it could sell off from the open or we might see a quick rally attempt (SPX 987) before selling off.

S&P 500, SPX, 60-min chart

Assuming we get the leg down as depicted on Tuesday it will then be time to protect profits on short plays, especially on any August puts. We should get a bounce following the leg down and I'm not sure yet whether it will be the start of the next rally leg (pink) or a sideways/up consolidation for a couple of days before heading lower again (downside target of about 950 into the end of the week). If the bounce becomes strong and tries to close today's gap it will be bullish. If it's weak and choppy then it will be bearish. Back above 992 would be bullish.

Like SPX, the DOW rolled over from Fib resistance (38% retracement of the 2007-2009 decline) and the trend line along the highs from May-June. Now the test comes next--the January high of 9088 is not far below and at the same time RSI is testing potential support near the 50 level. A break of both should be a good indication we'll see the DOW head for support at its uptrend line near 8600.

Dow Industrials, INDU, Daily chart

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

After retracing 50% of its 2007-2008 decline it looks like NDX is ready to test support after not being able to crack resistance. Its uptrend line and 50-dma are collocated near 1520.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1634
- bearish below 1500

The RUT's rally leg from the July low also ran into Fib resistance by achieving 62% of the rally leg from March into its May high. This is one of the common Fib relationships between legs in an a-b-c bounce and has me alert to the possibility that the correction rally from March has now completed which would mean we'll start the next big decline from here (dark red). A break below 520 would support that idea but in the meantime we could see just a pullback and then head higher into September (to the 600 area if not higher).

Russell-2000, RUT, Daily chart

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

Looking at the bigger market, the NYSE, the price pattern looks the same as the others. Not shown on the daily chart, but is shown on the weekly chart below the daily chart, are the Fib retracement levels for the 2007-2009 decline and the rally stalled at the 38% retracement, as did the DOW and SPX. There are several ways to label the wave count for the rally off the March low and I show only two possibilities on its daily chart (there are 11 different corrective wave counts and the correct one is often not clear until the end of the correction). The dark red count, which is the same as shown on the RUT chart above, calls the bounce off the March low as an a-b-c correction and wave-c (the rally from the July low) nearly achieved 62% of wave-a (at 6679) so that level and the 38% retracement at 6552 made for a good correlation for a potential top to its rally.

NYSE, NYA, Daily chart

As with the other indexes, one alternative that's shown in pink, is for a pullback to the uptrend line from March, currently near 6000, and then another rally leg into September (perhaps up to about 7000). I don't know what could drive prices higher like that but it's an EW possibility and therefore must be respected. A break below 6000 would make the pink wave count a much lower probability.

I'm showing the weekly chart because it's a good example of how parallel channels can be used to find support and resistance. I created a parallel down-channel using the first bounce into the May 2008 high and attaching the parallel to the low in January 2008. When price falls through the bottom of a parallel down-channel it's usually a good idea to leave that channel in place because a bounce back up will often find the bottom of the channel to be resistance (the opposite works as well for an up-channel). I'm not sure why (and certainly very few traders check this) but it probably has something to do with the cyclical nature and measured moves in the market. At any rate you can see the NYSE has now stalled at the bottom of the first down-channel. This could be a setup for the resumption of the decline to new lows whereas a continuation back up inside the down-channel would be at least short-term bullish.

NYSE, NYA, Weekly chart

I've mentioned the weakening momentum in the rally and loss of market breadth many times in previous weeks. The chart of the NYSE vs. the advance-decline line shows the negative divergence between new price highs for the NYSE and equal or lower highs for the a-d line. This is classic topping action and can be viewed as only bearish. It doesn't preclude another stab higher in price but each time it does it offers another shorting opportunity at this point.

NYSE vs. Advance-Decline Line, Daily chart

While the rally's strength has been waning we've seen a spike in bullish sentiment by several measures. Bullish complacency is never a good thing for the market. But one measure of "worry" is the VIX and today's climb had it breaking its downtrend line from March. As shown on the weekly chart this downtrend line could be the top of a bullish descending wedge (which of course means bearish for stocks). If this wedge gets completely retraced, as is typically done and done quickly, that would mean the VIX could be back over 50 in the next couple of months. That also means the stock market could be making new annual lows. But the bulls aren't in trouble, from a VIX perspective, until the VIX is above 35 (the top of a parallel down-channel from January).

Volatility index, VIX, Weekly chart

Part of the reason people have been bullish on the stock market is because of the strong rally in the banks, especially the one off the July low. Many feel that the banking problems are behind us and that the Fed is in control and won't let anything bad happen to us (snicker). But the bad news keeps pouring in and will soon make a difference in investors' mood.

Aug. 14 (Bloomberg) -- More than 150 publicly traded U.S. lenders own nonperforming loans that equal 5 percent or more of their holdings, a level that former regulators say can wipe out a bank’s equity and threaten its survival.

The number of banks exceeding the threshold more than doubled in the year through June, according to data compiled by Bloomberg, as real estate and credit-card defaults surged. Almost 300 reported 3 percent or more of their loans were nonperforming, a term for commercial and consumer debt that has stopped collecting interest or will no longer be paid in full.

News out over the weekend spoke about at least 1000 banks going belly up over the next 2-3 years (I think it will happen faster than that). Someone needs to remind me again why banks have rallied so strong off their March lows. Oh, that's right, because many are hoping the economy bottomed and banks are recovering. Call me skeptical on that thought.

The rally from the July low left a possible double top with negative divergence. I see the potential for one more minor new high (pink) before rolling over so if that happens within the next week or so it would be an ideal setup for shorting the banking sector. It takes a break below 111 to indicate the rally is probably already finished.

Banking index, BIX, Daily chart

The home builder index finished its rally with a small throw-over above its trend line from the December-April highs, which looks to be the top of a rising wedge pattern. Friday's and today's strong selling indicates to me the high is in. The throw-over finish and drop back inside the wedge is a sell signal. The rising wedge says it will be completely retraced quickly (back below the November low). I see nothing bullish about this chart. If by chance we get a pullback and a new high (pink) it will be an even better setup to short the home builders.

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

Last week I showed the weekly chart of the Transports to give a better sense of the parallel down-channel from 2008. The strong selloff today from the top of the channel (and the 62% projection for the 2nd leg up in the bounce off the March low) looks potentially very bearish to me. But it still takes a break below 3400 to increase the probability that we've seen the high of the bounce. In the meantime there remains the potential for more upside, especially with a push back above 3850.

Transportation Index, TRAN, Daily chart

Part of the reason the Shanghai index took a big hit today is because of the drubbing metal stocks took. There are many who are becoming more worried that weak economic data does not support higher commodity prices. Add in the U.S. dollar's strength (I covered the U.S. dollar chart last Thursday and today's rally confirms we'll likely see a strong dollar rally from here) and it's putting a lot of pressure on stocks and commodities. China is also starting to tighten bank loans in an effort to contain the excessive enthusiasm in their market. They did the same thing into the 2007 high. The commodity index shows those stocks dropping in synch with the overall stock market.

Commodity Related index, CRX, Monthly chart

Notice the very tight correlation between the stock market and the commodities index (I'd put the chart of the SPX behind the CRX but it gets blotted out). Also notice the double top in the CRX in June and August with negative divergence on MACD. That's pretty much a classic double top, including the negative divergence between the two highs in August. It doesn't mean it can't make yet another new high with more negative divergences but that would be a low-odds play from here.

But the bulls are not in trouble yet. Looking at another picture of the commodity index shows price pulling back to its broken downtrend line from May 2008, currently near its 50-dma at 623. It's also testing the top of a parallel up-channel (blue line). As per my discussion with the NYSE weekly chart, the top of that channel should act as support if the bulls are not finished yet. It takes a break below its uptrend line from March, near 600, to tell us the bears have taken over.

Commodity Related Equity index, CRX, Daily chart

Gold is considered a commodity but even more people look at it as a true currency. Fear of inflation due to excessive money printing by the Fed and other central banks has many looking to buy gold and other commodities as an inflation hedge (and a hedge against an outright failure of fiat currencies). I agree with the concept and look forward to being a strong buyer of gold down the road but not yet. Today's price action gave us a first hint of trouble for gold with the break of the uptrend line from July's low. It could be simply part of a larger sideways consolidation pattern but the bearish wave count (dark red) calls for a strong selloff from here. A break below 927 would confirm the bearish count while it still takes a break above 978 to put the bulls back in charge.

Gold continuous contract, GC, Daily chart

Oil is in the same position as gold but the bulls are holding on slightly better by closing at the bottom of its parallel up-channel from January-February. Neither the bulls nor the bears can claim any victories yet as neither key level, at 74 to the upside and 62 to the downside, has been broken. But any lower tomorrow would be the first bearish heads up.

Oil continuous contract, CL, Daily chart

The Empire Manufacturing index should have been very bullish for the market today since it supported the contention that the economy has bottomed and is improving. It did nothing for the market but you can bet it would have been credited had the market rallied instead. Tomorrow's reports have the potential to move the market initially but I would look at an initial pop higher very suspiciously. I think we'll get a new low before potentially setting up a larger bounce. Likewise for an initial decline in the morning--it could put in a tradable bottom so be carefully of volatility around the opening and first hour of trading (especially with opex exacerbating the volatility).

Economic reports, summary and Key Trading Levels

Many stock analysts have been getting more and more creative in their rationale for owning stocks. A common belief at the moment is "I don't believe in this rally, but I'll ride it until it looks like it's over, and then Ill sell." I think this same attitude is what got Bernie Madoff in trouble. This is exactly what creates bubbles and why Ponzi schemes don't end well. When enough investors share this sentiment, and people stop investing on the basis of sober, rational analysis, the result is sometimes a crash. I'm looking at price patterns (wave counts) that support the crash idea and bullish sentiment that has reached the same extreme that was reached in October 2007. We know how well that sentiment worked out for investors back then (Not). When 90% of economists agree on where the economy is going (as is the current situation where they're bullish) you can bet they're wrong.

How bad could it get? The last deflationary market decline (1930s) saw a big rally in 1930 (+52% in 22 weeks, which is the length of the current rally off the March low and the same kind of % gain) followed by a 89% decline into 1932. Will that happen again? We tend to repeat these kinds of patterns so I'll leave it at that. I will suggest investors do not want to be long this market. Period. I'd rather be in a position of protecting my capital rather than worry about return on my capital. But then again, I'm bearish the market longer term so that should be no surprise.

The SPX 992 level continues to be a important level to watch. Once that support shelf broke today it should now be resistance. A drop tomorrow to finish the decline from Thursday should be followed by a bounce. If the bounce makes it above 992 we'll probably see at least a larger sideways consolidation pattern play out or more bullishly we'll see another rally leg to new highs (but be careful chasing it higher). If the uptrend lines from March start breaking (and China could lead the way here), I'll start figuring out downside targets along the way but the first target of interest for SPX is down near 850 (July's low), 8000 for the DOW.

In the meantime there hasn't been enough damage to the price pattern to suggest the bulls are in serious trouble. A "normal" correction of the rally from July should take us into Wednesday at the earliest and as late as next week. If those uptrend lines are holding by next week we could be set up for another rally leg.

Keep an eye on the U.S. dollar. If it rallies above 81 I think we'll see a continuation of a strong push higher in the dollar. With bullish sentiment reaching a historically low 3% at its low in early August this one is ripe for a rally. And a rally in the dollar will put downward pressure on stocks and commodities. Watch the key levels shown on gold and silver as those could act as a heads up that stocks will follow their lead.

We're at a critical spot for the market so trade carefully until we get some confirmation which direction this market will head next. Use the key levels I've identified on the charts and trade the direction of the breaks. Good luck through this opex week and I'll be back with you a week from Thursday. For those on the live Market Monitor I'll do my best to show the setups as they unfold. It could get exciting from here.

Key Levels for SPX:
- cautiously bullish above 1018
- bearish below 940

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

Key Levels for NDX:
- cautiously bullish above 1634
- bearish below 1500

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

Keene H. Little, CMT