Market Stats

The good news is that the market broke its string of daily losses but the bad news is that volume was very light today, about on par with last week's volume as it was topping. It's not what the bulls would like to see. The price pattern looks like a corrective bounce which is supported by the lower volume. Both pieces tell us to expect lower prices before we get a bigger bounce. The reaction to tomorrow's employment numbers should set the tone for the day.

I had indicated last week that the week's candlestick pattern was very similar to the one in early June before it let go to the downside and a decline into July. I refer to these patterns as fractals and I like to make note of them since they can often predict the next move. We traders often react to the same stimuli in the same way and those reaction of course are reflected in stock prices. Now the bigger question is what can we make of the move down and will it continue to follow the pattern of June-July-August. I'll review those possibilities in tonight's charts.

There were a lot of pieces to the puzzle that were coming together last week that had me looking for a high. One is the extremely high bullish sentiment that the rally from March has achieved. The 89% bullish sentiment as measured by the Daily Sentiment Index from was higher than the 88% in October 2007. When everyone is bullish, the bets have been made and there are few buyers to propel the market higher. That's when the boat tips over.

Another sentiment indicator is the performance of the dogs. By that I mean the stocks of companies that are weaker relative to most other stocks. When those doggy stocks start rallying stronger than the broader averages you know bullish sentiment is getting frothy. These sentiment indicators are not timing tools but they provide very good warnings. Bloomberg recently reported on these weaker stocks and used NY University Professor Edward Altman's "Z-Score" method. He created this scoring tool back in 1968 to measure a company's likelihood to become insolvent based on earnings, assets and capital. He rates the stocks and then groups them according to their Altman-2 rating.

The chart of the Low Altman-2 stocks vs. the blue chips and High Altman-2 stocks is shown in the following chart:

Low Altman-2 vs. High Altman-2 stocks, Daily chart

You can clearly see the outperformance of the weaker stocks. This is reflective of excessive bullishness and complacency. It's also likely a result of short covering as the weaker stocks were probably shorted into a deeper hole than the rest of the market. Once those shorts have finished covering, the stocks become vulnerable to a stronger selloff (making them higher-beta stocks).

Another chart, courtesy, shows the outperformance of the much weaker financial stocks as compared to the stronger (although that's debatable) financials. Specifically, AIG, Freddie Mac and Fannie Mae have been on a tear lately and it's not difficult to understand that it's been mostly short covering.

Weak vs. Strong Financial Performance in the past 30 Days

The speculative buying in these weaker stocks as compared to practically no new buying in the stronger stocks speaks volumes about where the rally from March was heading. When that speculative buying and short covering is finished there's not much left to drive them higher. The move in the weaker financials had the smell of a blow-off move and it will be very interesting to see how they perform in the next 30 days if the market takes a "rest".

The weekly MACD on SPX has not crossed down yet but is threatening to do so and RSI is rolling over from overbought. This is occurring from the 38% retracement of the 2007-2009 decline and at the broken longer-term uptrend line from 1990-2002. A failed test of a broken trend line (kiss goodbye) could turn out to be a very bearish signal here and as shown in dark red, the next move could be to new annual lows before the year is out.

S&P 500, SPX, Weekly chart

Another possibility, shown in pink, is for the current pullback to find support at its uptrend line from March, currently near 972, followed by another rally leg into October (that would catch a few bears flat footed) before the market turns back down in earnest.

The 50-dma is coming up on 970 and is literally right on top of its uptrend line from March. Both should be near 972 by Monday/Tuesday. To say this will be an important support level, if tested, is a gross understatement. If SPX slices right through 970 without so much as a hiccup you'll want to get short and hang on.

S&P 500, SPX, Daily chart

Assuming we'll test the 972 area (not a given since many will front run that level) it will be a good opportunity to play the long side and see what kind of bounce develops. As shown in pink and referred to on the weekly chart, we could see another rally leg into October (how high would be the next question since I see 1050 and 1121 as upside potential). The bearish side of me says we'll get the bounce and then crash lower through the 970 level.

But I'm tempering my bearishness based on a possible fractal pattern playing out. I had mentioned fractal patterns above when referring to the candlestick pattern last week and comparing it to the action in early June. If that fractal pattern follows through we'll see another 3-wave move sideways/down to the uptrend line, like it did into the July low, followed by another rally leg. Neither side can get complacent here.

Key Levels for SPX:
- cautiously bullish above 1030
- bearish below 970

We've got a parallel down-channel from last Friday's high to watch for now. If today's rally continues tomorrow we could see the top of the channel tested. It could coincide with a rally back up to 1009 which is the 50% retracement of the leg up from August 17th. Any higher than that would be a bullish heads up that we'll get at least a higher bounce that could be part of the 3-wave pullback to the uptrend line from March (like we saw in June-July). If that were to play out I would expect 1016 to hold as resistance. Anything higher than 1029 would suggest we're already heading for a new high.

S&P 500, SPX, 60-min chart

The DOW's uptrend line from March is lower relative to the line for SPX. The more likely support for the DOW, if SPX finds support around 972, will be the January high of 9088. It takes a break below 8900 to indicate a much deeper decline is in progress. If the market rallies from here to a new high I suspect it will be a marginal new high with a continuation of the bearish divergence.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 9550
- bearish below 8900

As with SPX, the 50-dma for NDX is sitting right on top of its uptrend line from March, both currently near 1561. That should be solid support if tested within the next couple of days. Back above 1648 would be a signal that we're probably going to get a new high. Whether it would make it up to the 62% retracement at 1773 or do a retest of the broken uptrend line from July can't be known but that's the first area I'd look for resistance.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1648
- bearish below 1560

It's the same story with the RUT as with the others. The 50-dma and uptrend line from March will coincide near 540 in the next couple of days and that will be critical support. If support holds we'll then have to watch how the rally develops to see if it has the makings of a new high.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 580
- bearish below 540

We could be nearing a reversal in the bond market as the 30-year yield drops closer to the level where it would have two equal legs down from its June high 3.983%). If that level is tested and holds we could see a reversal higher in yields that will take the 30-year to the 5% area or higher. A drop below 3.9% would likely mean a continuation lower which would obviously mean a rally in the bond market (which could coincide with selling in the stock market). There is the possibility that we'll see selling in both bonds and stocks as part of a selloff in all asset classes.

30-year Yield, TYX, Daily chart

Looking at the banking index, it was one of the first to break its uptrend line from March. BIX is now bouncing back up towards it, currently sitting near 123. Something to watch for tomorrow is the potential for BIX to rally slightly higher to 122.69 where it would achieve two equal legs up from yesterday's low. It would make for a good setup for a reversal back down (and a kiss goodbye against its broken uptrend line).

Banking index, BIX, Daily chart

The downside price projections for BIX that are shown on the chart are from the early August high and yesterday's low achieved two equal legs down at 118.49 (the low was 118.04). That makes it possible for the completion of an a-b-c correction from the August high and as shown in pink we could now see another rally leg develop that takes the BIX to at least a marginal new high. Above 135 would open the door to a move up to the 150 area. But a drop below 111 would be a break of the 50-dma, a Fib price projection and price-level support. The 200-dma near 104 would be the likely downside target before a bigger bounce.

The August high for the home builder index tagged the top of a parallel up-channel for price action since the November low. Considering the overlapping highs and lows within that bounce it looks more like a correction (big bear flag) than something more bullish. It's always possible we'll see a pullback and then another attempt at a new high but right now the pattern favors a downside resolution and a new low below last November's.

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

We've all been hearing about the next shoe to drop in the mortgage business (and all the collateralized and securitized "investments") is the commercial real estate market. It's already in deep trouble but we're not hearing much about it reported in the press. I suspect that will change soon, just as it did in the home mortgage market well after it was in serious trouble (and still is).

The NY Times had an article yesterday in which it discussed this troubled market. They reported 65% of commercial mortgages maturing over the next few years will probably not qualify for refinancing. The drop in property values, the loss of tenants (making rating agencies nervous and dropping ratings on the repackaged loans) and new stricter underwriting standards are all conspiring against current property owners who will need to renegotiate their loans. Many feel the wave of defaults, foreclosures and bankruptcies that are coming will easily surpass anything we saw in the early 1990s.

Building values have already dropped as much as 50% in many parts of the country and even more in Manhattan where prices were driven much higher by too much easy money. Because banks are no longer the holders of most of these loans there have been service providers set up to manage the loan payments. These "master servicers" are not authorized to renegotiate loans and mortgagees are finding it difficult to find someone to talk to about renewing their loans. When a loan gets into trouble and the payer falls behind, the loan handling is then transferred to a "special servicer". By then the loan is already in default and the payer is likely already headed for bankruptcy.

There are currently about 3,100 securitized loans (6.1% of the total), with a face value of about $49B, are in trouble and with a special servicer now. Many believe the number will climb to over $100B before the end of the year. But banks will bear the brunt of the problem as they hold about $1.3T in commercial mortgages (including apartment buildings) and another $536B in construction and development loans. About $393B worth of these mortgages are expected to mature by the end of the year.

There appears to be a conflict of interest between the owners of the securitized loans and the special servicers which are chosen by the investors who hold the riskiest loans. Often these servicers are part of the same company and just 6 companies control 85% of the business. Therefore the servicers, i.e., the holders of the loans, may not be anxious to take a loss and settle with the mortgagee. This creates a situation where more loans are not being repaid, are in default and it's just a matter of time before the losses must be recognized. This is one reason why many are thinking we're only in the first or second inning of the commercial real estate collapse and why banks have much more pain directly ahead. In other words, the rally in the banks may be a bit premature.

Look at the DJ Real Estate index ($DJR), it's mirroring the broader market except that it showed relative weakness in late August by not making a new high. If the late-January high and June highs near 142 hold we could still see another rally leg up (shown in pink). Otherwise a decline shown in dark red is the more likely path.

DJ Equity REIT Index, $DJR, Daily chart

If the market decline continues into next week we should see the Trannies head down to its uptrend line from March. After tagging its 50% retracement of the 2008-2009 decline the test of the uptrend line would coincide with the 38% retracement near 3444 and its 50-dma, currently near 3493. I think the 3450-3500 area is going to be strong support if reached. As shown in pink we could get another rally leg into October from there (why, I don't know but the pattern supports the idea that it could happen). A break below 3400 would clearly be bearish as it would be a break of all that support above 3400.

Transportation Index, TRAN, Daily chart

Whatever's going on in the metals this week (strong rally) can't be "blamed" on the US dollar sinking. The dollar continues to motor along sideways. But the pattern in the dollar over the past two weeks leads me to believe we haven't seen the low for the dollar yet so I see the possibility for a drop to a Fib projection at 77.12 to finish its decline from March. The bearish sentiment on the dollar is thick enough to cut with a knife so it's not far from seeing an upside breakout, which could happen at any time. However, until it's able to break out of its parallel down-channel, the top of which is currently near 79.60, it clearly remains bearish.

U.S. Dollar contract, DX, Daily chart

The metals have been on fire the past two days and gold has broken out of its sideways triangle pattern that it's been in since the April low. It clearly has some upside potential, if it can get past 1001. Normally a breakout of a sideways triangle is a very bullish move and there are lots of traders jumping on this move. The risk, if you're long gold, is that it could be a false breakout and false moves are often followed by swift moves in the opposite direction so be careful.

Gold continuous contract, GC, Daily chart

Today's rally in gold had it nearly achieving a price projection at 1000.80 where the move up from July would be two equal legs up. The dark red wave count calls it the completion of a corrective wave pattern from the April low and depicts a sharp thrust lower in a strong c-wave to follow. Today's rally may have been a throw-over finish to the ascending triangle (flat top from the June high and an ascending bottom). But a rally above 1001 raises the probability that we'll see a rally at least to 1034 if not 1133.

The weekly chart of gold shows the bullish sideways triangle with an upside resolution to a Fib projection at 1133. Only as the rally progresses will I get a better idea whether or not that remains a good upside target. In the meantime, as discussed above, stay aware of the possibility we'll see a fast reversal back down.

Gold continuous contract, GC, Weekly chart

Silver has also rallied hard all week and has made a slightly higher high than June's. It has now achieved two equal legs up from July (at 16.10) so like gold it may be ready for a reversal back down. For both metals the bullish sentiment is running very high and therefore, like the stock market, it's ripe for a reversal if what we're seeing is a blow-off top. But the bulls are running and if they can keep it up there is upside potential to the top of its parallel up-channel from November, currently up near 18.

Silver continuous contract, SI, Daily chart

While the metals are running higher we can't say the same about oil. In fact the pattern for oil's rally since July looks more like an ending pattern to the upside which suggests it's close to breaking down. It continues to hold onto its uptrend line from February but it better hurry up and rally otherwise the breakdown could be swift.

Oil continuous contract, CL, Daily chart

The employment numbers tomorrow morning has the potential to reverse this week's decline or send it lower still. The price pattern supports the idea that another leg down is coming as the 2-day consolidation comes to an end and the decline continues.

Economic reports, summary and Key Trading Levels

Today's ISM Services number was in line with expectations and somewhat disappointing since it didn't match Tuesday's ISM report that was above 50. But the number continues to be "less bad" and the trend in the past several months is in the right direction. Now all we need to see is the index break its downtrend line from 2005:

ISM Services Index, Monthly chart

This week's selling has all the makings of a top for the rally from March but no major damage has been done to the charts yet. By major damage I mean the uptrend lines from March are holding (except for the banking index, which could be our canary) and the 50-day moving averages are holding (including for the BIX). If both of those support levels are broken in the next couple of weeks (or sooner) we could have a stock market that's in much more trouble than most people care to admit.

I've shown in most of tonight's charts the possibility that we're only going to get a pullback that's less severe than the June-July correction before heading higher again. There is a potential fractal pattern of the May-July price action and what we could be seeing since the early-August high. If true then we'll see the March uptrend lines hold fast. A rally into October would catch a lot of bears asleep at the switch so don't be one of them--manage your trades carefully and don't get aggressive either way.

If the market breaks 50-dma and uptrend-line support you'll have time to play the downside for some good profits. In the meantime manage any short plays with a short-timers frame of mind and don't be bashful about taking profits. As I said, you'll have plenty of opportunities to join the bears later.

If you're long the market, or looking to get long, you'll obviously want to see those support levels hold. Use SPX 970 as your critical level--short below and maybe long above. If you try a long play from here or above 970 you too need to manage it very closely. A bounce off support followed by a new low below SPX 970 will very likely be accompanied by strong selling. You don't want to do end-of-day trading with a long position.

Tomorrow is the Friday before a holiday and of course Monday the U.S. markets are closed. Once we have the reaction to the employment numbers (if there is one) we may find the market goes dormant on us. Don't force trades and instead take the day off and make a 4-day weekend out of it.

I hope everyone has a very nice long weekend and good luck next week. I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 1030
- bearish below 970

Key Levels for DOW:
- cautiously bullish above 9550
- bearish below 8900

Key Levels for NDX:
- cautiously bullish above 1648
- bearish below 1560

Key Levels for RUT:
- cautiously bullish above 580
- bearish below 540

Keene H. Little, CMT