Market Stats

"When popular opinion is nearly unanimous, contrary thinking tends to be most profitable. The reason is that once the crowd takes a position, it creates a short-term, self-fulfilling prophecy. But when a change occurs, everyone seems to change his mind at once. - Gustave Le Bon

While nothing goes in a straight line one could say the rally from last July has pretty much been in a straight line. One look at monthly charts on most symbols will show a sharp spike to the upside from July and that's a strong statement by the bulls. No matter whose sentiment indicator you look at you will see uber bullish readings. It doesn't matter what Mom and Pop feel about the market; they're not going to invest it anyway (they're too scared). If someone wants to be invested in the market the sentiment readings tell us they're already there.

The high sentiment readings along with the sharp spike to the upside since July is a little worrisome now because spikes to the upside have a habit of spiking back to the downside. So where might the stock market run into trouble? I think no matter which side of the fence you stand we should always question where the market could stumble. If I'm in a long or short trade I'm always looking for where I'm wrong so that I'm prepared to exit and know why I'm exiting. Entering a trade is fairly easy; it's the exiting part that is harder for most traders.

So we'll take a look at some longer-term charts tonight to help give a sense of where we are in relation to where we've been. We'll look for the road blocks so that we can get a better idea for where the market might run into trouble and be forced to take a detour or turn back before continuing on its route.

I show coming reversals on the charts (down arrows) because I'm looking for a reversal. It doesn't mean we'll get one but that's the setup I see in front of us. It's a big detour sign and unless you drive carefully here you could end up going through the barrier and over the edge. It simply means longs need to pull up their stops and think more about protecting gains while enjoying any additional ones that come with a continuation of the rally.

For those who are itching to get short, we don't have any sell signals yet. That means we need to wait for confirmation that a high is in place so that we can at least have a level that makes sense for a stop on new short plays. I'll address this in the charts.

But first a little on today's economic news which helped the market reach a little higher for the stars this morning. The housing numbers (starts and permits) were a bit of mixed news but taken as more positive than negative. The home builders index spiked up this morning so certainly some are looking at it as positive data. The headline was that new construction rose to its highest level in the past 4 months and higher than had been expected. Starts were up +14.6% in January from December but this is still -2.6% below the January 2010 level. Building permits were high in December but dropped -10.4% in January and are down -10.7% from January 2010. There's a reason the home builder sentiment index remains down in the mud at 16.

Looking at a chart of the 3-month moving average of the housing starts and building permits is not very encouraging. If you looked at the chart below as a stock to buy, would you? I view the sharp decline from 2006 to 2009 followed by the shallow sideways consolidation as a bear flag getting ready to break down and continue lower. But if you were looking at it bullishly you'd see a basing pattern. Using history as our guide I believe the bearish interpretation is the correct one.

Housing Starts and Building Permits

But the market wants to see everything through bullish-colored lenses right now so the increase in building in January sparked good thoughts about the spring selling season. I do have one question though about an increase in building starts -- won't that exacerbate the excess inventory problem that we currently have? Just askin'.

The PPI numbers were also reported this morning and it continues to give the Fed some wiggle room. At least by the way the Fed measures inflation (not counting commodity prices) they still have some wiggle room to keep the printing presses going. Both the PPI and Core PPI came in a little higher than expected, at +0.8% and +0.5%, respectively for January, and that's above their target rates of 2% annually. But it will probably take a few months of higher than 2% annualized readings for the Fed to start getting more concerned about inflation than their banking buddies.

If PPI keeps ticking higher it could make it problematic for the Fed to continue its QE program, which is really designed to feed money to the banks (to help them recapitalize and write down the losses sitting on their books). If inflation continues to tick higher the Fed will have some explaining to do in order to keep the presses in operation.

This afternoon's FOMC minutes showed some concern about keeping the QE2 program going at this point. Normally that would spark a little fear in the stock market (taking away their punch bowl) but this week the market is on a mission -- keep the market up for opex week. Also, the minutes made it clear that the Fed has no intention yet of scaling back their QE2 program and intend to let it finish in June. They did raise their economic forecast for 2011 though, from 3.0%-3.6% to 3.4%-3.9%.

The other morning report was Industrial Production (down -0.1% vs. +0.6% expected) and Capacity Utilization (76.1% vs. expectations for 76.2%). Both numbers were also down from December so they speak of softening in the economy rather than continued strengthening. The bulls thought that made a great wall of worry to climb so that's what they did on the news. It's one reason I simply don't trade the news. I use it instead as pieces of the bigger puzzle to help me figure out whether or not the larger fundamental picture supports the technical picture. When they diverge, as they have been (the market is more bullish than the underlying fundamentals suggest is reasonable), it's simply a heads up warning that something could change the mood of the market quickly.

Following this morning's rally there was a quick spike back down to a low at 12:00 PM that retraced a good portion of the rally. Most of the spike down was recovered in the afternoon so no harm no foul. The reason for the spike down was attributed to the news that Iran was moving two warships through the Suez canal and that Israel will be monitoring their movement closely and will not tolerate any threat from them. Ah, just another wall of worry for the bulls to climb and they reversed that spike down and pushed it back up into the close. It does show however that the market is sitting on pins and needles and it won't take much for a lot of sellers to hit the tape all at once. And when the program traders get into a sell mode there could be very few traders on the other side (shorts are gone).

Moving on to the charts, I want to start with a top-down view of NDX since it has a particularly good reversal setup, one that I reviewed in Sunday night's charts on the Market Monitor. Today's rally achieved the upside target I had projected and now it's do or die time for the bulls, and for the bears for that matter. It will either be very bullish from here with additional rally or we'll have a bonafide reversal on our hands.

Starting with the monthly chart, there is a long-term uptrend line from October 1990 through the October 2002 low that is currently near 2400 (bold blue line on the chart below). That trend line hasn't been tested since it was broken in September 2008 and it's normally a high-odds play that resistance will hold on its first test. The century mark of 2400 is likely to be resistance as well. Today's high was 2403.52 so it's time for bulls to kick it up a notch otherwise it's a good opportunity for the bears to step back into the game.

Nasdaq-100, NDX, Monthly chart

The weekly chart below is very busy with several trend lines but the bold blue one is the uptrend line from 1990 and shows price tagging it today (hard to see today's candle). The line at 2331.31 is the 38% retracement of the 2000-2002 decline and the other Fib level at 2397.88 is the 113% extension of the 2007-2009 decline, a Fib level that's common to double tops following a momentum move. FYI, the 113% Fib level comes from the square root of 127.2%, which is the square root of 161.8% (going the other way, the square root of 38.2% is 61.8% and the square root of that is 78.6%). So the Fib relationships are related in the square roots of each number as well. The bottom line is that the 2400 area for NDX is a very important level for a few different reasons and I suspect will be very tough resistance (or very bullish if it breaks through and holds above).

Nasdaq-100, NDX, Weekly chart

Moving in closer with the daily chart below, I've added the broken uptrend line from August to show there's another reason why price could struggle here. It's been pushing up underneath the broken uptrend line since February 1st while the bearish divergences continue. And I added a parallel up-channel for price action since November's low, the top of which crosses through 2400 with the broken uptrend line and the long-term uptrend line from 1990. This is going to be a brick wall and the high-odds play is to short it. But if the market holds up into the end of the week there is a little more upside potential to about 2420.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 2420
- bearish below 2340

And now moving in even closer with the 60-min chart below, there is a little more upside potential to the top of its rising wedge pattern for the rally from January 28th, currently near 2409. The waning momentum (bearish divergence) at the current high fits with a final 5th wave which is how I'm counting the rally. So the setup is here for a reversal at any time but it takes a break below 2380 to signify it has started.

Nasdaq-100, NDX, 60-min chart

Looking at a monthly chart of the DOW, the entire bull market for the past century can be seen. I was playing with some uptrend lines from the 1932 low and one from the 1966-1982 bear market and noticed a couple of interesting ones. The green dotted uptrend line goes from the 1973 high through the 1987 high and it's where the October 2002 low found support, suggesting traders think it's an important trend line. It was broken in September 2008 and the current rally has brought the DOW back up to it for its first test since breaking. The first test is usually not successful.

Dow Industrials, INDU, Monthly chart

The 3 uptrend lines are drawn from the 1932 low and the first one was support during the rally from 1932 to 1968 and then broke in 1969. Notice that that trend line was never retested after it broke until 2000 and it failed the retest, all those years later. Wouldn't it have been nice back in 2000 to have played that reversal?

When price consolidates sideways, as it did during the bear market from 1966-1982, you'll often find that the trend lines drawn from the previous low through each pullback low in the sideways consolidation will come into play sometime later. The 2nd uptrend line is drawn through the 1970 low and you can see how price swung up through it in 1987 but then crashed back down through it. It then followed it higher from 1990 to 1994 before blasting higher to the first uptrend line in 2000. The 2nd uptrend line is now being tested for the first time since breaking in 2008 so we've got two long-term trend lines that the DOW is dealing with (and the market is overbought with waning momentum).

But an overbought market can become more overbought and bears need to respect the possibility of another 1987-like spike above the trend line (and then very likely a market crash). We've got resistance here but no reversal yet so both sides need to be cautious. However, there's one more reason why I like a top here for the DOW.

Looking at the above chart for the DOW with a parallel up-channel for the rally following the 1932 low, I'm using an EW count to define the channel. You draw a line from wave 1 to 3 and then attach a parallel to the bottom of wave 2, which gives you the channel where it's very common for the 4th wave to find support, which is exactly what it did in 1975. The strong rally in the late 1990s busted out the top of the channel, which was clearly bullish, pulled back and tested it in 2002, rallied to a new high in 2007 (with bearish divergence), broke back into the channel in 2008 and found support at the mid line of the channel in March 2009. It rallied back up to the top of the channel in April 2010 and now is back up testing the top of the channel again in 2011. I do not believe it will break out of the channel again and it's another reason to feel an overbought market has a greater chance of at least pulling back first.

Dow Industrials, INDU, Monthly chart with parallel up-channel

Dialing in a little closer with the DOW's daily chart, price is also up against the top of a rising wedge pattern for the rally from July. It has also reached the 161.8% extension of the April-July decline, a level that's common in a H&S topping pattern (meaning this high could be the head and the left shoulder is the April high). The DOW is clearly in an uptrend and buying the dips has worked like a charm but the setup here is for the bend at the end of the trend. However, bears are not in control of the tape until they break the DOW below 12K.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 12,300 to 12,800
- bearish below 12,000

SPX has a similar chart to the DOW's as it has rallied up to the top of its rising wedge pattern. From a Gann perspective, twice the March 2009 low (666.79) is 1333.58 which has now been achieved (and is often resistance but not yet). And then assuming we'll get the reversal and at least a correction of the 5-wave move up from July, a common retracement level is back to the previous 4th wave which is between the November high and low, so between 1175 and 1225. A 5%-10% correction off the high gives us a pullback target zone between 1204 and 1271. The April high is near 1220 so if we were to get a pullback to the 1220-1225 area I suspect it will be a very good buying opportunity even if it will result in only a big bounce to correct the decline (right shoulder?). But first, let's see if we get a reversal to the downside that we can play.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1340 to 1358
- bearish below 1311

SPX has chopped its way higher this month and has formed a rising wedge pattern for its rally from early February. So it has rising wedges within rising wedges and speaks volumes about the probable quick move back down once they start breaking. It's bullish until it's not and when it's not it could be a fast move as the bulls start selling en masse. A break below 1324 could open up the flood gates so take a break of that level seriously.

S&P 500, SPX, 60-min chart

There are a lot of gaps to be filled in the rally from July. It's anyone's guess how long it will take the market to fill them but they're like magnets right now, pulling on the market. Today's gap up was the 13th unfilled one so I'm wondering if 13 is going to be an unlucky number for the bulls.

S&P 500, SPX, 240-min chart

Since breaking its broken uptrend line from August in mid January the RUT continues to push up underneath it, which is not exactly bullish even though it continues to make new highs. But the new highs are accompanied by bearish divergence, supporting the non-bullish move in the past month. When it breaks down it will probably go fast. A break below Tuesday's low near 819 would be a bearish heads up since it would also be a break of its shorter-term uptrend line from January 28th. Below 804 would be confirmation we've seen the high. In the meantime the bulls remain in charge.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 810 to 840
- bearish below 804

Banks struggled a little today and were not as supportive of the rally as the bulls would like to see. Using XLF as our banking proxy, it has achieved the minimum upside target level I expected to see for the 5-wave move up from November. At 17.16 the 5th wave achieved 62% of the 1st wave. Only slightly higher now, near 17.25 tomorrow, is the top of its rising wedge pattern. Based on the wave count and the rising wedge I'm expecting XLF to find a top right around here but it takes a break below 16.70 to confirm we've seen the high so bears can afford to wait for confirmation before attempting the short side.

Financial sector SPDR, XLF, Daily chart

"Extraordinary -- another day of DIVERGENCE with the DJIA down and Transports up. This makes 11 out of 31 trading days of 2011 with divergent action. Never seen anything quite like it. Indications of confusion and distribution." -Richard Russell, February 15, 2011

From a guy who has been writing the Dow Theory Letter for 53 years that's a strong statement. The good news for the bulls is that the bearish divergence that was in place since the mid-January high in the TRAN has been negated with the new high in the TRAN this week, confirming the DOW's new highs since mid January. Looking at its chart I now see upside potential to about 5470 for the TRAN where it would retest it broken uptrend line from August where it crosses the trend line along the highs from August. The price pattern remains bullish as long as TRAN remains above 5143 but turns bearish below that level.

Transportation Index, TRAN, Daily chart

I've been keeping my eye on the DJ REIT index, DJR, because it should be one of the signals for how well the economy and real estate markets are doing. So far there are no bearish signals but I think we're now close. Based on how quickly DJR dropped out of its last rising wedge pattern, into the November high, I think it's possible we'll see something similar again and potentially stronger to the downside. The wave count calls for a breakdown from the rising wedge pattern from November and the bigger one from March 2009. A break below 230 would be a bearish signal and we could see trouble around 240 if reached. You can play the short side of this sector with the inverse ETF, SRS, which has options.

DJ REIT index, DJR, Daily chart

Many stock market analysts continue to suggest investors move into the emerging market. I think I know why -- they're trying to help their firms get out of that sector and need willing buyers. When you look at EEM vs. SPX you will see it peaked back in November and then retested that high in early January. It's been downhill since then.

Emerging Market ETF, EEM, Daily chart

When looking for sectors or stocks to invest in you should look at its strength relative to another stock/sector/index. For example, if we look at EEM's relative strength to SPX we see significant underperformance since last October. So all the talk about hot money rotating into the emerging markets, such as from the Fed's printed money, is not reflected in the chart. Go with the charts and never with what someone says on CNBC or what you read in the papers.

EEM vs. SPX Relative Strength (RS), Daily chart

The U.S. dollar hasn't exactly been a ball of fire to the upside since its February 2nd low but as long as that low at 76.88 holds I'm expecting the dollar to work its way back up to at least the 88 area this year, up to the top of a potential sideways triangle pattern.

U.S. Dollar contract, DX, Daily chart

Since gold's January 28th low it has had a very choppy bounce back up, which continues to look like a correction to the January decline. It has now retraced just shy of 62% of the decline. The bounce has been cycling around its broken uptrend line from October 2008 and assuming the bounce is just a correction to its decline we should soon see it let go to the downside and easily break below 1300 and potentially make a quick trip down to 1200 (and then lower).

Gold continuous contract, GC, Daily chart

Oil broke below the uptrend line from August through the January low so that trend line becomes resistance until proven otherwise. We could see price bounce between the uptrend line from February 2009, currently near 82.50, and its broken uptrend line near 87. It takes a rally back above its February high at 92.84 to turn the pattern at least short term bullish again and until then the price pattern is bearish.

Oil continuous contract, CL, Daily chart

Tomorrow's economic reports should not be market moving. The market players are more concerned about finishing opex at the current levels.

Economic reports, summary and Key Trading Levels

Referencing the quote at the top of tonight's newsletter (about market sentiment) the chart below shows the high bullish sentiment as measured by the Daily Sentiment Index, a widely respected sentiment measure from

SPX vs. Daily Sentiment Index (DSI), chart courtesy

It's obvious that sentiment is not a market timing tool but when combined with the other technical tools we employ, throw in a little overbought and then stir, the concoction looks bearish. Now all the bears need is a sell signal.

Several readers have asked if I've learned my lesson and changed my stripes yet. With so many turning bullish surely I've seen the light by now and joined the bulls. Many of you have questioned me recently because I backed off on the longer-term prognostication in my effort to focus on the short-term moves.

To the dismay of bulls and relief of the bears (all two of us), I remain longer-term bearish the stock market. I'm one of the few remaining people who believes 2011 will be a down year for the market. I could be completely wrong but I think it helps if you know my bias. We all have a bias for without one we would not trade. Call it a market opinion rather than a bias. Based on the longer-term pattern from 2000 and what history tells me follows a credit bubble (bullish exuberance followed by despair and a credit contraction), I believe the large (and strong) 3-wave bounce off the March 2009 low will be largely, if not completely, retraced.

It's too early for me to show longer-term projections, other than the monthly DOW charts I shared tonight, but I will and the reason I will is because I want all traders, regardless of how wrong you think I am, to think about the possibility. Many of you will ride out the next pullback with a firm belief that the market will continue to rally this year. But what if it doesn't and what if it instead starts heading back for the March 2009 lows in a hurry? Do you think it might bother you that you didn't do a better job protecting profits? Do you think it might be prudent to protect profits, let the market pull back and then buy back in at a lower price? Even if you buy back in with a break to a new high you will not have lost that much in profit potential. Trading is all about risk management -- what's my profit potential vs. my downside risk?

So all I ask is that you give some serious thought as to how you're going to play a coming pullback (whether from here or 1000 points higher in the DOW). Think it through now and make your trading plan (write it down). Change it every day if you want but not during market hours. Making exit decisions on the day the DOW drops a 1000 points is absolutely the wrong time to make the decision. That's a panic decision and usually it's the worst kind that creates the biggest loss. Decide now how you're going to trade and where your exits are. If you decide you're in for the long haul and will ride out any and all corrections, great, that's a trading plan (not a good one but that's just my opinion, wink).

I think we're putting in a high of importance here, or I should say we're potentially putting one in. If the market rallies appreciably higher (say above DOW 12400 and SPX 1350) we could be looking at a blow-off move (as I alluded to with the DOW's monthly chart when referring to the 1987 spike up followed by the crash) and that kind of move could easily add 1000 points to the DOW and in a hurry. So bears can't be jumping the gun here. Wait for confirmation and use the key levels I've identified on the charts. If I'm correct about the longer-term pattern you'll have plenty of opportunities to play the short side.

Today's midday spike down on the Iran-Israel news may have been just a warning shot. We already know this market is reacting to global news with a sell-first-ask-questions-later response. We've got a 3-day weekend ahead and it's anyone's guess what could cause a sell trigger for this market but it sure feels like we're close to one.

As for this year, and as I mentioned in the beginning, nothing moves in a straight line. I believe we're going to have a very exciting year this year with big swings up and down. My plan is grab those swings and make some money in both directions. We want to be traders, not buy-and-holders, and this year I think is going to be a good one for traders. So polish up your trading skills and get ready. Sticking with a trend for two years has become boring (wink).

Good luck as we finish up opex week and I'll be back with you next Wednesday.

Key Levels for SPX:
- bullish above 1340 to 1358
- bearish below 1311

Key Levels for DOW:
- bullish above 12,300 to 12,800
- bearish below 12,000

Key Levels for NDX:
- bullish above 2420
- bearish below 2340

Key Levels for RUT:
- bullish above 810 to 840
- bearish below 804

Keene H. Little, CMT