Market Stats

The market is looking tired after bolting higher from the October 4th low and has pushed up to very tough resistance, marked by the 1220-1230 band of resistance for the S&P 500, and seems as though it might be ready to pull back in hopes of regrouping before making another attack. The bears have been able to overwhelm the bulls after making their long journey over the past two weeks. Assuming the market is ready for a pullback, we'll be able to learn a lot from its pattern to help determine the next move after that.

Following the rumor yesterday afternoon about Merkel and Sarkozy agreeing to how the bailout plan was going to work, which spiked the market up to new highs, the market had pulled back into the close and then dropped a little lower this morning. It then bounced back up to minor new highs or tests of the highs but the failure to hold then led to an afternoon selloff, leaving bearish divergences at the highs. The market is tired and as I had mentioned last week, the higher this market goes without a decent pullback, the more dangerous it becomes for the bulls. We could be into dangerous waters here.

Starting off the day with some economic reports, we received some inflation data and housing construction data. The CPI continues to hold at just under 4% annualized but the core rate (if we stop eating and using energy) is holding around 1.2% annualized.

Housing starts came in better than expected, jumping +15% to a 17-month high. At 658K for September vs. estimates for 590K it was a nice jump above the 572K in August. But much of the gain came from the more volatile multi-family construction and expectations are for a big pullback next month. Also helping housing construction was the rebuilding efforts following Hurricane Irene. Building permits declined to 594K from August's 625K and came in a little less than forecast.

The home builders got a little boost from today's number but unfortunately the slight increase is not doing much for the chart showing housing starts. The steep decline from 2005 to the low in 2009 has been followed by the chart motoring along the bottom. Is it consolidating before the next leg down? Certainly the high inventory levels and potential problems with more foreclosures coming if the economy takes another hit says we will likely get another leg down before finding a bottom.

Housing Starts and Permits, chart courtesy

The market was holding up today until the Fed's Beige Book came out at 2:00 PM and even though it didn't tell us anything we don't already know (many of the districts saw only "modest" to "slight" growth), the market reacted negatively to the report and dropped out of what looked like a bullish consolidation pattern near the high. Failed patterns tend to fail hard and the selloff was quick once it broke down this afternoon.

Europe continues to be the worry and I think the market is getting worried that all the hoopla over an expected fix is not going to actually fix the problem. There are all kinds of numbers floating around and it's all based on how much they can leverage the existing bailout money. But the kind of leverage they're talking about means they need to get investors to step in and buy the leveraged products. Yea, good luck with that one. Even France's and Germany's credit spread is widening as investors become worried about who's going to bail out the bailers.

Everyone knows Greece is going to default on their loans but what's worrying everyone is what happens to the countries that follow Greece, and there are several, with Italy waiting in the wings. The banking crisis is bound to get worse before it gets better, even though the market has been rallying on hopium that the banks will be immune to the problems. As for Greece, George Friedman at summed up the problem quite nicely:

Greece and the Banking Crisis, chart courtesy

Hope is a wonderful thing. Without it we wouldn't go to bars, get married, have kids, work hard towards goals, etc. But hope in the stock market is dangerous. The "slope of hope" is the way bear markets proceed -- big spikes up on hope-induced rallies followed by a slide back down to new lows. The rally off the October 4th low has been built on nothing but hope -- hope that Europe really will solve their banking crisis this time and hope that earnings will show the economy is not sinking into another recession (forgetting that earnings is a lagging indicator).

The rally has been one of the strongest we've seen in quite a while and it has pegged many overbought indicators. I saw a chart on the site that I think is fair warning to bulls thinking this market has plenty of room to the upside. The EWI chart shows a measure of the percentage of S&P 500 stocks above their 10-dma, which stood at 98.8% on Friday. The two previous highs in the reading since May, which was less overbought by this measure, were July's high (98.4%) and August's high (99.0%).

Percentage of stocks above 10-dma, chart courtesy

The extreme readings are indicative of bear market rallies (sharp and relatively short-lived). As they show on their chart, this highlights how stretched the market is and the coincident highs in the stock market. As they also pointed out, the August reading of 99.0% was the highest reading in the previous 4-1/2 years and the current reading is only 0.2% shy of that high. For the past readings the peaks in price occurred with the high readings and proved good times to turn bearish, not bullish. With the volume continuing to contract during the rally, indicating big money is not buying into this rally, we have further evidence that the rally is mostly short covering. Caveat emptor.

And with that, let's get to tonight's charts. The small cap index, RUT, has been the more volatile of the indexes as the risk-on trade gets quickly replaced with the risk-off trade and then reverses again the next day. The whippy pattern we've seen since August has been a tough one for traders to follow and is a good one to start off tonight's review, beginning with its weekly chart.

Similar to the SPX weekly chart I've been showing, there is a possible H&S pattern developing since February 2010 with the left shoulder in April 2010, the head in May 2011 and the right shoulder being built since the October low. A pullback from the current rally and then pressing higher into the end of the year would do a nice job building the right shoulder. From a wave count perspective, we'd have a 1st wave down from May, a 2nd wave correction into December and then a strong decline early next year in the 3rd wave.

Russell-2000, RUT, Weekly chart

As I'll point out in the other charts, there is a possibility that all of the price action since the August low has been a correction to the May-August decline (wave-A down into August low and then a sloppy whippy wave-B correction to the current price). This interpretation says the sharp rally off the October low is the completion of the correction and that the next big move will be a decline into the end of the year, one that could duplicate the leg down from May to August, which would have a downside target near 485. The pattern of the pullback/decline will help answer the question as to what we can expect into November/December

If instead of a sharp decline from here we get a choppy pullback with overlapping highs and lows within the pullback pattern over the next couple of weeks it will be a good indication that another rally leg is coming. For the year-end rally I'm showing a pullback to about 650 into mid-November and then the start of the next leg up to a new high for the bounce off the October low. But if the decline starts to look sharp and impulsive then it will be time to look to short the bounces after that since the next leg down into the end of the year could be strong.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 714
- bearish below 680

In recent newsletters I've compared the 2007 top to the 2011 top and the similar 5-wave moves down (to the January 2008 low and the October 2011 low). The January-May 2008 bounce would be imitated by an October-December rally and I've been reading more analysts now pointing to this analog pattern, and that has me nervous. The more people that see a pattern the more likely it is to fail (the nail in the coffin for a pattern is when CNBC reports on it). If we get too many people believing we're going to have an end-of-year rally it's going to make it less likely to happen. That thought supports the idea that we've finished an a-b-c bounce pattern off the August low and now we'll head for new lows into the end of the year instead.

But guessing where the market will be at end of the year is obviously something for gamblers. As traders we look for ways to improve the odds and right now we have to wait for further price action. I'm showing on the SPX daily chart below, in green, the path price might take for an a-b-c bounce off the October low and the pullback before heading higher again could be deep -- down to the 1120 area into the first part of November. If we're about to start the next leg down in the big bad bear market then the decline will become steeper earlier.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1230
- bearish below 1190

Whether the market does just a pullback or starts a more serious decline we could be looking at the possibility for at least a deep pullback. Therefore those holding long stock with an anticipation of higher prices ahead might want to consider at least hedging your positions. A break below 1190 would confirm we've seen the high for this leg up and playing the short side will be the better bet from there.

There are several Fib and price-level resistance lines for SPX in the 1220-1223 and 1226-1231 area and it managed to push up through them all and make a minor new high yesterday at 1233.10 but was unable to hold it. Today's high at 1229.64 was a failed test of yesterday's high and it takes a rally above 1230, that holds above, to keep the bulls alive a little longer. At 1228.80 it ran into the 127% extension of the previous leg down (Sept 27-Oct 4), which is often a good Fib to keep an eye on for a possible reversal. Of course the August high at 1230.71 was also expected to be resistance.

S&P 500, SPX, 120-min chart

One possibility for the current leg down from yesterday's high is for it to conclude a type of a-b-c pullback that has a downside target near 1180. That could set up another rally leg (green) although that's a little risky considering how overbought the market is. But bears need to keep the possibility in mind. The greater likelihood, if we're to get just a corrective pullback into the first part of November, is for a choppy pullback that goes deeper. A sharper decline into the end of this month and below 1135 would have my bear fur standing up on the back of my neck.

Before continuing with the other charts, and speaking of analog patterns earlier, I came across the following chart from Doug Short, comparing the price patterns of other significant bear markets. The chart below compares the Dow from 1929-1949 (gray), the Nikkei 225 index (1989-present) and the S&P 500 (2000-present) and you can see the similar shapes. One could say the Fed-inspired, QE-induced, rally from July 2010 to May 2011 is "out of whack" with the pattern, meaning the rally from March 2009 went higher and further than it normally would have if it had not been helped by the liquidity push by the Fed.

Mega-Bear Markets, chart courtesy

If we follow the analog pattern we're due for another leg down that drops below the 2009 low. If the rally extended further and higher than it would have without the liquidity push might we then get a stronger reaction to the downside than it might have been otherwise? We know what happened after the government's efforts to lift the housing and auto markets. It's definitely something to think about since it will take many more years for your long-only portfolio to recover.

The wave pattern for the a-b-c bounce into the end of the year, as with the others, calls for a steep pullback before heading higher again. There are lots of different possibilities for what price could do into the end of the year before heading lower next year, including a continuation of the whippy sideways consolidation. It could head higher than what I'm depicting (above the 200-dma). There's no way to tell and so I'm just showing one idea. The thing to keep in mind is that if we're into a correction of this year's decline it's a correction that could go anywhere and the continuation of a news-driven market may be with us into December.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 11,640
- bearish below 11,200

NDX has been struggling with its broken uptrend line from March 2009 - July 2010, which also stopped its rally in September. As shown on its chart below, its rally from the October 4th low also achieved the price projection for two equal legs up from the August low, potentially completing an a-b-c bounce correction to the July-August decline (retracing a little more than 78.6% of the decline). The significance of the a-b-c bounce pattern is that it calls for another leg down at least equal to the July-August decline, which would target 1972. There's also price-level support near 1900-1920 if the October low gives way in November.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 2350
- bearish below 2290

The bullish possibility for a rally into the end of the year will remain but as shown by the green depiction (which is obviously speculation) we could see a big pullback before heading higher into December. So short term, assuming the high is in for now (or close to it), we should see at least a stronger pullback and if it's a choppy pattern it will support another run up into December. A strong decline followed by choppy bounces will point us lower so we'll have to wait for a pullback pattern to help determine what we might see into the end of the year.

Another index running into trouble here is the NYSE -- its weekly chart below shows it has run into its 200-week MA and a downtrend line from May through the first bounce high in late May. The NYSE broke above the downtrend line in late June, tested it in July and then crashed back below it in early August. It is back up testing with this rally. Near the same level is the 50% retracement of the 2007-2009 decline, at 7284. Not shown but the 38% retracement of the May-October decline is at 7295. The daily oscillators are getting ready to roll over from overbought at resistance and it looks ready for at least a pullback.

NYSE Composite index, NYA, Weekly chart

We've been hearing about the wonderful earnings from the banks in the last week with earnings reports. Too bad they're all bogus. The regulations have been so distorted to favor the banks to the point where it's heads they win, tails you lose. GAAP-approved earnings reports mean nothing now. As an example FAS (Financial Accounting Standards) 159 allows banks to declare as income any gains from DVA (Debt Valuation Adjustment). If a bank's credit rating drops, making the value of their debt less, it means it would cost less for the bank to buy back its debt. They get to claim that difference as a gain. Therefore, the worse a bank's credit rating the better their earnings report.

The banks have FAS 157 that enabled banks to boost earnings in good times and they paid themselves large bonuses and leveraged assets to an extraordinary degree, suffering catastrophic losses as the derivatives blew up in their faces. Their reward? A bailout by the taxpayer. Now they get to reward themselves in bad times through FAS 159. Is it any wonder so many feel banksters are lower than whale excrement?

BAC is a good example of what's going on here. They reported earnings increased +9.6%, aided by "asset sales and accounting gains". [emphasis mine] They had several large one-time gains from "accounting methods" and a big gain from the sale of China Construction Bank shares. There was a fair-value adjustment that added $4.5B, the sale of China Construction added $3.6B and the DVA added $1.7B. And how did their investment business do? Oops, they lost $2.2B related to private equity and strategic investments. But their headline number was +9.6%.

Europe's banks are in no better shape. The recent failure of the French-Belgian bank Dexia highlighted a problem with the recent "stress test" done on the European banks, which was essentially a joke. Even with only 1% in tangible equity behind its assets Dexia reported a capital ratio of 12.1% through accounting gimmicks. Enron had nothing compared to the games these banks are playing. Dexia came out of the stress test looking like one of the stronger banks. That says a lot about the other banks who didn't look so good.

When you consider the fact that most U.S. banks, just before the U.S. credit crisis in 2008, sported gross leverage ratios of about 12 (where Citigroup, Morgan Stanley, Goldman Sachs and JP Morgan remain today), the gross leverage ratios of European banks today are truly astounding. The European banks are sporting leverage ratios in excess of 20:1, 30:1 and even 50:1, including Dexia and Landesbank Berlin. Dexia's demise is very likely just the start of a series of bank failures.

I've said for years that the banks are the worst place to be invested, short or long term, and I think that will be true for a couple more years at least.

It's looking like the bank index, BIX, has completed a bear flag consolidation pattern following its August low. It popped above the top of the flag last Wednesday on the euphoria over the European bank save and then gapped right back down into the flag pattern the next day. It has tried each day since last Thursday to get back above the line, near 123, but has failed on each attempt. It has also run into its 20-week MA at 122.96. It could press higher but I think the higher odds are in favor of at least a pullback. The bearish wave count calls for a new low from here.

S&P Banks index, BIX, Daily chart

The TRAN is the one index that I thought might make it up to its price projection near 4879 where an a-b-c bounce off the August low would have the c-wave = 162% of the a-wave. I'm not so sure it will be able to make it. Keep in mind that once the rally leg from October 4th has completed, the wave count for the move down from July calls for the start of wave 3. This is the one index that keeps me thinking the a-b-c bounces off the August lows is what we should be considering, which calls for a steep decline into the end of the year, not a rally. Only time will tell.

Transportation Index, TRAN, Daily chart

The pullback in the dollar could be over but there's no confirmation of that yet. A rally back above 77.50 would help the dollar bulls but until then there remains the possibility for a continuation lower in the dollar. If the dollar does rally back up from here we will likely see downward pressure on the stock market and commodities.

U.S. Dollar contract, DX, Daily chart

Gold broke down on Monday out of its rising wedge pattern for its bounce off the September low, which should mean it has completed the correction to the previous leg down and is ready for another leg down. It may find its uptrend line from October 2008 to be support for a little longer, currently near 1620, but once that breaks we should see gold make another steep drop.

Gold continuous contract, GC, Daily chart

The longer-term pattern for gold is shown on its weekly chart below. With the idea that a deleveraging economy will see all asset classes suffer losses (except cash), I'm looking for a significant decline in gold next year. I'm showing the possibility for a drop below its uptrend line followed by a bounce off its 50-week MA and/or its 200-dma, at 1530-1550, and back up to the broken trend line, perhaps into December to match a possible rally in the stock market. Following that should be a stronger drop lower next year, with the 200-week MA being a good first downside target, perhaps near 1200 by the time it gets there.

Gold continuous contract, GC, Weekly chart

Oil dropped sharply this afternoon, similarly to the stock market, and broke below its uptrend line from October 4th after doing a little throw-over finish to its rising wedge pattern yesterday and today. It looks ready for its next leg down and a break below 81, and its long-term uptrend line from 1998-2001 would spell trouble for oil bulls (and be predicting a slowing in the economy, just as copper is currently doing).

Oil continuous contract, CL, Daily chart

Other than the normal unemployment claims numbers tomorrow we'll have existing home sales, the Philly Fed and Leading Indicators, all out at 10:00 AM. They could move the market so be careful if you're in a position heading into 10:00.

Economic reports, summary and Key Trading Levels

The rally leg from October looks tired. Other than a couple of news-inspired spurts to the upside (and now rumors are trying to accomplish the same thing) we're seeing a slowing in the volume as the rally progresses and waning buying momentum. The market is back into overbought territory (by a lot when you look at the chart at the beginning of this newsletter showing the number of stocks above their 10-dma) and therefore vulnerable to at least a pullback.

If the hopium-filled balloon gets popped this coming weekend with word out of Europe that the bailout plan has some holes in it, this market could drop very fast as traders run for cover out of fear that there's nothing else holding the market up. I would not want to be a holder of stocks over this coming weekend, which means Friday could see some selling if it's still holding up until then.

As pointed out on the charts, it's possible the October rally is finishing the correction to the decline into the August low, which calls for a resumption of the selling to new annual lows into the end of the year. Consider that possibility if you're holding long positions and don't want to tolerate even a deep pullback. The pullback could develop into something substantially more bearish.

The end-of-year rally still has merit and a choppy pullback over the next couple of weeks would support that move. So we'll simply have to evaluate the coming pullback for clues as to what it could be and therefore what might follow. The pullback will come, even if from a higher high first (and the higher it goes from here the faster it's going to come back down) and right now I consider the upside very risky while the downside has a good reward:risk ratio associated with it.

Trade carefully the rest of this opex week and good luck. I'll be back with you next Wednesday.

Key Levels for SPX:
- bullish above 1230
- bearish below 1190

Key Levels for DOW:
- bullish above 11,640
- bearish below 11,200

Key Levels for NDX:
- bullish above 2350
- bearish below 2290

Key Levels for RUT:
- bullish above 714
- bearish below 680

Keene H. Little, CMT