Market Internals


Several Option Investor writers, including Jim Brown over the weekend, have pointed to a disjunction or divergence from normal behavior in the markets: the behavior of the dollar versus equities and commodities. Although relationships can shift, it's not typical for U.S. equities and commodities to perform as well as they have when the dollar strengthens.

We Option Investor writers have been pointing out other disjunctions this last week or two, such as the relative weakness of some indices versus others. Jim noted this weekend that the RUT had not bounded as high into its resistance range as had the SPX and other indices, by relative measures. I've noted that the transports were underperforming the industrials in the same way. For example, when viewed on the Keltner charts I use, it's clear that the transports were stopped at a lower resistance level on Friday than were the industrials.

Such disjunctions typically do not persist. We don't know yet which way these disjunctions or divergences will resolve, but we've been alerted. The market suffers from a condition I'm calling disjunctivitis.

Economists are warning of another disjunction. Reportedly, JPMorgan and Goldman Sachs economists agree with those appearing on television in noting that projected job growth of about four percent scans higher than projected GDP productivity growth of about 1.1-2.0 percent. The productivity number varies according to the economist making the prediction. The trade report last week heightened the disjunction. This translates into productivity being weak, a worrisome condition. One economist provided a rosier reasoning. Because some job growth has been in small businesses and small businesses tend to have lower production numbers, that makeup of the growth may be distorting the production numbers.

As it stands, however, that disjunction alerts economists that something may not be quite right. They worry that the improvement in the jobs numbers may not be sustained. Others, however, point out that the improvements have been backed up by others, such as lower claims numbers. Perhaps it’s the productivity forecast that's wrong?

That kind of slight uneasiness or uncertainty may have been infecting U.S. traders in the premarket session. Perhaps U.S. futures traders reacted to European bourses trending down after their quick run up into positive territory early in their trading session. We might also attribute some global uneasiness to the meeting of EU finance ministers in Brussels. Italian, Portuguese and Spanish debt saw yields rising as the approval of 130B euro Greece bailout package was discussed. Both Portugal and Spain will issue new debt this week, although I could not confirm the dates. Yields on the German bund were dropping as were yields on our ten-year and thirty-year bonds, as investors preferred these safe-haven bonds over others. Later in the day, the ten-year was to settle down again a bit. However, any time we start thinking in terms of "safe havens" and defensive trades, markets might predictably be skittish. This skittishness may persist into the scheduled March 19 auction related to Greek debt covered by the Credit Default Swaps, and it certainly was present ahead of tomorrow's FOMC announcement.

Monday's Developments

The only U.S. economic event scheduled for today was the Federal Budget Balance. The prior report revealed a deficit of $27.4 billion. When I checked one source over the weekend, I saw a projection for a drop to a deficit of $229.3B. The next source predicted a $229.0B deficit. Bloomberg's calendar offers details. January's deficit had measured only half the anticipated deficit, due to the timing of the report but also due to a good-news increase in receipts, Econoday suggested. Over the last 5 years, Econoday reports, the February average has been $165.9B, and last February's was $222.5B. The Department of the Treasury reported an even bigger deficit than forecast, at -231.7B. Some indices seemed to drift a bit lower after the announcement, and bond yields drove higher, but the reaction was not pronounced enough to be able to attribute it to that announcement.

Auctions of 3-month and 6-month treasuries took place at 11:30 am ET and three-year notes at 1:00 pm ET. The three-year auction saw the third-highest dollar demand seen in the last twelve months. Treasuries settled back after the auction, however.

The cost of gasoline produced headlines, with the national average price for a gallon of gasoline rising above $3.80 today, according to an AAA survey. Prices rose 3.4 cents a gallon over Saturday and Sunday.

Although the U.S. had only one scheduled economic release, others from across the globe were announced. Today the OECD, the Organization for Economic Co-operation and Development, released its January leading indicators. For the U.S., the indicator rose 0.7 percent. Japan rose 0.5 percent. The eurozone and the U.K. both rose, too, by 0.2 percent and 0.1 percent, respectively. Reuters characterized the eurozone numbers as "showing tentative signs of improvement." As was noted last week in other reports, China and Brazil appear to be weakening, with drops of 0.6 and 0.2 percent, respectively.

Story stocks included ORCL (29.71, - 0.42), dropping after a downgrade to Hold from Buy by Jeffries. Defibrillator manufacturer Zoll Medical (ZOLL, 92.92, +17.84) announced that it would be acquired by Asahi Kasei, with the outstanding shares purchased for $93/share. In other news, YHOO (14.49, - 0.14) slipped to the third place in Internet searches. News sources reported that it was filing a patent lawsuit against Facebook. AAPL (552.00, +6.83) and IBM (201.00, + 0.38) chugged up to new 52-week highs, although IBM drifted down in the afternoon and didn't complete a new recent closing high. At the same time, some semi-conductor stocks proved weak, with the SOX closing down.

As we search for causes and probable outcomes of the disjunctivitis that has hit the markets, it may pay to keep a close watch on the financials. They have often led the way to equity rallies. This week, The Federal Reserve will release the metrics and then the results of the latest stress tests. The Federal Reserve tests the largest 19 banks in an effort to forecast how they would fare in a severe U.S. market downturn or if a severe market event in Europe spread its contagion here, according to a NY Times article by Nelson D. Swartz. The outcome of this test will factor into decisions regarding dividends or buybacks, Swartz concludes in "Latest Stress Tests Are Expected to Show Progress at Most Banks." The metrics are to be released at any moment and the results announcement is expected by Thursday, the article notes, and will be made public by the Federal Reserve. Banks will be informed of the results before the public announcement.

At the end of the day, we saw skittishness prevail with small-bodied candles on many indices produced in low-volume trading. Trading was mixed here and abroad.


Before I discuss the charts, I wanted to add a note about my setup since some readers have inquired. I use nested Keltner channels. Although they may look a bit like scribbles, they're a channeling system as everyday and ordinary as Bollinger bands. No voodoo. Keltner channels are based on a central average. The only thing I'm doing differently is nesting several Keltner channels together based on central averages of different intervals. Through this decade of writing for Option Investor, I've written many articles about how I use them. If you're interested, the last two were Trader's Corner articles from January 29, 2010 on the basics and February 19, 2010 on setting targets.

Last Monday, I concluded this Wrap with the statement that it was time that the markets pulled back to test nearby support, with the caveat that the markets hadn't asked my opinion. I provided a likely first downside target for several indices. The SPX did pull back, its drop exceeding that first likely downside target before the bungee cord snapped back and propelled it higher again. That bungee cord snap was automatic, a technical given, but now former support may be acting as resistance.

Annotated Daily Chart of the SPX:

The last two days' candles are such small doji candles that they may be difficult to spot on this chart. They're aligned along the 1371 level, where significant potential resistance on daily closes may exist. That potential resistance extends up toward 1381-1383. Although the SPX's prices were able to pierce the first resistance intraday, prices closed along that level, showing that resistance did hold. The 9-ema waits below, looking like first support. However, with this configuration, I consider that 9-ema part of the resistance band itself. A sustained drop below that 9-ema suggests another retest of last week's low, with a potential 1333-1336 downside next target, where support might be found on daily closes. A breakdown below that on consistent daily closes suggests a retest of 1295-1300. If the SPX instead breaks through resistance again, forming new daily closing highs, then a potential upside target of 1435-1438 must be considered.

For now, the chart suggests that a retest of the 9-ema and last week's low may be slightly more likely than a powerful thrust higher. What happens after that, if there is such a pullback, would give us more information about whether lower targets should be considered.

Last week, the DOW also dropped below its flattening 9-ema, dropping to support slightly deeper than the first level of support that had been showing up on my charts. Now what?

Annotated Daily Chart of the Dow:

The Dow appears weaker than the SPX on a Keltner basis, not managing to make it up to that 13,064 level that would be analogous to the SPX's level of the last two trading days. That 13,064 level should be considered potentially strong resistance on daily closes, but you didn't need to see converging Keltner channels to know that. A sustained decline beneath the red daily 9-ema that isn't quickly reversed suggests a retest of last week's low here, as it did on the SPX chart. Between last week's low and the 13,064 level, the SPX merely churns within a congestion zone without providing much of a prediction of next direction. Sustained daily closes above that 13,064-13,066 level or below the 12,740 level suggest that the next 13,630 and 12,360-12,414 might be next upside and downside targets, respectively.

The NDX, like other indices, finally dropped below its daily 9-ema last week and slipped to test lower support. It rebounded. Channel lines begin to converge, suggesting a slight firming of support. Will it hold?

Annotated Daily Chart of the NDX:

The NDX chart is one that renders predictions about market direction more difficult. It's outperforming the other indices we've seen on a Keltner basis. Not only has it broken above the Keltner resistance configuration we've seen on other charts, but it's also converting that potential resistance to potential support. The NDX hasn't been able to break cleanly above the potential historical resistance that has held it back over recent weeks, however, so that although a potential upside target of 2705-2710 upside target has been set on a Keltner basis, we can't yet consider that upside target firmly in place. Right now, it looks as if it would take another big market jolt to break the gathering support on a daily closing basis, however, so we must consider the NDX as churning in a noisy congestion zone, also without much prediction of the next direction. This index needs either a jolt or some time for the support or resistance to soften. Market events scheduled for this week have the potential to provide a jolt or two.

The RUT was one of the first indices to slip beneath its 9-ema on daily closes. Its relative weakness with regard to some other indices sets its chart up slightly differently than others. Potential support appears to be firming, but so does nearby potential resistance.

Annotated Daily Chart of the RUT:

The RUT's second day of closes above the 9-ema maintains a potential upside target of 825-830, where next potential resistance on daily closes appears to be strengthening. That's countered by strengthening support at the 9-ema, and in another band from 790-800. The RUT has been overrunning potential upside and downside targets, so these should be considered approximate targets, not to-the-number ones. Any sustained trading below the 9-ema that isn't quickly reversed suggests that another test of last week's low and any sustained trading beneath that low that isn't reversed suggests a test of 765-767. Any sustained move above the 833.02 historical resistance suggests an upside test of 885-890. "Sustained" doesn't mean 30 minutes immediately after the FOMC announcement, however. Unlike some of the other indices, the RUT moved up right underneath the congestion zone in which it had previously been trading rather than moving back into it, so it remains weaker on this comparison.

Last week, Europe provided the jolt that powered the U.S. dollar above massed potential resistance. This week, plenty of events in Europe could combine with our FOMC's decisions and announcements to either power it higher or send it back to test that former resistance to see if it holds as support.

Annotated Daily Chart of the Dollar:

A potential upside target has been set at 81.00-81.40, with that potential target in place as long as daily closes remain above about 79.40-79.50. A sustained break below about 78.70 suggests a retest of that recent 78.12 low down to about 77.50. Between those numbers, we're seeing noise in a congestion zone. Tomorrow's 1:00 pm ET 10-year auction could help swing the dollar one direction or the other, but the FOMC announcement is likely to put the biggest push behind any move the dollar makes, in whichever direction.

Some traders will be scanning the volatility indices tonight. This morning, for example, the VIX dropped to a low of 15.23 before jumping in the late morning and then drifting slowly lower again. It ended the day at 15.64. As many market watchers point out, that drop might have been an artifact of today's expiration. Remember those cautions you get from your broker about a non-standard expiration when you trade a vehicle with options that expire some odd, non-standard day? The volatility indices are among those with non-standard expirations, a fact that catches some traders in the volatility indices flat-footed. Tomorrow, we may see traders entering new positions, which may distort what we see pre-FOMC announcement. We may not be able to count on what we're seeing as being predictive of next market direction.

I continue to say what I have been saying: we have to think in terms of probabilities as well as our own market analysis, and the probabilities when the volatility indices drop this low are that they will steady or climb, and a climb is usually accompanied by an equity pullback. That doesn't mean that will definitely happen. When I flip a coin, I know the probability is that I'll have a 50-50 chance of it coming up tails. However, I might flip 10 coins in a row and have all heads. If we're placing bets on what happens, we have to be aware of where the probabilities lie, however, so we can assess our risks. In my personal trading, I'm certainly watching for the possibility that the RUT, the vehicle I'm trading right now, might next power straight up toward 833, and I bought a call credit spread this afternoon to hedge my delta risk in that direction. However, I have also assessed the possibility that the RUT might again drop to 800 or even to test last week's low before we know whether the 766-770 level might need to be tested. I'm making sure my trade is okay if that happens, too. Perhaps you can't structure your preferred trades this way, but you should at least know where you will take profits if your underlying heads in the direction you want it to head and where you'll take losses if it heads to its potential target in the other direction.

Tomorrow's Economic and Earnings Releases

Tomorrow's global economic calendars suggest that we also ought to be watching a couple of releases in Europe, the German and European ZEW Economic Sentiment numbers due at 6:00 am ET. Economists forecast a rise to 11.2 in the German ZEW from the former 5.4 and a rise to 3.8 in the European ZEW from the former drop of -8.1.

Here in the U.S., the Conference Board releases Retail Sales at 7:30 am ET tomorrow morning, with the prior numbers up 0.4 percent for the headline number and 0.7 percent for core retail sales. Core sales are sales excluding automobiles. Forecasts anticipate a gain of 1.1 percent in the headline number and 0.8 percent in the core retail sales. I watch the RLX, the S&P Retail Index, as one of my signal indices giving me some insight into the underpinnings of the market. It's been zooming higher, bouncing from its daily 9-ema as have many other indices. Unlike some of those other indices, the bounce got even stronger in March, but has stalled the last two trading days. The closes have been higher, but the candles have been first a small-bodied candle on Friday and a doji today. That 9-ema still slants sharply upward, showing no damage has been done, but it might be a good idea to put the RLX on your watch list to observe tomorrow after those retail reports come out. A weakening of the RLX, especially if coupled with a weakening in the financials as indicated by the BIX and BKX, could remove some of the energy from the markets, making them more susceptible to weakening, too. I would have to see the RLX forming consistent daily closes beneath a turning-lower 9-ema before I would take any pullback as anything more than the most normal of retracements, however.

Economic releases related to the retailers or other equities won't stop of the Conference Board's announcement. Weekly Redbook sales will be reported at 8:55 am ET. At 9:00, U.S. Business Inventories and the IBD/TIPP Economic Optimism could influence markets. The Census Bureau reported a prior gain of 0.4 percent for the business inventories, with a gain of 0.5 percent predicted for tomorrow's number. TIPP reported 49.4 for the last Economic Optimism report, but forecasters predict a rise above the benchmark 50.00 to 53.2 for tomorrow's number.

Treasury auctions for Tuesday include a 4-week bill auction at 11:30 ET and a 10-year note auction at 1:00 pm ET. Normally the 10-year auction might be notable, but the markets might put any reaction on hold until after the FOMC announcement.

All attention may be focused on the Fed Funds Rate to be announced at 1:15 pm ET or, rather, on the accompanying FOMC statement. This weekend, Jim detailed some of the concerns that face traders as they await that statement, and I urge you to read his synopsis if you haven't already done so. Options traders should take care, as we often see a rising or at least steadying in the implied volatilities of options leading into this report, while prices coil just above support or below resistance. This action renders oscillators such as RSI and MACD less useful in predicting the direction of any breakout post-FOMC. Moreover, once the direction of the immediate breakout is known, implied volatilities can sometimes slip, so that the short-term option trader doesn't see the expected gains even if the chosen underlying moves in the expected direction. That effect may be somewhat muted since volatility indices are so low, but volatility indices and implied volatilities in individual underlyings aren't always synonymous.

Moreover, the first post-FOMC breakout can sometimes be reversed, either immediately or over the next day or so. Of course, if the break is to the downside and is virulent enough, those implied volatilities won't slip. With volatility indices as low as they are now, they may not slip much if the indices head higher, either. If you're considering betting on a post-FOMC direction, decide whether you want to go in with a full allotment or only with lottery money.

What about Tomorrow?

Annotated 30-Minute Chart of the SPX:

The SPX's 30-minute chart pins the next potential upside target and potential resistance exactly where you'd expect it to be. That's at about 1373-1375 on 30-minute closes. It pins the next potential downside target and downside support on 30-minute closes exactly where you'd expect it to be, with any downside thrust pushing the dynamic channel line now at 1367.80 down to about last week's low. Anything between those levels is churn and isn't predictive. A breakout above resistance suggests that traders should be prepared for a possible thrust up to the 1381-1383 zone, where next resistance might exist. Any break below last week's low that is sustained suggests that the SPX will drop to 1364, where light historical support exists, too. However, if the SPX drops that low, I wouldn't be surprised to see the Keltner line now at 1364.54 pushed down far closer to the 1361-1365 level, so I wouldn't think a test of that zone farfetched.

Annotated 30-Minute Chart of the Dow:

Based on this chart setup, I wouldn't consider a break to a new recent Dow high a clean breakout until and unless the Dow sustains 30-minute closes above about 12,978-12,980. Such a breakout, if sustained, suggests a potential upside target near 13,086-13,095. However, the Dow ended the day clinging to the support of the 9-ema on this 30-minute chart. A drop early tomorrow morning might turn that moving average into potential resistance and set up potential downside targets first at 12,940 and then at 12,920-12,928. Sustained 30-minute closes beneath that level suggests a pullback toward 12,870.

Annotated 30-Minute Chart of the NDX:

Like the Dow, the NDX ended the day clinging to the support of its 9-ema on this 30-minute chart. A drop early tomorrow morning might convert that support today into resistance tomorrow and set up a first potential downside target at about 2640-2642. A failure there on sustained 30-minute closes suggests 2625-2629 as a next downside target, where support looks relatively strong on 30-minute closes. A climb first thing tomorrow, unless it gaps the NDX higher, would soon face potentially strong resistance at about 2649-2652. I would not consider a new upside target set unless the NDX sustains 30-minute closes above last Friday's 2651.98 high. Between today's low and Friday's high, we see a noisy congestion zone, with no predictive value until Keltner channels realign. A support test looks just as likely as a resistance test and vice versa.

Annotated 30-Minute Chart of the Russell 2000:

Like several other indices, the RUT ended the day clinging to the support of its flattening 9-ema on the 30-minute chart. If the RUT should spring higher from that moving average tomorrow morning, it will face potential resistance well ahead of last Friday's high of 821.19. Instead, it will face resistance on 30-minute closes from about 816.72-818.00, with dynamic Keltner channels pushed around a bit by a market move. Unless the RUT gaps higher in the morning, I would watch for potential resistance in that zone. A gap or sustained 30-minute closes above that number after trading opens would set up a potential upside target of 823.81-826.00, but traders will of course be watching Friday's high of 821.19. If I had bullish short-term profits and was wary of tomorrow's FOMC announcement, I would consider locking in or otherwise protecting my profits at that level. If the RUT heads down first thing tomorrow morning, a retest of today's low and maybe even a drop to 809-811 might be next downside targets and areas of potential support on 30-minute closes. A sustained break below that on 30-minute closes suggests a test of 804-806.

Studying the RUT's 30-minute chart points out something visible on other charts. If you look at the shape of the RUT's pullback since Friday's high and the size of that pullback compared to the rise off last Tuesday's low, you can see the potential bull flag shape of that pullback. The same setup is true of many indices. You can see that the flag is a little wide when compared with the size of the narrow run-up channel, and that always concerns me a bit, but there's been no technical damage done to the indices. On some, there has been a strengthening of resistance, however, but it's not yet something that a strong post-FOMC reaction couldn't overcome.

I haven't shown the BIX as I've already gone way too long with this Wrap. Its volatility is a little more worrisome, the index is beginning to take on a little head-and-shoulders look on its short-term 30-minute chart. However, what we're seeing on this and other indices is indicative of what we often see leading into an FOMC meeting. We see churn, and we see some potentially strong support and resistance against which prices might be nestled into the FOMC announcement. In the past, at least, we've often seen breakouts immediately after that announcement, but here I want to warn you. The breakouts don't always last. As we head into the announcement, examine the churn zone and the next targets, giving some leeway for them to have moved in the direction of the trading by the time of the announcement. Be sure you're ready to defend your trade if the breakout is in the direction in which you think it might be and also in the direction you hope it isn't, and try to position the trade so that you can withstand a whipsaw that moves both directions. Tough order, but the idea is that you don't want to do anything that will see your 401K evaporate if the RUT zooms up 8824 and beyond or the SPX drops to 1361 or beyond.

When the day's action is summed up, we had a low-volume, small-candle-bodied day indicative of indecision. Markets have already gone into the wait-for-the-FOMC-announcement mode, a mode that could be broken by an unexpected result in the 10-year auction, something related to the Greek situation or results of our banks' stress test.

Be careful about new positions before the FOMC post-decision dust settles. If you're in other positions that have acquired major delta-related risks that would be in big trouble with a move one direction or the other, you might consider some tactics to lower that risk before the FOMC decision, especially if that position is in about-to-expire options. One easy way to lower risk is to remove a portion of the position, particularly if one has a profit and can lock in partial profits. If there's a loss, a more difficult decision will need to be made. Hedging delta-related risk can be accomplished in many other ways, including buying in some short positions, adding longs or adding verticals. Verticals, such as a call or put debit spread, has the advantage of buffering some of the volatility risk from options prices deflating suddenly, too. Each choice has its pros and cons and should be employed only if you understand those pros and cons.

I suggest keeping the transports ($DJT on some charting programs), retailers (RLX) and financials (BIX and BKX) on your radar screen, and the SOX if you're an NDX trader. You want these to confirm the direction of the other indices. They can give you a heads-up that something might not be right. In normal conditions, the volatility indices would also be key to watch, but their expiration today may skew these as traders enter new positions tomorrow.