Tonight's newsletter is longer than usual and I apologize to those whose time is precious. We read a lot of material each night and I try not to overburden you with a long report. There are some important things I'd like to cover tonight, some of which will address recent emails that I've received, expressing real angst and anger about my bearishness. I also have a few more charts than usual I want to cover.
Opex week has lived up to its reputation of being a bullish week. An overbought market has become more overbought and most of the market indicators are stretched to the breaking point. But don't stand in the way of bulls on a mission and that mission has been to buy up the market in front of the expected next round of Fed QE (Quantitative Easing). It might not be logical for the market to rally on only the hope that the Fed will be successful this time (when their previous efforts have been unsuccessful) but hope is a powerful emotion. Not quite as strong as fear but hope is what makes the world go 'round.
Prior to Wednesday's gap up and run higher the market was building small rising wedge patterns over the previous couple of weeks with the confirming bearish divergences, suggesting a top was near. But fear about the negative impact of QE on the dollar has driven the dollar lower and all other asset classes higher. The overnight rallies in the equity futures, especially since August, have led to a series of gaps to the upside in the cash indexes, including Wednesday's rally. This helps create a sense of panic among the mutual fund managers who are then forced to chase the market higher in an effort to keep up with their competition, especially as we approach the end of their fiscal year. Their bonuses are dependent on their performance against the benchmark, typically the S&P 500. So when the S&P runs higher the funds must do more buying and that's what the overnight buying in the futures (manipulated or not) has accomplished.
Based on the premise for why the market has been rallying so strong -- one being the expectation of the Fed's QE2 program and another is the fund managers chasing the market higher into the end of the fiscal year -- the big question is what happens if the Fed doesn't give the market what's already priced in (according to Goldman Sachs the market has already priced in more than $750B of QE) and fund managers become more interested in protecting profits as the end of the month approaches rather than chasing it higher. One whiff of a big decline and fund managers will be running for the doors en masse, trying to get out at any price.
Mutual funds are all in and every day the rally continues the more the mutual fund managers are required to use what little cash they have available. People have been pulling money out of mutual funds this year so it's not like a whole lot of new money is making it into these mutual funds' accounts. I don't have the figures for September but based on the strong rally, which has continued into October, the level of cash as a percent of total assets in mutual funds is now at record lows. It is lower than where it was at the market tops in 2000 and 2007, significantly lower. When we have a market where the bulk of the money is all in and bullish sentiment is at an extreme, there's really only one direction left and it's likely not to be that much higher. From a risk:reward perspective it's not a great time to be betting on the upside. Keep in mind that holders of stock are sellers in waiting.
Having said that, I must admit to being a highly frustrated bear. I try not to let my bias taint my technical analysis but obviously that's easier said than done. I've been looking for tops to bounces rather than bottoms of dips and I've fought this rally all the way up. The number of emails received in the last week -- highly frustrated and angry with me for my bearish analysis -- is not something I've seen since the top in October 2007 when I was receiving an equal number of angry emails about how wrong I am to fight the rally. So if it's any consolation, the level of frustration and anger that I'm reading right now is the sign of a top. I'm also ready to capitulate and that's another sign of a top. A trading buddy sent me this after my nightly update on the Market Monitor last night (in which I was calling for more upside after a pullback today):
When it comes to market analysis and trading I put my money where my mouth is and I'm feeling the pain. I continue to believe looking for a top, rather than an entry on the long side, is the right approach here. I firmly believe the ride back down, like in 2008, will more than make up for losses trying to short too early. Other than the fast and strong rally from August, this year has been a grinding affair for both sides. But the sharp rally from August actually does a good job at finishing a corrective pattern (a-b-c bounce off the July low) instead of setting up a more bullish pattern. So while Wednesday's rally was extremely disheartening for bears, and it might not be over yet, the pattern and stretched conditions to the upside speak loudly to me to get ready for a fast and strong reversal right back down. This year will end up looking like one big roller coaster ride and both sides will feel whipped.
I need to do a better job at highlighting where I think the trend changes and therefore where the trading opportunity lies. I've been attempting to pick a top but not focusing enough on the key levels that I place on my charts (shown with a bulls-eye symbol) that indicate when the trend has likely changed. Focusing on those levels would have done a better job at keeping us bears on the right side of the fence and even if we did not want to trade the long side we could have stayed out of danger.
My shorter-term trading style is to probe for reversals at tops and bottoms because I can better manage risk. That trading style has been showing up more in my charts and for that I apologize -- I did not make it clearer that we need to wait for confirmation of a breakdown before establishing the longer-term short positions. I know this is where many of you also have been hurt. I feel your pain and take your complaints seriously.
So please take note of the key levels to the downside on my charts. Until those levels are broken we have to continue to respect the upside potential. Personally I will not trade the long side because of the plethora of signals warning of an impending reversal (and hard reversal) back down. But in hindsight this needed to be traded more conservatively and wait for the signal the top is in place. I'm still working on hindsight trading as a technique but haven't been able to perfect it yet. You'll be the first to know once I've got it down (by my absence since I'll be off on an island somewhere doing my trading).
There are 11 different correction patterns in EW (Elliott Wave) analysis and I thought we had a more bearish pattern in play prior to September's rally. It's what kept me bearish longer than I should have been (I'm talking relatively short term since the longer-term pattern is still clear as a bright sunny day and it's bearish). The shorter-term pattern since July has become clear again and now it's a "simple" matter of identifying the top to wave-c of the a-b-c bounce off the July low. The larger wave pattern from there suggests another leg down to at least match the April-July decline so that's the potential for the bears (any left out there?). As an example, a drop from yesterday's high would have SPX down to 974 for starters. Once that happens we'll probably have 95% bears instead of 95% bulls and I might be looking for a rally when everyone else is screaming there's no bottom.
Starting with the SPX weekly chart, SPX has pushed above its downtrend line from October 2007 through the April 2010 high. This is an unconfirmed trend line (two points to establish it and a 3rd point is need to confirm it) so it could be meaningless. Back in April SPX stopped at its 200-week MA and if the market continues to press a little higher that's where SPX will run into trouble. That's of course just shy of its April high near 1220.
S&P 500, SPX, Weekly chart
There is a horizontal price-level resistance area between 1174 and 1183 and that's where SPX has stalled so far. It's a little hard to see on the chart but today's red candle closed just below the top of a rising wedge pattern (which is rallied strongly above yesterday). This might be giving us a sell signal after a possible throw-over finish to the rising wedge and then close back inside. I'll believe it if SPX breaks below 1166 (the key level to the downside), the bottom of the wedge and the uptrend line from August. This uptrend line has held each pullback since the beginning of the month so a break of it would be important (and hopefully not just a head-fake break). A close above 1183 opens the door to 1196 (as per the weekly chart above) if not the April high of 1220. Wait for a break below (and stay below) the uptrend line from August before initiating any new short positions--let the market prove to us that a top has been made.
S&P 500, SPX, Daily chart
Key Levels for SPX:
- cautiously bullish above 1175
- bearish below 1166
The 60-min chart below shows a possible short-term up-channel for price action October 4th, the top of which also points to the 1196 upside target. So keep your eyes open for that level and watch how price behaves. If you feel bold enough to try shorting it there, that's the place to try. Otherwise wait until the key level at 1166 is broken and then start looking for bounces to short. There will be plenty of opportunities to short this market (as long as they don't keep gapping it to the downside with very few bounces, forcing traders to chase it lower just as they created chasing to the upside) so be patient and be careful. This market is not acting sanely right now.
S&P 500, SPX, 60-min chart
The DOW's failure to get above its rising wedge pattern is a little more pronounced than on SPX. It ran above it yesterday but was unable to close above it. Today's candle is a bearish dragonfly doji still within the wedge. In any normal circumstance this would be a flaming sell signal that I'd be pouncing on. A break below 11K would be a bearish heads up and below 10913 would confirm we've seen the top (that's our key level to the downside). Otherwise any further push higher will clearly have the April high at 11258 in the bulls' sights.
Dow Industrials, INDU, Daily chart
Key Levels for DOW:
- cautiously bullish above 11,000
- bearish below 10,913
GOOG reported after the bell today and apparently pleased the longs (or scared the shorts) and rocketed up about $50 from its closing price near $540. If that holds into tomorrow morning it will surely have the techs on fire. NDX has stalled at the April high but price action hasn't done anything wrong yet. Therefore further upside potential clearly exists, especially if more bears throw in the towel and a bunch of stops get hit above the April high. In that case I would keep my eye on 2106 which is where the 127% extension of the April-July decline is located. This is a common extension and reversal level (common in a double top/bottom pattern). It takes a break below the key level at 2025 to tell us the top is in place but as of this evening that's not looking like the high-odds play yet.
Nasdaq-100, NDX, Daily chart
Key Levels for NDX:
- cautiously bullish above 2060
- bearish below 2025
A rally without the semis is like a day without sunshine. And the semiconductor stocks have been balking as of late. The SOX has been stuck underneath a downtrend line from June (which fits as the top of a parallel down-channel from May-June) near 356. It is also stuck at the 78.6% retracement of the July-August decline at 357. A burst through this resistance level could see a quick trip up to the June high near 371. If NDX/COMPQ rallies but without the participation of the semis (or only gets half-hearted support from the SOX) stay wary of the rally. The SOX needs to drop below its key level at 341 to declare the top of the bounce is in place.
Semiconductor index, SOX, Daily chart
Like the other indexes, the RUT jumped above the top of its rising wedge pattern on Wednesday and closed strong. It's hard to see but the RUT pulled back and closed right at the top of the wedge, thanks to a late-day rally into the close. Yesterday it came close to tagging its 78.6% retracement of the April-July decline near 712 but if it can push higher I'd watch for a run up to the 720 area where it will hit the top of a larger rising wedge, the top of which runs along the highs since early September. It takes a break below its key level at 685 to declare a top is in, although a break of its uptrend line from August, currently near 694 would be a bearish heads up.
Russell-2000, RUT, Daily chart
Key Levels for RUT:
- cautiously bullish above 700
- bearish below 685
If the Fed follows through on their threat to implement QE2 (2nd round of Quantitative Easing) and purchase a lot more Treasuries it should maintain a bid under their prices. Any increase in bond prices will lower their yields and so far that's what looks like will happen. The parallel down-channel from April remains intact and the trend is your friend until the bend in the end so stick with the trend until it breaks above 2.56%. Any rally in Treasury yields would be an indication the Fed's effort to hold rates down is not working and that would likely spook the other markets. But if money continues to pour into the bond market that could put some additional pressure on the stock market (not that that's mattered for the past month where both have been rallying).
10-year Yield index, TNX, Daily chart
Another vehicle of choice for those looking for riskier but higher-yield bonds, the HYG is a good representative of these high-yield corporate bonds. The weekly chart below shows the peaks in January and April 2010 are being tested again. This is a measure of complacency in the market. These are the junk bonds and the willingness to bid up the prices of them shows a willingness to take on higher risks to get the higher yield. What's bearish about this chart is the testing of the highs but with bearish divergence. There's just not as much conviction in owning them this time. Any failure from here and a break of the uptrend line from March 2009, near 88.30, would be a very strong sell signal following this 3-drives-to-a-high sell setup.
High Yield Corporate Bond ETF, HYG, Weekly chart
The VIX is also giving us a sell signal for the stock market (but keep in mind that it can lead the stock market by up to two weeks). When the VIX closes above or below the Bollinger Band, indicating a move in excess of two standard deviations from its 20-dma, and then closes inside the BB it's a reversal signal. A reversal up in the VIX is a heads up for a reversal back down for the stock market. You can also see the bullish descending wedge pattern for the VIX since May. The bottom of the wedge is the downtrend line from January 2009 which was broken in May. The VIX has been dropping back down to retest it multiple times since then. The bullish divergence on the oscillators shows the decline has been running out of momentum. Once again, in a normal market where these technical indicators work, this is a BIG warning to stock bulls.
Volatility index, VIX, Daily chart
The banks were hit hard today. There is growing concern about the mortgage mess and this morning's news from RealtyTrac did not help. They reported foreclosures in September jumped to a new all-time high of 100K for the month. Many banks, JPM and BAC among them, have placed a moratorium on foreclosures (I could say something about the political timing of that move but I won't) but the reaction to this move has been mostly negative. This is only delaying the inevitable and further confusing the buyers/sellers, which is further slowing home sales. The moratorium is even emboldening some to stop payments and there's a story about a couple moving back into their CA home from which they insist they were improperly evicted. The house has since been resold twice and the new buyers are now unable to move into the house. But reading the story about the evicted couple makes me feel sorry for what happened to them because of the ineptness of the banks. What a mess.
Several people, including some senators, are now coming out and suggesting the banks are going to be forced to buy back all the mortgages that Fannie and Freddie are sitting on which don't meet government standards for writing. The review of "improper" paperwork is showing a huge number of mortgage contracts that do not meet the standards. Compounding the concern is the news that all 50 states' Attorney General offices are working together to investigate potential fraud (throw in waste and abuse too) in how the banks wrote all these mortgages that are now failing left and right.
Many are now starting to speculate that the only correction to this mess is for the banks to buy back all those mortgages that they repackaged and sold off to the market under the pretenses that they were AAA-rated mortgages. The GSEs (Government Sponsored Enterprises, such as Fannie Mae and Freddie Mac, and Government Motors; OK, maybe not the last one, yet) can only hold government-standard mortgage paper so any mortgages that they bought from the banks that do not meet these standards will have to be returned to the banks. If forced to buy these mortgages back from the GSEs it would literally bankrupt many of the big banks. I see Banking Crisis II coming out of this and no amount of QE 2, 3, 4, 5 or 6 is going to correct it (we can't afford the debt and people will be absolutely screaming "off with their heads" if the government tries to bail out the banks again).
Is this one of the reasons the banks sold off hard today? One can only guess what's driving this market any more but I'd say it's a good guess. The banks have been significantly lagging the broader averages since August and that's been a huge red flag (to me, not that it hasn't mattered to the rest of the market).
Looking at BKX, the KBW Banking index, it has been in an ascending triangle pattern since the August low, something that is normally considered a bullish pattern. But when it follows a move down into it, which it has, there is a good possibility that it is instead a bearish continuation pattern. And a failed bullish pattern (as interpreted by many traders) will often fail hard and that's what we see in the chart below. Yesterday morning there was a quick throw-over above the top of the triangle followed by an immediate drop back inside and that created the first sell signal. The hard break below the bottom of it today confirmed the sell signal. This pattern can only be interpreted as bearish and the next move will be a drop below the August low.
Banking index, BIX, Daily chart
Speaking of real estate, one thing that has baffled me is the strength in the REITs, as measured by the DJ REIT index, DJR. One reader said it's because there are so many good deals out there right now (distressed sales) that property managers are finding deals where the investment is paying off (from rental income) in 5 years instead of the usual 10. So the managed REITs have been doing well. But DJR has an interesting pattern that suggest short is the way to go very soon. The move up from July has formed a rising wedge pattern with the requisite 5-wave move inside (labeled a-b-c-d-e). The final wave, wave-e, can truncate (finish short of the top of the wedge), do a throw-over or anything in between. Therefore I'm watching for a failure at any time now. A way to play this market short is to buy the inverse ETF, SRS.
DJ REIT index, DJR, Daily chart
The Trannies had a good day yesterday, following the earnings report from CSX. It caused the index to spike above the top of a parallel up-channel from July and the top of a rising wedge for price action since August. Today it closed back down on these trend lines. It's a setup for a reversal back down but we'll have to see how it does with a broader market rally (if it rallies). A drop below the key level at 4551 would confirm we've seen the high.
Transportation Index, TRAN, Daily chart
The reason du jour for the rally in most asset classes is the decline in the U.S. dollar. The dollar is very hated right now, even more so than back in November 2009 and its previous low in August. With only 3% bulls in the dollar one can only imagine what a short squeeze will look like in the dollar. It seems everyone has shorted the dollar and invested the money in other assets and currencies. The reversal of these overcrowded trades could be a sight to behold. Ideally we'll see the dollar drop a little lower now that it broke below 77. There is strong Fib and trendline support near 76 so keep an eye on that level. Any strong reversal in the dollar is bound to be negative for just about all other asset classes and currencies pair-traded with the dollar. The euro should experience a very strong decline (it currently has a DSI (Daily Sentiment Index from trade-futures.com) reading of 97% bulls. Not too many buyers left in that currency and now they're all sellers waiting for an excuse to unload.
U.S. Dollar contract, DX, Daily chart
To keep the dollar's move in perspective, the weekly chart below shows the 3-wave pullback which fits as a correction to the November 2009-June 2010 rally. It has gone deeper than I thought it would (which has helped the stock market rally, as well as commodities) but it's still a correction. Once it completes the pattern then calls for a strong rally that will take it well above the June high. I'm guessing we'll be hearing how the Fed's QE program is not working by then.
U.S. Dollar contract, DX, Weekly chart
Stand back and let the rise in gold and silver flame out. It has gone parabolic, as can be readily seen on gold's daily chart below. This is very common for the metals and it's always hard to figure where the blow-off top will finish. One technique is to use a Fib extension off the previous correction, which in this case is the June-July decline. The current rally pushed through the 161.8% extension and therefore the next one to look to is the 224% extension which is near 1402. This Fib extension is often associated with v-top/bottom patterns. The next move after these is typically a 78.6% retracement of the move, which for gold would be quickly back down to about 1200. Parabolic conclusions to a rally never end well so if you want to ride a wild pony on the short side, keep an eye on gold for a good setup.
Gold continuous contract, GC, Daily chart
Silver tends to move faster than gold and once it started rallying from August there was no holding it back. Talk about a spike up! The weekly chart below shows how quickly it traveled from the bottom to the top of its parallel up-channel from 2008, and in the process has spiked above the top of the channel. It tagged the 127% extension of the previous decline in 2008, near 24.98, the common reversal level. Yesterday's high was 24.95 and whether it will reverse here or not will only be known in hindsight but that's the setup. When silver starts back down it's going to go fast. You can play a silver short with puts on SLV or calls on the inverse fund, ZSL. This one could be fun, and profitable, if caught well. It could also slice you to ribbons if you try to short it too early (I speak from experience).
Silver continuous contract, Weekly chart
Oil is struggling below Fib resistance at 84.54 (88.6% retracement of the May decline, often associated with double top/bottom patterns). At the same level the bounce off the August low had the 2nd leg up achieving 161.8% of the 1st leg up (to complete the 2nd a-b-c bounce within a larger double zigzag wave count for the correction off the May low). Resistance could get tested once more before it's ready to decline. Any break above 85 would be bullish while a break below its key level at 80.88 would confirm the top is in place.
Oil continuous contract, CL, Daily chart
Sorry, running out of time tonight. The chart below shows the economic reports for Friday morning. Only one caution about the CPI numbers--if, like the PPI numbers, they show inflation taking root it could scare the Fed away from another round of QE. If the market even suspects that could happen we could get a quick unwinding of the September-October rally.
Economic reports, summary and Key Trading Levels
Summarizing, some of the bearish indicators in the market include the following:
1. We've had multiple Hindenburg Omen signals in recent months, which remain valid through the end of the year (so not a good timing signal for the bears but a significant warning).
2. VIX/VXX dropping below the lower band of their respective Bollinger Bands (signifying a move beyond 2 standard deviations) and today closed back up inside the band, creating a "buy" signal which is bearish for stocks. Again, not a timing signal but a warning.
3. Parabolic moves in many of the leadership names in stocks and in the metals--fear of missing out on the upside never ends well.
4. Overbought indicators across the board. Bullish sentiment at an extreme not seen since 2000 and 2007.
5. Mutual fund cash levels, as a percent of total assets, at record lows -- lower than in 2000 and 2007.
Keep in mind that the bullishness through September and into October does not imply we'll have a bullish finish to the year. September was the best September since 1939. Interesting that they make that comparison because back in 1939 the September high led to a significant decline and it took three years to climb back above it, thanks primarily to the entry of the U.S. into World War II.
When we look at the number of S&P 500 stocks above their 50-day moving averages we see just one of many indications of a very overbought market. The last time the percentage was this high was in April. But even back then the market rallied a little higher, leaving a bearish divergence against this indicator at the end of the month. So it can of course become more overbought but would you feel comfortable entering a new long trade at this level? And if you didn't want to enter a new long trade then you need to seriously consider your risk:reward in holding on for more to the upside. That's just part of risk and money management. It may be too early for shorts but I think it's too late for longs.
Percentage of S&P 500 stocks above their 50-day moving averages
Countering the bearish indicators is another round of QE, which is what has so many market participants declaring "don't fight the Fed". They have a strong argument but I think the market has gotten way ahead of itself on this. You can get the latest POMO (Permanent Open Market Operations) from this site: Fed's POMO schedule and the table below shows the latest (updated today):
Federal Reserve Bank POMO Schedule
At the top of the table on the Fed's web site it mentions the intent to purchase about $32B of "agency debt and MBS [Mortgage-Backed Securities]". These purchases are made possible through the use of electronically-derived money (out of thin air) and the intent is to give the big banks more money so that they can then loan it out. The fractional reserve banking system is dependent on loaning money so that the money supply can be increased. Many believe these banks are hoarding the cash instead and giving it to their proprietary trading desks to trade. JPM's latest earnings report demonstrated higher earnings on reduced revenue--it's coming from their trading desks. Your tax dollars (or debt) at work.
The previous POMO schedule, for the period September 15th through October 6th, was for the purchase of $27B. So those who argue not to fight the Fed certainly have a valid argument. That's a lot of money potentially entering the stock market, especially if the Fed starts buying stock ETFs like Japan's BOJ is saying they'll do. My argument is that the new money will not make it into the monetary system (the banks are not lending and borrowers are not borrowing) and the deflationary spiral will continue. But nothing moves in a straight line and obviously the hope that the Fed will be successful is what's driving the dollar lower and all other asset classes higher (with the worry about deflation in the dollar and inflation in the prices of all other assets). When it's proven that that's not working (how long for that to happen is the big question mark) we'll then suffer a reversal in the moves we've seen since August.
The charts point to the possibility of at least one more push higher although the afternoon drop (before being rescued into the close) violated some downside levels that indicated we might have seen the high. Obviously any bullish follow through to the futures this evening would give us another bullish day in the market. The pattern for the dollar also looks like it should drop a little lower and that should keep some upward pressure on the other asset classes.
We're in an irrational market, one that expects the Fed to save the day. Hope is a four-letter word for the market place but it clearly has emboldened some bulls and scared the lights out of the bears. Stay ready to grab a chunk out of this market on the way down but give it some room to prove the rally has finished. Follow the key levels on the charts and when they break then you can start laying a little heavier on the short side. In the meantime continue to respect the upside. And watch the dollar--that's going to be our key to knowing when reversals are underway.
Good luck and I'll be back with you next Thursday.
Key Levels for SPX:
- cautiously bullish above 1175
- bearish below 1166
Key Levels for DOW:
- cautiously bullish above 11,000
- bearish below 10,913
Key Levels for NDX:
- cautiously bullish above 2060
- bearish below 2025
Key Levels for RUT:
- cautiously bullish above 700
- bearish below 685
Keene H. Little, CMT