Option Investor

Daily Newsletter, Monday, 8/23/2010

Table of Contents

  1. Market Wrap
  2. New Plays
  3. In Play Updates and Reviews

Market Wrap

Bulls Have One More Chance To Rescue the Market

by Keene Little

Click here to email Keene Little
Market Stats

The day started bullishly after the futures ran higher during the overnight session. The market gapped up, ran a little higher but then proceeded to close the gap and in some cases (NDX) it retraced the entire bounce off Friday's low by mid morning. By 11:00 AM most of the price action seemed to be finished and the market consolidated in a small bounce until 2:00 PM (the typical reversal time if there is to be one). Following that bounce there was another sharp move lower into the close, leaving a bearish taste in traders' mouths.

As Jim had mentioned in his weekend wrap, volume is expected to dry up some as we close out the summer. Today's volume was not the lowest of the year but close to it and one could say it was not useful for confirming today's move. What will be important are the relative volume levels in rallies and declines.

There were no significant economic reports today so the market was left on its own to try to recover from a less-than-bullish opex week. Now as we enter the final full week of August, the bulls need to do some work in order to save the month. August is historically the 3rd most positive month of the year (September is the worst and October is typically the bottoming month). If August is a down month it doesn't give us any warm and fuzzies about September.

The month of July closed at SPX 1101.59 and today (Monday) closed at 1067.36, making August negative by -3.1%. The question is whether or not the market will rally into the end of the month (a week from tomorrow) and get us positive for the month. At the moment I do see the possibility for a rally this week (although the possibility decreased as the market sold off into the close) to finish a larger correction from the August 16th low but I'm not sure the bulls will be able to hold the market in positive territory for the month even if we do get a larger bounce. And if Friday's lows are broken then I think August could close very negatively.

The good news is that we did not get a market crash today. As you'll recall, I showed a chart of the 1987 crash setup in my Thursday wrap and said we were close to a very similar pattern last week. However, there was not a strong selloff on Friday and certainly no gap down and crash today. We can effectively eliminate that analog (similar pattern) from consideration.

Now all we have to do is ignore the confirmed Hindenburg Omen (HO) signal we got last Friday (and missed by only 1 issue on Thursday). A confirmed signal is when you get a second HO within its active 40-day window. Its creator, Jim Miekka, said in a telephone interview that he's taken all of his money out of the market now rather than waiting for September. If only he followed OIN so that we could show him how to make some money in a down market. ;-)

As more and more talk turns to the possibility of a double-dip recession (which will soon change to talk about one large and longer-lasting recession, otherwise known as a depression) it's worthwhile reviewing previous bear markets to see what happens to stock market values during these times. The stock market is of course only one asset class but it's easily measured and therefore a good one to compare one period of time to another, especially during bull and bear market cycles.

As a side note, whenever anyone talks about a depression, a word the Fed refuses to even acknowledge, you would think we're talking about the end of the world. In fact, prior to the Great Depression of the 1930s, a depression in the economy was simply a description of the economy dipping below the average, which typically follows a period that was above the average. One could say we had humps and depressions.

So a depression in the economy was really not much different than thinking of a dip in the road--it was something to be expected as a normal correction to excess and something from which the economy would grow again in a healthier manor. The Great Depression was a depression that lasted longer than a "normal" one and following this one the word recession was used so as not to scare anyone with the "depression" word again.

Because the Great Depression was marked by more pain than usual (unemployment, failed banks, lost savings, etc.) it has been the Fed's mission to make sure we never suffer a depression again. In the last 20-30 years it's actually been the Fed's mission, certainly under Greenspan and continued by Bernanke, to fight any kind of recession. Be it arrogance in the power they thought they had or truly not understanding the healthy benefits of a recession/depression (it cleans out the excesses including debt, bad companies, bad management, overexuberance, etc.), the Fed has allowed excesses to build for a longer than normal time. They've pushed out the correction but they will not be able to prevent the eventual correction and in fact have made the coming correction worse.

At any rate, back to the comparison of the stock market's values during previous bull and bear market cycles, the chart below shows how the DOW has moved since the 1920s, with the top chart in nominal prices and the bottom chart is priced in gold.

DOW, 1920-2010, chart courtesy elliotwave.com

The interesting message out of this chart is that even in a sideways bear market you lose. We've been in a sideways market since 1999 but you can see the real value of the DOW has dropped significantly already. Look at the drop in the real value back during the late 1960s and 1970s. High inflation killed real values (even while making people think things are improving) while the market itself ran sideways. During the depression in the 1930's, once the low in 1932 was made, nominal and real values were more closely aligned during the deflationary period.

It took until the early 1960s for values to recover back to the 1929 high (over 30 years). This of course elicits the question "how's that buy and hold working for you?" From the high in the mid 1960s it took about the same 30 years, until about 1999, to get back to the real value in 1966. The high in 1999/2000 will probably take much longer than 30 years for the real value to return there (we're in a larger-degree correction, correcting the rally from 1032). You can see by the peaks in the real value during the 20th century how little progress was actually made (the same can be said for housing). Investment values are made in relatively short periods of time and then must be protected by getting them out of the investments.

During a bull market it's been beneficial to stock prices (and other investments such as homes) to have inflation. It's just the opposite during a bear market where it's been a killer of investment values. And yet the Fed wants inflation all the time. It's of course very helpful to them, and other debtors, because loan values decrease over time in an inflationary period. During deflationary times the loan values actually increase in value and therefore become more expensive to pay off. It's not good for governments (and certainly the U.S.) that typically run with deficits and now we've got governments massively increasing their debt loads during a deflationary period of time. It's not going to end well for any of them (us).

Interestingly, for all the fun I poke at the Fed for using the term "disinflationary", that's actually something we've been experiencing for quite some time. If you look at the yield on the 10-year Note, it has been steadily dropping in a nice parallel down-channel since it peaked at 15.84% (can you imagine?!) in 1982. This chart is updated through June, when it was still above 3%, and the yield has since dropped and is hovering around 2.6%. As "disinflation" continues there's a good chance we'll see the 10-year yield below 2% before the end of the year.

10-year Treasury Yield, 1960-2010, chart courtesy elliottwave.com

The true measure of inflation/deflation is the money supply (price changes are merely a "symptom") and as hard as the Fed fights to increase the money supply, it's just not working. Money needs to be leveraged by the banks so that the Fed can achieve the multiplying effect (velocity) through lending. The trouble is that lending is way down. The following chart shows the slowdown in the multiplier ratio since the peak in the late 1980s. The sharp drop since 2007 is unprecedented. The more money the Fed prints and the more debt the government takes on, the less effect it has been having since 1987.

M1 Money Multiplier Ratio

I'll start with NDX this evening and its weekly chart shows how the bounce off the July low walked up underneath the broken uptrend line from March 2009 through the May 25th low. The big red candle for the 2nd week of August left a bearish kiss goodbye. Currently NDX is trying to find support around the 50-week moving average near 1833. You can see how the 200-week MA was used as support at the end of June.

Nasdaq-100, NDX, Weekly chart

The bounce into last week's high was either the entire correction to the decline from August 9th or it still has another leg up for a larger a-b-c bounce. I will say the chances for a higher bounce looked better this morning than it does this afternoon. The dashed line on the daily chart below shows another leg up this week to complete a larger bounce correction, with the possibility for a rally up to the 1872 area (two equal legs up from the August 16th low and the 38% retracement of the April-May decline). A break below 1800 would be a more immediately bearish sell signal and would negate the idea for a higher bounce (not that it couldn't happen but the probability would drop significantly).

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish to 1880
- bearish below 1801

Last week's weekly candle for SPX finished with a doji and that left an inconclusive finish for the week. It's basically an indecision candle and can be interpreted as either a bearish consolidation candle or a bullish reversal candle. But bullish is relative; I expect any bounce this week, regardless of how small or large, will be followed by stronger selling into next month. A downside projection to the 950 area, if not 870, should happen over the next few weeks (possibly much faster).

This week's bounce, which could already be finished, will tell us a lot about what to expect into the end of the month. We should get a good sense for the potential for a higher bounce vs. just a correction of last week's decline before heading lower again. Like on the NDX chart, on the daily SPX chart I'm showing the possibility for a stronger rally into Wednesday/Thursday (dashed line) that could take SPX as high as 1113 before heading back down. This projection is based on what's called an expanded flat a-b-c correction where last week's decline was the b-wave pullback. A rally back up for a c-wave that equals 162% of the a-wave is where the 1113 projection comes from. But the risk for the bulls is a smaller bounce followed by a break below Friday's low--that would be immediately bearish and indicate the next leg down, which will be very strong, is underway. Today's drop into the close increases the chances for the bears to take over and Tuesday should confirm it if that's the case.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- cautiously bullish to 1117
- bearish below 1064

Some other levels of interest, just above 1113, are 1114-1116. A 138% extension of last week's decline is near 1114 (a common resistance level if a bounce makes it above a previous high). The 100 and 200-dma's are collocated near 1116 (and the 100 is about to cross down through the 200, after the 50 did so back in early July). And then there's the downtrend line from April through last week's high (therefore an untested trend line) which will be in the 1113-1115 area on Wednesday/Thursday.

On the 60-min chart below I'm showing some Fib levels of interest. First, the failure of this morning's rally within a point of the 50% retracement of last week's decline, at 1082.03, is bearish since a 50% retracement is a typical correction. Any continuation of the decline below Friday's low would leave a potentially completed correction to last week's decline.

S&P 500, SPX, 60-min chart

The reason I say a drop below Friday's low (1063.91) would be a potential sell signal and not confirmed is because of one more possible bounce pattern that we might get tomorrow. As shown on the 30-min chart below, it's possible a slight break of Friday's low could lead to a snapback rally up to SPX 1092 as part of an expanded flat a-b-c correction to last week's decline. As mentioned this afternoon on the Market Monitor, the break of this morning's low was a sell signal and my recommendation was to be short against this afternoon's high. Any rally back above 1076 could result in a short-covering rally up to 1092 before collapsing back down. In other words, beware of a possible whipsaw over the next day or two.

S&P 500, SPX, 30-min chart

The DOW's potential is the same as the others--while it's possible we'll get a bigger bounce up to the 10570 area (dashed line on the daily chart below), the chances of that happening were reduced dramatically with this afternoon's selloff into the close. But the possibility for a higher bounce on Tuesday, as shown on the SPX 30-min chart above, remains. It takes a break below 10147 to be bearish and below 10140 (two equal legs down from this afternoon's high) to confirm we're probably heading directly lower from here.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish to 10570
- bearish below 10147

Nothing new to add for the RUT--it's the same setup. Two equal legs down from this afternoon's high is at 598.74 and therefore a break below 598 will likely lead to very strong selling over the next few weeks. Otherwise there is the possibility for a higher bounce tomorrow to at least 625ish (with higher potential above that if we get an immediate rally tomorrow).

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 648
- bearish below 600

The banks were once again a leading indicator for the bearishness we saw this afternoon. The bounce in the banks was less than the broader market and even less than the semiconductors which were also weak. The BIX was the weaker of the different banking indexes and closed below the July 1st low, which would mean SPX below 1010 if it were to do the same thing. So the daily chart clearly looks bearish. As with the other indexes though, the bullish divergences at the new lows over the past few days may be an indication that we're forming at least a short term bottom. There is the possibility that the BIX formed a 5-wave decline from the August 2nd high and that calls for a bounce to correct the decline (dashed line). Clearly the broader market would be helped by a bigger bounce in the banks. It would also be a way for the month of August to be saved from the bears and possibly close in positive territory.

Banking index, BIX, Daily chart

I haven't shown the home builders index in a while and it's worth watching here to see if today's small break below its shelf of support over the past two months near 222 will get reversed or not. Watch for it to be resistance if broken and then retested. With the housing market entering a confirmed slowdown (again), and with builders' sentiment hitting lows not seen for a year, investors should abandon these stocks in droves (for a 3rd wave down) as they realize all the hopes and dreams for a rebound in housing are recognized for what they are--hopes and dreams. Reality bites.

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

Bullishly the transportation index continues to hold above its broken downtrend line from April through the June high, which has held each low since August 12th (with only intraday breaks). A close below 4130 in the next day or two would confirm support is breaking.

Transportation Index, TRAN, Daily chart

The U.S. dollar looks ready to continue upwards to at least the 86-87 area before consolidating and heading higher again. It's possible we'll get a little larger correction pattern (dashed line), which would likely happen if the stock market manages to get another rally leg going. Otherwise look for the current trends in both to continue.

U.S. Dollar contract, DX, Daily chart

Gold is once again testing its uptrend line from the end of July. Assuming it holds for at least one more time we could see a push up to the 1250 area. But the bounce pattern off the late-July low can now be considered complete and therefore the next leg down could begin at any time. Taking out the series of higher lows would confirm the top of its bounce is in place.

Gold continuous contract, GC, Daily chart

Oil's pattern continues to support the idea that it's ready for a bounce to correct the decline from late July. However, I would not go bottom fishing here since it's equally possible it will simply accelerate lower from here.

Oil continuous contract, CL, Daily chart

The only major economic report tomorrow is the existing home sales. If the number comes in worse than expected watch the home builders index for a confirmed breakdown.

Economic reports, summary and Key Trading Levels

Summarizing today's charts, the selloff into the close today gave the short-term charts a bearish tone. A small break of last Friday's lows could be followed by a snapback rally that exceeds this morning's highs so be quick to cover if you shorted against today's or this afternoon's highs. A move back above this afternoon's highs would be confirmation we'll probably see a move above this morning's high. But don't trust a higher bounce as it should get reversed quickly (by Wednesday) for a hard decline.

The more immediately bearish pattern calls for hard selling to kick in right away on Tuesday. If we get more than a minor break of Friday's lows and the decline keeps going then it will be one of the few times I'd recommend shorting in the hole, something I hate doing (for fear I'll catch the bottom and it'll come whipping back up in my face).

Good luck and I'll be back with you a week from Thursday. By then we'll see how the month of August closes.

Key Levels for SPX:
- cautiously bullish to 1117
- bearish below 1064

Key Levels for DOW:
- cautiously bullish to 10570
- bearish below 10147

Key Levels for NDX:
- cautiously bullish to 1880
- bearish below 1801

Key Levels for RUT:
- cautiously bullish above 648
- bearish below 600

Keene H. Little, CMT

New Plays

Waiting on Triggers

by Scott Hawes

Click here to email Scott Hawes
Editor's Note:
Good evening. We do not have new plays to release tonight but we are waiting to be triggered in 3 short positions and one long position in SSG (which is an inverse ETF and a bearish trade). If the market weakness continues tomorrow we should get triggered in ADP (short), SBUX (short), and possibly SSG. Please refer to the weekend newsletter for comments/details on these new plays with trigger levels and email me with any questions. They are also listed in the portfolio snapshot below.

In Play Updates and Reviews

Positions Nearly Unchanged

by Scott Hawes

Click here to email Scott Hawes

Editor's Note:
The market traded in a fairly tight range today and most of our positions closed near, or slightly below, their Friday closing prices. The exception was ATHN (long) which sold off -2.71%. ATHN has retraced some of its recent gains and closed at a key support level of $28.50, its upward trend lines, and the 20-day and 100-day SMA's. I'm looking for ATHN to bounce from here back up towards our targets. If it fails readers may want to consider exiting positions.

All of our targets and stops remain the same for now. Please refer to the weekend newsletter for updates as the comments remain the same. Below is an updated snapshot of our current model portfolio. Current Portfolio: