Market Wrap, Thursday, 04/02/2009 The Land of Make Believe by Keene H. Little Click here to email Keene

HAVING TROUBLE PRINTING?

The FASB (Financial Accounting Standards Board) was strong-armed into changing the rule for the banks so that they could change the value of the toxic assets on their books from mark-to-market to mark-to-make-believe and the broader market reacted as if this is a good thing. There is plenty of debate about this issue so I won't get into a lot of it but the bottom line for those who believe it's a good thing is that it will help banks write up the value of the asset-backed securities, such as mortgage-backed securities, thus allowing them to free up money in their reserve accounts (reserved for losses on these assets) thus giving them the ability to loan more money.

This of course sounds good in theory and the broader market certainly thinks so. As Scott wrote to me, as George Costanza says to Jerry Seinfeld before his polygraph, "it's not a lie if you believe it." As we know, the economy has been hamstrung by tight credit so if the banks can free up money to offer as credit it will grease the skids of the economy and get it moving again. There's one small problem with this scenario and it's similar to the Fed creating massive amounts of money and giving it to the banks with instructions to send it out to be fruitful and multiply (their effort to re-inflate the economy and stop deflation).

I've said many times that the Fed is pushing on a string here and that it doesn't matter how much money they create and give to the banks it's not enough to overcome the destruction of money through the collapse of debt (which removes money from the monetary system) and it still doesn't help the banker overcome fear that they won't get the money back. And we've got people who are now afraid and making a stronger effort to pay down debt and not take on more. Businesses are slowing down and pulling in their capital construction budgets. Creating more money or making more money available through make-believe rule changes does not change the mindset of the people the Fed needs to start binging again on debt.

We should know shortly if the rule helps the credit situation by watching the spreads between the asset-backed securities and Treasuries. As of today's numbers the spreads using A-rated commercial asset-back securities as an example, are not improving yet--the spread remains near its historical high.

Markit CMBX Spread

The latest price is today's and you can see that the spread has actually ticked higher this week, this after knowing FASB was going to change the ruling allowing greater flexibility for the banks to mark up the value at will. The market for these assets is so far not agreeing.

And this is where those who argue against the mark-to-market rule change come in. The market is the final arbiter of what the price should be, not some computer model or hoped-for value by a bank who can now cook the books at will by simply changing the value of the assets on their books. We have companies managing earnings to the penny through various methods, such as stock buy-backs, moving funds in and out of reserve accounts, one-time charges, etc., and now the banks will be able to take this game to a whole new level. Transparency just got thrown out the window since investors will have even less of an idea what the bank is really holding and therefore what the stock is really worth. The larger question of course is whether or not the rally off the March low is based more on hope (and therefore just another bear market rally) or substance.

Morgan Stanley strategist, Jason Todd, lists reasons why the latest run-up is a bear market rally:
1. The size and speed of the rally
2. Lack of credit market participation
3. Strongest performance from largest short interest stocks/sectors
4. Limited improvement in volatility (VIX)
5. Baltic Dry Index has fallen consistently throughout the rally

I already mentioned the signs from the credit market, with the Markit index, which is not supportive and the performance of the banks themselves leaves open the question how good this will be for them. If we follow the money then this afternoon's underperformance by the banks is a warning shot across the bow. The banks got a pop up this morning with the rest of the market but then sold off and never even came close to hitting this morning's high. This happened while the major indexes continued to chug higher most of the day. If this ruling is such a good thing why didn't the banks follow suit? And if the banks aren't rallying stronger on the news then what is the rest of the market so excited about this? These are all legitimate questions one must ask when looking at today's rally. It's just possible we will have been set up for a sell-the-news event if the market starts to sell off tomorrow. We'll see if the charts agree with that possibility or not.

As for the strength of the rally, and thinking it must be the start of something bigger to the upside, I've got a couple of observations to think about. One analyst, Walter Deemer, made the comment, "The market has never staged a correction as severe as this one during the early stage of a breakaway momentum rally that signaled a new bull market." Very strong rallies tend to be more short covering than anything, which goes back to point #3 by Jason Todd above, and then the buying suddenly dries up.

I had mentioned the some stats earlier in the week on the Market Monitor that are worth repeating. SPX rallied +26.8% from the March low to today's high (+23.8% from closing low to closing high) and that's bigger than most. But looking at other bear market rallies will show some previous strong rallies that did not hold:
March-May 2008 -- +14.6%
October 10-14, 2008 -- +24.3%
October 28-November 4, 2008 -- +19.2%
November 21, 2008-January 6, 2009 -- +25.1%
Jim showed some similar bear market rallies during the 2000-2002 decline in Tuesday's Wrap.

In the 1929-1932 bear market there were five bounces between +20% and +23% and all five were followed by a new low. So the recent rally fits right in there with the other rallies. I have no idea whether the March rally will be followed by a new low but it sure wouldn't be unprecedented. In fact a new low from here would be typical. None of the economic and financial problems are predicted to get better this year (regardless of the FASB rule change) so this could be just another one of several bear market rallies as part of the slope-of-hope slide lower. Don't get caught up in all the hype and end up disregarding proper risk management with your positions (that goes for shorts too).

And here's a contrarian sign for you--the Rydex Internet Fund now has about $70MM in assets, near its all-time high peaks in August-September 2000 and October 2007. It wasn't smart to follow those people then and it might not be smart to follow them now. It's certainly possible that the buying momentum will build on itself and continue to break resistance levels. We've seen this happen time and again, especially back in the bull market phase of the larger bear market. We could even be starting the next bull market phase. But at this point we've got a situation again where it's been too much too fast and that says we need to be cautious about at least a larger pullback correction before heading higher again.

On the SPX weekly chart I'm showing, in dark red, the bearish scenario calling for a new low inside what is essentially a large descending wedge pattern, which is a bullish ending pattern. Today's rally has now brought SPX very close to the top of the wedge which is the downtrend line from January-February. At the same location, near 850, is a parallel downtrend line from the August-September 2008 highs. It's entirely possible the rally will just bust through this resistance level near 850 and not look back but that's not how I'd want to bet my money right here.

S&P 500, SPX, Weekly chart

The daily chart zooms in on this potential descending wedge pattern and shows another trend line of interest--the broken uptrend line from the March low, which SPX came up and gave a kiss at today's high. Again, it can continue to rally through resistance and not look back but this is a game of odds and I believe the odds are greater for at least a pullback than a continuation of the rally (other than the possibility for a brief pop higher tomorrow morning).

S&P 500, SPX, Daily chart

If SPX pulls back over the next week and drops down to the broken downtrend line from January-February we could see a retracement down to about 750-760 (which would also meet some Fib projections and retracements as well). More bearishly, shown in dark red, is the possibility we'll see a choppy decline into May for the new low (which should be the final low for the year if it happens). As shown on the chart, a drop below 750 would increase the probability for the more bearish price pattern.

Key Levels for SPX:
- cautiously bullish above 850
- cautiously bearish below 750

Zooming in even closer to the rally itself, I see the possibility for a little bit of consolidation and then one more new high, shown in pink on the 60-min chart below, before at least a little larger pullback (not shown but this pullback could be much deeper, like that shown in dark red). The dark red price pattern shows the deeper pullback to the 750-760 area, which should be a relatively sharp decline (enough to cause the bulls to doubt the rally and shake out weak long holders). From there I would be suggesting testing the long side since it would be quite possible, if the low is in for now, that we'll get a strong rally leg to new highs above the current rally's high. Think of it as one big whipsaw--shake out the longs on a pullback and then spike out the shorts on the subsequent rally.

S&P 500, SPX, 60-min chart

But if we were to get the bigger pullback (dark red), a bounce and then a continuation lower, the probability for a new low into May would significantly increase. This can only be conjecture at this point and we'll have to evaluate each leg of the move to see what sets up and test both the long and short sides of the market to see which sticks. It's a time to be very careful in your trades and make base hits. Hit it, take profits (or small losses), get out, rinse and repeat. This is not a buy-and-hold market and it will even be difficult to make reliable swing trades (trades lasting more than a few days). The overnight futures action this week is testimony to the riskiness of holding trades overnight. We're into a corrective price pattern and they're known for choppy price action and plenty of whipsaws. The strong rally off the March low might not be repeated in a while.

The DOW found support at the March low at the bottom of a parallel down-channel (parallel to the downtrend line from November-January). It's not unreasonable to think it will find resistance at the top of the channel, currently near 8250. But notice that it too ran into its broken uptrend line from the March low. It's set up for a bearish kiss goodbye right here. I'm showing RSI broke its uptrend line (similar to what I showed on SPX) and have often mentioned that that gives you a heads up that price will do the same. But I often see price then press back up to a new high, often testing its broken uptrend line while RSI leaves a bearish divergence (and just the opposite in a decline). So far RSI is leaving a bearish divergence against today's new price high.

Dow Industrials, INDU, Daily chart

Whether the DOW makes a run for it up to its downtrend line from November, either directly or over the next few days as it "walks" its way up underneath the broken uptrend line (I've seen that happens a lot), we can't know. But considering the picture I'm seeing on the daily charts and the short-term overbought picture on the 30 and 60-min charts, I would be very reluctant to chase this market higher and would have my stops tucked up underneath to protect profits.

Key Levels for DOW:
- cautiously bullish above 8300
- cautiously bearish below 7250

I mentioned last week that NDX's pattern is potentially more bearish than the others, as far as pointing to a new low coming, because of the possible bear flag pattern since the November low. I thought last week that NDX would find resistance in the 1302-1308 area for a possible high for the rally off the March low. Two equal legs up from November is near 1308, which is now at the top of the parallel channel (bear flag) and the 2004 low at 1302 has been a support/resistance line since then. Today's high was 1311.67 and it closed at 1294.30. Whether that was it or not we'll only know in hindsight but this is one of the best short play setups you'll see--stops can be kept tight for now.

Nasdaq-100, NDX, Daily chart

As I had shown on the SPX 60-min chart I can see the possibility for a quick stab higher to finish a short-term wave count to the upside. So that would make it tough to use today's high for a stop only to find out you got stopped out and then it dropped without you. I see the possibility for NDX to push as high as 1340 if it rallies back up tomorrow so if you're interested in trying the short side you need to know what your risk level is and manage your trade accordingly.

Key Levels for NDX:
- cautiously bullish above 1308
- cautiously bearish below 1180

The weekly chart shows the bigger picture and how the bear flag pattern from November fits the larger wave count. It fits well as the 4th wave correction with the need for a 5th wave down. I've been pointing to the Fib time relationships between the turns and thought we might see a final low during the week of April 12th. If the rally continues we could instead see a high during that week instead. As shown on the daily chart, upside potential is to a Fib projection near 1473 where the 2nd leg up in a A-B-C bounce off the November low would achieve 162% of the 1st leg up (the next common relationship after equality). On the weekly chart I'm showing that as the possible top of the 4th wave correction (pink).

Nasdaq-100, NDX, Weekly chart

In either case, whether from here or from a high around 1473, I'm showing the larger price pattern needs a 5th wave down. The bears are standing there saying "you can pay me now or you can pay me later, with interest". Assuming this is correct and that we do get another leg down, there are a few downside projections--about 940 (previous low in 1998 and 2003 and a 62% price projection for the 5th wave in relation to the 1st wave), 795 (previous price low in 2002) and 727 (where the 5th wave down would equal the 1st wave down). That lower price projection would surely have the VIX spiking to new all-time highs. The complacency in the VIX has been bothersome (and interestingly it did not drop much during the March rally and has gone essentially sideways since mid March).

I showed the SOX chart last week and so will follow it for a little bit to see if we get any kind of diverging or supportive signals. So far its pattern is very similar to NDX but with a slightly more up-sloping bear flag pattern. The top of the pattern, the top of its larger parallel down-channel and the price projection for two equal legs up from November all coincide near 257 in the next day or so. Whether it will reach that level, or stop there, can't be known but it's a very good setup for a short play. Its larger pattern shows the same thing as NDX--it needs a 5th wave down to a new low.

Semiconductor sector, SOX, Daily chart

The RUT continues to look very similar to the other charts so we've got more agreement than disagreement between the major indices. Like the others it came back up for a kiss of its broken uptrend line from the March low and at the same time reached its 62% retracement of the January-March decline. It doesn't have to but it too is at a good place to start at least a larger pullback.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- cautiously bullish above 481
- cautiously bearish below 400

The bank index is in potentially a bullish continuation pattern shown on the daily chart with a small pennant forming since the March high. Forgetting about why the banks are showing relative weakness lately, if that pennant resolves to the upside with a break above the March high near 88 it would be bullish. In that case follow the money to the upside and forget about trying to figure out why the market shouldn't be rallying. It would be a time to listen to the market (price). But for the moment the BIX is also struggling with its downtrend line from November and a turn back down would be a bearish failure of the potentially bullish pennant pattern (and failed bullish patterns tend to be sharp failures).

Banking index, BIX, Daily chart

If the banks have put in a bottom for the year we should only get a pullback and then a continuation higher, shown with the dashed green line. Otherwise we could see banks head lower with, or leading, the broader market. Disappointment that the latest FASB ruling not helping could set up that kind or sharp decline. Citigroup has already come out and said the new ruling will not change much for them. If that ruling and all the money creation so far does nothing to improve the credit market the hope-filled rally could pop rather suddenly.

What if the Fed holds a Treasury auction and no one came? This is not that farfetched an idea considering it's already happened in the U.K. Last week they had an auction for their newly created money and it was under-subscribed (less demand than supply). This was the first "failed" auction since 1995. Gilt (U.K. bond) prices plunged and interest rates spiked higher. If that starts happening on a world-wide basis (since every country will be forced to resort to Zimbabwean tactics) we could easily see supply completely overwhelm demand.

Since the U.S. dollar is the world's reserve currency we still have a better chance than most to get our Treasuries bought up. But it should be of some concern that the Fed and Treasury are creating entirely too much debt to be able to find enough buyers. China is already rattling their saber. And without enough buyers it would drive prices lower and yields higher. Washington and Wall Street keep whistling past the graveyard, consoling themselves with statements like "no auctions have failed yet so therefore we have no problem--keep spending!" Consider the possibility of a spike lower in bonds if you're heavily invested in longer-term Treasuries. The charts are agreeing with this scenario so far:

30-year Treasury, TYX, Daily chart

After the strong run up in yields off the December low they've been running sideways for two months now. Spike up, run sideways--guess what usually comes next? I show two equal legs up at 4.6%, a full percentage point above today's rate. That would crush the spirits of those who are hopeful the Fed will be able to monetize the U.S. debt at low rates. But if the 30-year rate drops below the recent spike low near 3.4% (the post-FOMC move) then the failed bullish pattern could see a quick drop in rates.

The drop in rates would be just a guess at this point. I think the more probable result here will be another leg up within the parallel up-channel drawn on the chart. And if yields are going up then bond prices would be going down (likely as a result of a failed auction as discussed above). A slightly wider view is shown with the TLT chart for a broader perspective of where bonds were and where they could be going.

20+ Year Treasury ETF, TLT, Daily chart

Again, after the sharp drop from the December high bonds have been trading sideways for two months. Yesterday's rally in bonds took TLT back up to the top of its trading range and sold off today. The consolidation pattern may be complete at this point and if so then the next big move will be down. The price projection is below the June 2008 low at 88.59.

Gold has been struggling to hold its gains and is starting to show some bearish signs. It broke its uptrend line briefly and for only one day on March 18th (making the March low of 882.70 in the process) but recently has convincingly broken its uptrend line. Not only did it break it but it has been retesting it for the past 3 days and has been unable to get back up inside. If it does bounce back up it will then be doing battle with its new downtrend line from the February high, which intersects the uptrend line near 941.

Gold contract, GC, Daily chart

I've been bearish gold for some time now and I will admit it still makes me nervous. There are so many valid reasons to be buying gold now as a hedge against the inflation that's coming. But I think we still have a serious deflation problem to get through and that will deflate the prices of all assets (but not cash). If I'm correct, we'll have a "golden" opportunity to buy gold at a much lower price later this year.

Watching the price pattern for oil has been a bit frustrating. It looked like it was going to break out and then break down. Now it looks like it's getting ready to break out again. But keeping it simple--look for a break of it March high now, at 32.16, for a bullish signal. Until that happens there is still a very good chance we'll see oil give up its gains from February and head back down as people start to fear again that the global economy may not be ready to improve anytime soon.

Oil Fund, USO, Daily chart

I also show the possibility for another leg down for a larger pullback correction of the February-March rally. That could then be followed by a stronger rally leg up (dashed line). This is actually the same scenario for the stock market and I suspect oil and the stock market will be very similar.

Today's economic reports were no real surprise and continue to look dismal. A chart of the unemployment count shows a parabolic rise in the number of unemployed. It's scary how many people are losing their jobs and even scarier how many are saying how difficult it is to find one. If you have the ability and time, get involved with support groups and help however you can. Think of it as networking.

Economic reports, summary and Key Trading Levels

The factory orders ticked up from last month but it's all in the noise category. The number is still ugly. In fact a chart of factory orders visually shows how quickly the economy dove off the cliff:

Factory Orders, 1994-2009, chart courtesy briefing.com

That sharp decline is not likely to see a sharp reversal. At best we can probably expect it to run along in the mud for a while before starting to climb back up. And of course dropping further is not out of the question.

Summarizing where we are this week and what can be expected heading into next week, I think we're now very near some tough resistance levels at a time when the market needs a rest. Whether it is price projections, trend lines, bearish divergences or wave counts, we look to be close to finishing the rally leg from March. Whether we get a small pullback, large pullback or the resumption of the bear market decline, we'll only know that in hindsight. But at a minimum I would haul your stops up tighter now to protect profits in long positions.

And when I say protect profits in long positions I also mean protect your positions if you did not get out at any time during the bear market decline. This rally could be a very good time to exit some of your positions and go to cash. If we get a pullback, let's say to SPX 750-760 and then the market proceeds to run higher, you can put your money back to work. But if we've got new lows ahead of us, why ride it back down to an even lower low?

If you exit some of your long positions and hedge the rest you could make a little money on the downside or at least be in a position to get back in at a lower price. Just some things to think about.

If you're flat and wanting to get long the market I think you'll have a better entry soon. As I had mentioned with the charts, a pullback over the next week or so could set up a buying opportunity in case the pullback leads to a stronger rally out of here that breaks all the resistance levels just above the market. If the setup looks good I'll try a long and if stopped out I'll reverse short (especially if SPX breaks below 750 in the process).

The bottom line here is that this is a very tricky spot to trade. We don't know if a final low is in or not and we don't know how big (if any) a pullback will get. As I've been recommending, trades need to be base hits right now. No homerun attempts. In a corrective price environment, which we're in and likely will be in for most of the year (with some brief strong trending moves) it's far better to get in and out quickly and don't get seller's remorse because the move continues without you. Get over it and look for the next bus to take a ride on. Busses come along every day and usually a few times a day. Flat is a position in the meantime. Don't force trades and instead let the market come to you in a setup you've identified. If it doesn't come to you and then runs off without you don't chase it--you'll usually get slapped silly for the effort.

For now keep an eye on the key levels on the charts and trade accordingly. Good luck and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 850
- cautiously bearish below 750

Key Levels for DOW:
- cautiously bullish above 8300
- cautiously bearish below 7250

Key Levels for NDX:
- cautiously bullish above 1308
- cautiously bearish below 1180

Key Levels for RUT:
- cautiously bullish above 481
- cautiously bearish below 400

Keene H. Little, CMT
Chartered Market Technician