Market Wrap, Thursday, 04/23/2009 Topping Process by Keene H. Little Click here to email Keene

HAVING TROUBLE PRINTING?

The March bottom, and the November bottom before it and the two October bottoms before it, were very good examples of the typical v-bottoms seen in the stock market. These are emotionally charged events where fear and panic set in which causes the selling to intensify until most who want out are now out (they all reached their "puke point"). The shorts pile in on top of the sellers of long positions and it becomes a selling frenzy. And then the selling stops and the shorts get nervous and start covering to protect their profits. Short players are typically a very nervous bunch and they're constantly watching for where to exit their plays, as opposed to long players who tend to hold their positions too long in the face of a reversal.

These selling climaxes are typically then followed by an acceleration of the buying as more short players get stopped out of their positions. Brave long players start to climb on board fearful that they're going to miss the next big rally (they hope it will be a big rally). And so begins the v-bottom reversal followed by a strong rally. These strong rallies are then followed by proclamations THE bottom has been found and following that are "good-news" reports justifying why the rally is real this time and how smart the market is to be able to forecast a coming improvement in the economy/earnings. News follows price, not the other way around.

Tops, in the stock market, tend to be just the opposite. The buying starts to dry up and most of the shorts are already out of the picture (the longer-term short players will still be in but not a factor here). Those who were scrambling to get long are now in and following a big rally many become fearful of the next pullback. Some profit taking starts but bullish enthusiasm keeps players coming back and buying the dips. Bears try to short the rallies but keep getting pushed back out. This tug of war can continue for weeks and months and the net result is the market typically works its way a little higher but starts to form a rounding top. Bearish divergences appear (waning buying momentum) and uptrend lines start to break.

But the bulls don't give up easily and they can keep the market held up for long periods of times (to the constant frustration of the bears). I think this is the point where we are currently in the market. We're at the left side of a rounding topping pattern. Interestingly, commodities tend to trade just the opposite. Oftentimes tops in commodities are fear driven. Panic about inflation or shortages will drive prices skyward in a parabolic rise until it flames out. The subsequent decline is usually swift and back to where the rapid rise started. The tops tend to be v-tops and the bottoms tend to be battles between the bulls and the bears and form rounding patterns (cup and saucer).

I could certainly be wrong about my assessment of the pattern today but until proven otherwise, with a rally above last week's highs, I think we're about to start back down. Whether it drops quickly or continues the choppy up and down price action we've seen over the past month is the big question at the moment. I think it will drop more quickly than it rose over the past month but the bears could find the environment very frustrating (right John?). Bulls could be lulled into believing it's just a minor pullback and nothing to worry about. They could be right but usually when they recognize they're wrong is when the strong selling starts again, in which case look for that v-bottom (wink).

As for today's price action, have you noticed how often we're getting a very big move in the final 30 minutes of the trading day? There has been a lot of recent discussion about the effect that leveraged ETFs are having on the market. It used to be dangerous to hold a position overnight. Now it's become dangerous to hold a position over the final hour of trading. These ETFs are forced to buy or sell huge quantities of stocks to rebalance their holdings vs. their margin and position requirements with the big broker/banks. This creates a huge imbalance in market-on-close (MOC) orders that has less to do with a desire to buy or sell particular securities and more to do with balancing their books. It's also why big moves into the close (which I've been calling mini-capitulation moves) tend to see an immediate reversal the following day--there's typically no follow through to the end-of-day move.

Today's jam into the close in the final 30 minutes was just another example of that. Tuesday's large selloff was an example. Look at the last 30 and 60-minute candles each day and check the volume in the final hour and you'll often see a big move. It's making our job as traders that much more difficult. I strongly believe most of what you need to know about the market, and how to trade it, is right in the charts. The charts reflect human emotion (crowd behavior) and that's the real driver behind the buying and selling. News is for nannies. It makes for good sound bites but we all know the same bit of information is used one day to explain why the market sold off and the next day why it rallied. I stopped listening to the CNBC bobbing heads years ago and I strongly recommend not listening to market news during the day or reading chat rooms. It's pure distraction. Trust what your charts are telling you since that's hard enough. So onto the charts we go.

The past two weeks left hanging man dojis and this week's candle is going to potentially be another hanging man doji. These are of course bearish candlesticks but need a red candle to confirm. If this week ends up being down for the week we could have confirmation of the reversal pattern. Bullishly price remains above the broken downtrend line from November and used it this week (Monday's and Tuesday's lows) for support to launch the bounce. A break back below it (near 825 which is where it would also close the April 9th gap) would be bearish confirmation of a top.

S&P 500, SPX, Weekly chart

While SPX broke above its downtrend line from November it stalled at the top of a parallel down-channel from the November low and January high (the top line is parallel to the line along the November and March lows). A break back above 875 would be more immediately bullish but in the meantime I'm expecting at least a pullback to the 780 area. As you can see on RSI the bounce since Tuesday morning's low has barely registered a bounce, meaning the bounce has had relatively little strength.

S&P 500, SPX, Daily chart

The broken downtrend line from November and gap close from April 9th, both near 825 would be logical support if it drops back down there on Friday/Monday. Assuming that doesn't hold then the next support level will be its 50-dma near 790. The low on March 30th, which is the starting point for the rising wedge pattern, a typical retracement point out of these wedges, is near 780. As shown on the 60-min chart below, there are a couple of other reasons to look to that level as a downside target for now.

Key Levels for SPX:
- cautiously bullish above 876
- cautiously bearish below 875 and more bearish below 780

I've seen a few people report today the potential H&S pattern on SPX so it's obviously a pattern that has jumped out of the chart for a lot of people. One thing about obvious patterns is that when they're too obvious they obviously fail. But there are a few reasons why I think it's a valid pattern at this point with a downside projection at 774. The Fib projection for the 2nd leg down, where it will achieve 162% of the 1st leg down, is just under 783. As mentioned above, the beginning of the rising wedge pattern is near 780. This confluence of targets near 780 makes for a more likely possibility that it will happen. But as shown on the chart, two equal legs down is near 813 so watch for potential support and reversal from that level if tagged, which could be near the neckline of the H&S top if it takes a few days to get down there (assuming of course it will).

S&P 500, SPX, 60-min chart

The bigger question will be what the decline from the April 17th high will be. Assuming it gets down to the 780 area and finds support it could be the conclusion of a 3-wave pullback correction to the March-April rally and it will be off to the races to the upside (as part of a large A-B-C bounce pattern off the March low). Or we could see just a choppy sideways/up bounce as part of a larger 5-wave decline. Therefore until we know which it could be I think it will be worth testing the long side around 780 and we'll see what kind of bounce develops which should provide some clues as to what will follow. I'll be watching this very closely on the Market Monitor and hopefully help identify how to trade it.

The DOW's daily chart is very similar to SPX and appears to be rolling over after tagging the top of its parallel down-channel. Note that the top of its channel happens to be the downtrend line from November as well. That makes this line doubly important for the bulls to conquer. Until last Friday's high is taken out I think we'll get a deeper pullback at a minimum first.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- cautiously bullish above 8300
- cautiously bearish below 7400

The techs remain the stronger index and NDX has yet to break its uptrend line from March. But the fact that RSI has already broken its uptrend line I believe price will soon follow. A break below Monday's low near 1295 would be immediately bearish whereas a minor new high would not necessarily be bullish (although I wouldn't want to be short if it rallies above yesterday's high near 1363). The next sell signal from RSI would be a break of its "shelf" of support at recent lows during the rally.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- cautiously bullish above 1363
- bearish below 1295 and more bearish below 1200

The shorter-term 10-min chart should provide some early clues tomorrow. The bounce off this morning's low will achieve two equal legs up at 1349.49 but watch the broken uptrend line from Tuesday morning, near 1347 at the open (which is also the 62% retracement level). You can see the first test resulted in a failure but sometimes it takes two, or even three, tests before the bounce finishes.

Nasdaq-100, NDX, 10-min chart

Watching the techs is important as a way to determine the "animal spirits" of the market. Looking at a few key tech stocks further helps get an idea of what kind of buying interest there is in this sector and by extension the broader market. I was alerted to KLA-Tenor (KLAC) yesterday because of its high-volume break above resistance identified as the top of a parallel up-channel from November and last week's high. It also broke above its 200-dma. I wanted to see how price behaved today and while the jury is still out on the validity of the breakout there are a couple of things to watch as this stock could be a very good bellwether for the broader market.

KLA-Tencor, KLAC, Daily chart

The fact that price came back down and tested previous resistance (with only a small throw-under) is bullish, as is closing above its 200-dma for the 2nd day. Bearish is the hanging man doji that was created today. If it closes lower tomorrow it would create a reversal candlestick pattern. Not shown on the daily chart but visible on an intraday chart is its volume pattern. A daily chart with volume shows a high breakout (bullish) but intraday shows the majority of that volume came at the end of the day which created a shooting star doji and then a red candle into the close. It looked like a reversal pattern with volume and may have negated the bullish view on the daily chart. And now with today's hanging man doji I'm wondering about the validity of the breakout. A failed breakout here would likely be followed by strong selling after setting a bull trap. Watch this one tomorrow.

Of course the other tech chart that I like to watch is semiconductor index. Not only is this a good reflector of traders' willingness to risk buying the sexier techs but in fact the semiconductor index is a very good barometer of general business conditions. Just about everything has a chip in it these days. Just as the transportation index is excellent for showing us business conditions by what is shipped, the semiconductor index shows us what is being produced. I've been pointing to a potential top in the SOX for a couple of weeks now and I don't see anything yet to change my opinion. It too has been going through a topping process and until it manages to rally back above last week's highs (which isn't that far away and therefore the risk on a short play can still be kept very tight) I continue to lean short this index.

Semiconductor index, SOX, Daily chart

Notice that the small cap index is the only one that finished in the red today. Even with this afternoon's rally it was not able to get into the green all day. Money managers appear to be in distribution mode when it comes to the small caps (riskier stocks to be in if you're worried about a selloff). The daily chart of the RUT continues to confirm the picture we're seeing in the blue chips.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 482
- cautiously bearish below 449 and more bearish below 408

The banks held up reasonably well today but gave off some mixed signals. When the market rallied yesterday afternoon the banks did not follow and we got a strong selloff into the close. Today the banks were consolidating while the market rallied but they got a pop higher in the afternoon with the broader market. But like the broader market, and as shown above on the NDX 10-min chart, the BIX achieved two equal legs up today when it tagged 99.04 just before the close. That sets it up for an immediate selloff Friday morning. If the banks sell off we would likely see the broader market doing the same.

But the pullback pattern remains somewhat supportive for at least a minor push higher as part of its topping process. The broker index has been slightly stronger than the banks and as shown on its daily chart there is the possibility we'll see a little more rally and a tag of the trend line along the highs since mid March and the 200-dma, both coinciding near 97 (Wednesday's high was 95.54 and today's high was 94.88). But be careful as this supports the view that we're seeing a topping pattern form (unless it breaks above its 200-dma and keeps heading north)

Brokers index, XBD, Daily chart

Continuing to plague the banks, and our economy, is the credit crunch. The credit market shows there's been virtually no improvement over the past two months. The whole rally in the stock market has been built on the hope that things are improving in the economy (if we can call "less bad" as improving) and part of that "story" of improvements has been coming from the banks. After all, they're making money hand over fist again and happy days are here again. Of course what they're not telling us is that the M-T-Mb rule change has allowed banks to mark up the value of their toxic waste holdings and write that to the bottom line. I'm surprised we're not hearing more mentioned about this but then I know I shouldn't be surprised. The independent bloggers report on it but not bubblevision.

I've shown the Markit indices the past couple of weeks and I'll continue to show them as we watch for either confirmation of the stock market rally or a warning about its validity. A continuation of the credit market tightening will significantly challenge the premise that things are getting better and that we should therefore be looking for a continuation of the stock market rally. As long as the credit market remains tight we know that lending is not going to be nearly what's required to grease the skids to get our economy moving again. Credit in the economy is like oil in an engine and blood in our bodies. Without them they all die.

The credit crunch is still with us and hasn't improved at all. The Markit indexes now show prices for both the mortgage-backed assets (ABX.HE) and the commercial mortgage-backed assets (CMBX) and as you can see there's been no improvement in prices over the past two months. This means no one has shown any interest in these and the risks for owning them are as high as they've ever been. Without improvement in the prices of these bonds I don't see how we can expect improvement in the credit markets which in turn will continue to have a negative impact on our economy and company earnings. The hope-inspired rally since the March low will soon face reality, again. The big worry is what I'm reading and seeing in the commercial real estate market. This one is going to be a painful impact on the economy.

Markit indexes, Daily chart since October 2008

I've seen a few stories about banks and their lending practices and as always there are at least two sides to the issue. There are those, especially the Fed, who want to see the banks making more loans, and then there are many who think the banks have been reckless enough without forcing them to make more bad loans.

The Fed of course is charged with the responsibility to pump more money into the system in order to stop the credit contraction (which is deflationary). The massive amounts of taxpayer money given to the banks, through the TARP, TALF and several other ABC programs, is designed to not only plug the huge leaks in the USS Bank but more importantly it's designed to get it out into the monetary system where it can multiply and thereby increase the money supply. Hence the pressure to get the banks to lend the money instead of hoarding it.

As credit contracts (which is part of the deleveraging process) the money supply contracts and the Fed has been creating money like there's no tomorrow in an effort to build up the money supply (through lending and creation of credit which expands the money supply). But as I've often said, the Fed is trying to paddle up the creek without a paddle as the economy goes through a necessary correction of the massive credit buildup over the years. We've been experiencing a significant deleveraging process whereby debt is either being paid off or liquidated for non-payment (bankruptcies, foreclosures, etc.). The deflationary forces scare the hell out of the Fed governors, who have been genetically modified before appointment to their positions, to fight deflation at all costs. It will be interesting to see how they scramble to fight the inflation monster once the deflation monster is licked (which they'll actually have very little control over as it will simply run its course).

We've heard before that the fix that the Fed is trying to arrange is a lot like giving a drunk a drink. We got ourselves into this mess by binging on credit. We were collectively living beyond our means (and our Federal government is taking that to new extremes) and spending more than we earned, especially with the help of the housing ATM (until that dried up and now we've been using our credit cards and payday loans). We were all told for years that we could spend our way to wealth. What a preposterous notion and yet we "bought" it hook, line and sinker. So now that we've been forced to recognize reality (with the decline in home values and job losses unfortunately two of the consequences) we are finally back to becoming net savers even if it is only a small amount. Did you know that many in the poorer Asian countries feel bad if they're unable to save half their income? We here in one of the richest countries on the planet feel bad if we can't spend half again whatever our income is.

But this erosion in spending, and saving it instead, removes money from the monetary system. The Fed wants us to keep doing what we were doing--we are being encouraged to borrow and spend as if nothing has happened. That's the story we're getting from the bank heads (who lie through their teeth) as they report business is great and they're lending more. It's exactly the opposite and if you listen to the actual statements of people like Ken Lewis, head of Bank of America, he's saying the economy stinks, it's going to get stinkier before it gets better and they don't want to lend (OK, those are my words but you get the picture).

Jeff Cooper republished a story I had seen about a year ago that I'd like to include here as I think it sums up beautifully the problem we're dealing with and the Fed's efforts to get us to use more credit and spend more. I had used the analogy of giving a drunk a drink to feel better so this story is all the more appropriate:

'Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers--most of whom are unemployed alcoholics--to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting her customers loans).'

'Word gets around and as a result an increasing number of customers flood into Heidi's bar. Taking advantage of her customers' freedom from immediate payment constraints, Heidi increases her prices for wine and beer. Her sales volume increases massively. A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Heidi's borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral.'

'At the bank's corporate headquarters, expert bankers transform these customer assets into DRINK-BONDS (DBs), ALK-BONDS (ABs) and PUKE-BONDS (PBs). These securities are then traded on markets worldwide. No one really understands what these abbreviations mean or how the securities are guaranteed.'

'Nevertheless, as their prices continuously climb, the securities become top-selling items. One day, although the prices are still climbing, a risk manager (subsequently fired due to his negativity) at the bank decides that the time has come to demand payment of the debts incurred by the drinkers at Heidi's Bar.

'However they cannot pay back the debts. Heidi cannot fulfill her loan obligations and claims bankruptcy. DBs and ABs drop in price by 95%. PBs perform better, stabilizing in price after dropping by 80%. The suppliers of Heidi's bar, having granted her generous payment-due dates and having invested in the securities are then faced with a new situation. Her beer and wine supplier also claims bankruptcy, and her supplier is then taken over by a competitor.'

'The bank is saved by the Government following dramatic round the clock consultations by leaders from the governing political parties. The funds required for this purpose are finally obtained by a tax levied on the non-drinkers.' (Now the bankers who have been given TARP money are jacking up rates and/or canceling credit cards and loans.)

Those who do not understand what's happening today were probably customers of Heidi's a little too long. It would be a funny story if it didn't ring so true. There's a reason we're starting to see and hear outrage among the public, around the world. Most people don't have a clue what's going on but they do understand one thing--fairness. It's not fair that those who have been responsible are forced to bail out those who have been irresponsible. And at the top of the smelly heap is the Fed and Treasury as they steal taxpayer money to satisfy the power brokers on Wall Street. Obama and is administration are the most Wall Street-controlled administration we've ever had. So much for change and "yes we can".

Gold and silver got a big bounce today and the US dollar dropped. So they were more in synch today than has been true in the recent past. It's difficult to predict the movement of the metals based on the movement in the dollar. I've been expecting a bounce in gold so today's rally is not a surprise. There is a little more potential up to its downtrend line from the February high which is just under its 50-dma at 924. It doesn't have to bounce that high but that's clearly the potential. It would be obviously be bullish if gold were to rally above both the downtrend line and 50-dma and therefore my short recommendation is based on gold staying below 930. Above that level and I would want to be long the shiny metal. Same for gold stocks covered next.

Gold contract, GC, Daily chart

Assuming gold will turn back down, which for the moment is what I'm anticipating, I think we'll see it drop down towards 800 before another bounce and then lower again into the summer. But notice my comment about the RSI break of its downtrend line from February. This is a big heads up warning to those of us who are short. This kind of move by RSI is typically followed by price. Therefore take a break of the downtrend line by gold itself as a bullish sign.

The gold stocks look more bearish to me than the metal itself. The pattern of the decline from the March high looks like an impulsive 5-wave move. That suggests the trend is down now and the current bounce is counter-trend. The bounce off last Friday's low achieved two equal legs up at 33.13 (today's high was 33.49) and therefore the bounce may have finished today. But if it can press higher there is resistance near 34.27 where its 50-dma and broken uptrend line from November are both located. That would be an excellent opportunity to try a short play as you can keep your stop relatively close. Following this bounce should be a stronger leg down (the 3rd wave).

Gold miners, GDX, Daily chart

Oil has been struggling to rally and I thought for a bit that the sideways consolidation over the past few weeks would result in a continuation higher. But it broke down instead and now its fighting its 50-dma from below. It may have finished its decline though at the bottom of a bull flag pattern so a rally back above 30 would be bullish. In the meantime the downside risk is to a new low below the February low.

Oil Fund, USO, Daily chart

The only reports of potential significance tomorrow morning are the durable goods number and new home sales. But I don't think either one will offer any surprises.

Economic reports, summary and Key Trading Levels

The weather is improving and it will be Friday. The bulls and the bears are probably getting tired of the fight and we could see a slow consolidating kind of day. But the risk as I see it is for a strong move lower. If today's bounce finished a correction of Monday's decline (or possibly after a brief push higher Friday morning) the wave pattern is set up for a strong decline in a 3rd wave (the strongest wave in a 5-wave move down which is what I'm expecting to see for the decline from Monday). Therefore if the selling kicks into gear I would not be looking to buy the dip tomorrow. Instead look to sell the bounces (which could be relatively small).

With a downside target of SPX 813, but more likely 780, there's some good potential for a short play. This has been a whacky market, especially near the closes, so keep your risks under control and consider options or ETFs rather than futures. Volatility is starting to tick back up so don't be afraid to play some quick swings and take profits early if you can watch the market intraday. If you can only play end-of-day setups I think I'd concentrate on the short side (or flat side) or the next week or two as we watch to see what unfolds to the downside. But if we get a rally back above last Friday's highs (and even above Wednesday's highs) I would be either flat or long the market. In either case it's wise right now to play small and use hit and run tactics rather than any buy and hold or sell and hold.

Because it's unclear what the larger wave pattern is I think it's prudent to play this market one leg at a time. That's why I'm suggesting playing the short side for a move down to SPX 780 (target for now) but then be prepared to flip around and go long. If the bounce looks too corrective I'll flip it around again and go short. One leg at a time while we wait for the larger pattern to present itself.

Trade carefully over the coming week and I'll be back with you next Thursday.

Key Levels for SPX:
- cautiously bullish above 876
- cautiously bearish below 875 and more bearish below 780

Key Levels for DOW:
- cautiously bullish above 8300
- cautiously bearish below 7400

Key Levels for NDX:
- cautiously bullish above 1363
- bearish below 1295 and more bearish below 1200

Key Levels for RUT:
- bullish above 482
- cautiously bearish below 449 and more bearish below 408

Keene H. Little, CMT
Chartered Market Technician