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The stock market cheered the US central bank’s historic interest rate cut today, surging nearly 5% on the S&P 500 back above 900 to 911.82. The rate cut, combined with continued quantitative easing in Treasury bonds was evident in today’s trading, with a flood out of US dollars in to commodities and other currencies as well as bond yields dropping sharply.

The implications are clear. Inflation will begin in some measure of time, whether it is days, weeks or months. We can see traders already preparing by taking long positions in anything that stands to benefit from the dollar’s fall. Near term we could see the US dollar index fall as low as 72, retesting its prior lows and further confirming the head and shoulders pattern. Commodities and currencies remain attractive buys.

Talks in the US Senate to create a compromise in the auto bail out bill have failed. The US futures, Asian and European equity markets are taking a large hit. The S&P 500 is below 850 pre-market, meaning if we open that way the support level has been breached. Car makers, industrials and energy companies are taking a big hit. These are unprecedented times with big news every day. Keep your eye on the markets!

The US dollar index is forming an all too familiar pattern.  This is certainly a result of wreckless monetary policy turning deflation in to a potential stagflationary situation. At this point we recommend purchasing commodities (DYY is a good ETF because it is 2x leveraged and well diversified) and other currencies while there are reasonably priced opportunities.  We like the Euro and Yen for this trade.

US dollar index shows head and shoulders pattern

The courageous may consider purchasing commodities stocks as they will likely participate, but the future of the equities market is not necessarily certain as the recession is deepening.  Today’s unemployment claims were higher than the expected 525k at 573k.  That is a very bad sign that the worst is far from over in terms of how many layoffs we can expect.

Commodities have had tremendous strength for the past few days along with commodities stocks seeing money pour in. This is a potential trend worth watching and it is continuing pre-market today.   I will have more detail in a later post.

We are seeing confirmation of a head and shoulders pattern on the NASDAQ composite. This pattern is potentially very destructive to the rally that has taken place thus far. If you are still long this market, a stop slightly below 880 on the S&P or 1550 on the NASDAQ composite is wise, as that seems to be the only level holding back a collapse of the uptrend.

Watch this trend closely because the weekly chart on the NASDAQ composite shows the same pattern forming, meaning we could be retesting our lows in short order if it traces out the right shoulder and breaks below the neckline.

The US Federal Reserve, a private bank, is mulling issuing its own debt.  There are several problems with this, one of which is that if the debt is backed by nothing, no one will buy it. If it is backed by the full faith and credit of the US Government it needs Congressional approval.  Either way, the fundamental story is clear.  The Federal Reserve has overextended itself and finds its balance sheet loaded with worthless assets that it can not sell.  Karl Denninger has a nice rant about this on his blog that I recommend for your morning reading.

You’re being billed for one anyway!  That’s right, the $15B auto bailout seems likely to pass and be signed in to law, using funds for the DOE’s energy efficient vehicle program to instead bail out the very non-energy efficient American auto makers.  I am personally opposed to assisting any enterprise that cannot sustain itself in a free market.  This decision is not going to save the auto industry, but instead it’s as though the US government has bought some time for the auto makers to show us they can fail again.

The markets reacted positively overnight, with Asian equity indexes rallying and US futures shooting up about 1%.  The key number of 900 on the S&P 500 has again been flirted with and will be important to watch throughout the day.  The traders I’ve spoken to seem to think that the bail out was already priced in so we’ll see if the optimism lasts today.

This is not a call on either side, but a recommendation instead to watch the action in DRYS as we are seeing incredible buying interest in this stock over the last few days and especially today. Again, I don’t recommend buying or shorting here. The interesting factor is how this optimism is related to the future expected performance of and demand for commodities.

Commodities have seen a sharp and unprecedented sell off after their inflationary highs earlier in the year. Many, including myself, feel this sell off is overdone. The action in DRYS may confirm that theory. Watch this one closely in the days and weeks ahead!

In addition to my short call on APOL, I’m making a short side call on GPC. This stock is intertwined in the automotive parts industry in Northern America and is poised to experience significant deterioration regardless of whether any bail out packages are passed by the US Congress. Recent talk of the bail out has been supporting the stock’s rally, but my analysis says that this stock’s run is out of steam.

Diminishing volume during a rally is a sign that it is going to fade. I am calling this short because I feel that American automotive business related activities, such as demand for parts and vehicles will diminish in this recessionary environment. My target on the downside is $36. A stop around $41 is prudent.

I’m making a call on the short side for APOL. I feel that private education companies will be impacted by the lack of credit availability, slowing growth and higher unemployment constricting the pocketbooks of Americans. My target on the downside is $65. We see higher than average put buying activity at that price.

Apollo Group runs University of Phoenix. They’ve seen increased enrollment over the past several quarters, but with the US economy significantly deteriorating, I feel that this trend is poised to sharply reverse.

The charts show us that $78 is an area of long term resistance, so a stop around $81-82 is a prudent measure to protect against a potential breakout in this stock without giving in to higher than normal volatility.

Prior rallies during this bear market that hit the 50 day moving average have been rejected.  This rally seems to be bumping below the 50 day moving average and is seeing that as an area of resistance. 

This trend is important to watch because if the market decisively breaks above the 50 day moving average that will add to short term bullishness. If the market can not break above the 50 day moving average and slumps lower, that may be a sign that the uptrend is ending.

With stocks up 10% in the rallying we’ve seen, the downtrend line broken and a lot of technical buyers of index ETFs, are we seeing an X-mas rally take shape?  Seasonally we do have a few factors that could point this direction, but it all depends on market sentiment.  Options expiration is December 19th, which is traditionally a volatile day with the potential to drive a tremendous bear market rally (or sell off).  We also have had a slew of economic news that was nothing less than terrible and the market has reacted in a neutral to positive manner with amazing resilience.

The bottom?

That’s not how it looks at this point.  In fact, the uptrend itself is only beginning to show itself.  We aren’t out of the bear market until the worst volatility is behind us and there’s optimism regarding the future.  I feel that this has more potential to be a short-lived seasonal bear market rally.

How high can we go?

It’s possible with the current pattern we’ve formed, which resembles an inverted head and shoulders, that the S&P 500 could hit 1000.  At that point there is major resistance that would probably cause some consolidation and perhaps profit taking.

Patterns predict markets?

Sometimes patterns and other technical analysis can help to show where the market is going based off prior behavior.  There are plenty of charts on the bottom of the sea from failed navigation and the market is no different.  You can be just as wrong as you are right.

What happens next?

We need to see a close above 920 on the S&P to fundamentally change the picture.  From that kind of close we have the potential to rally up to 1000.  Long term my bias hasn’t changed.  I still believe we could break below our 741 lows to the 450-600 area.

Today’s non-farm employment change was nearly twice as bad as consensus expectations and the worst in 34 years, slamming futures on all major US indexes sharply lower.  This economic data confirms that the US economy is in a deep recession and puts in jeopardy the consensus GDP estimate of -4%.  We may see a number as bad as -8% on the next quarterly GDP report because of the massive contraction in employment and ISM data.

Should the negative sentiment continue, this sell off could push markets much lower.  Futures are hovering at support levels and could be pushed significantly lower at open.  Watch this market closely today.  The price action will be extremely important in determining the next likely move.

Volatility is potentially poised to surge as the VIX six month chart is showing a large ascending triangle formation.  Below is a chart showing both the Bollinger bands with 50d moving average and the ascending triangle with resistance at about 80 and a support trend line from September until now showing the massive surge.

I think there is a high likelihood of a retest of the 80 area and possibly a break above in the next few days.  Right now the NYSE and NASDAQ McClellan oscillators are showing that the market continues to be overbought and must correct.

It’s worth noting that a lot of false bullish signals in the stock market can occur when volatility is this high.  I’ve seen many skilled technicians get suckered in to buying the tops of these rallies.  Be careful!

Much of yesterday’s rally was predicated on a rumor being circulated about the US Treasury planning to price fix new home mortgage interest rates at 4.5% and other whispers.  Many who selectively watch the news or ignore it may fail to fully realize how this short term optimism can impact markets.

We had a sleu of negative economic data yesterday, but it was trumped by the aforementioned rumor and speculation that the TARP be brought back to fund more bailouts.  Today we see terrible same store sales from every chain but Wal-Mart.  We also have unemployment claims at over 500k and factory orders at 10am that promise to be nothing short of terrible.

There will be plenty of Fed speak today.  I can’t for the life of me imagine any optimism they could install after yesterday’s gloomy beige book.  Most of the chatter will probably be about how the Fed wants to avoid cutting to 0% by using quantitative easing strategies, such as buying long bonds and forcing prime interest rates lower.

The futures are weaker by about 2% this morning, giving back much of yesterday’s gains.  Market gains made Tuesday and yesterday are still part of a bear market rally.   Markets are facing the upper resistance line of a falling six month wedge pattern on all major indexes.  Don’t get BULLied!  Remember the trend is your friend.

He plans to potentially cut rates to 0%, creating a liquidity trap, much like our friends in Japan did in the late 90s.    This is an absurd solution to a problem that originated with too much cheap credit availability.  It is also naive to speculate with trillions of dollars, mortgaging our next generation’s future for the mistakes of bankers and regulators.

What if it doesn’t work?

There is a strong likelihood that this “fix” will create stability (not necessarily growth) in other asset classes by sacrificing the dollar.  If it doesn’t work, however, we could see a protracted global depression with many central banks already having expended their monetary policy ammunition prematurely.  Japan’s crisis never technically ended.  Their stock markets never regained their 1990 highs.  Since then they have been in a deflationary environment for 18 years.

Won’t the bail outs help the country?

Probably not.  Capitalism was built on the philosophy of letting the strong prosper and the weak fail.  If a company can not make a profit or has made terrible investment decisions, the tax payer should never be held accountable.  Bailing out the weak also stifles real growth and innovation.   Other companies are usually poised to fill the gaps left behind by the weak companies failing with better products or services.

If it won’t help, why try?

Central planning rarely works, but is often utilized in times of crisis to provide moral support.  We are going down a dangerous road that could end in the socialization of corporate America while leaving the middle class to decay.  The favoritism employed by Treasury and Federal Reserve officials to arbitrarily choose what lives and what dies is the polar opposite of free market capitalism.  It undermines the very framework that could have been the solution to our credit woes.

How do you make money in this environment?

So far short term trading, while risky, seems to be more reliable than any buy and hold approach.  Some folks are playing the double and triple leveraged ETFs based entirely off of technical indicators and having good success.  Others are accumulating positions in commodities for what they expect to be an extremely inflationary environment.  My take is that both strategies are applicable, depending on your risk tolerance, time horizon and availability to watch this volatile market.

Now that the recession is official, many are taking their queues from economic data and yesterday we saw very negative readings on ISM.  In fact, the worst in 30 years.  This shockwave sent the markets down sharply, giving back much of last week’s gains.

While yesterday’s vicious selling may seem overdone, and may even yield some light buying ahead of the next wave down, I believe we are simply confirming the six month falling wedge pattern and will be retesting the intraday lows of 741 in short order.

On a side note, the tremendous easing the Fed is implenting by buying bonds, cutting rates and opening the lending windows to all will eventually yield to a very inflationary environment.   Commodities and currencies will begin to become attractive early in 2009.

As reality quickly dismisses the holiday optimism that swept through markets last week, equity indexes are paring their gains and looking lower to reprice risk. The Yen is especially strong today as the carry traders give in to fear. This is likely the beginning of the next selling stage as outlined in my articles from last week. If I am correct, I expect we retest the 741 intraday lows and possibly break down below to the 600 area in the coming weeks and months.