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For the past seven weeks there has been an impressive, rip roaring 30% bear market rally from the March lows.  There has been no fundamental reason or glimmer of hope that truly spells the end of this recession.  Instead what we have are bank earnings that no one in their right mind can trust with the amount of accounting trickery taking place.  Consumer credit card interest rates skyrocketing.  Record foreclosures in both residential and commercial real estate.  And a parade of uninspiring earnings and guidance from the S&P 500.

Room for gloom and doom

The market has been ignoring bearish news which  could be viewed as bullish, except it is also ignoring the fundamental macroeconomic picture.  Emerging markets in Eastern Europe and Asia are hard hit by the global economic crisis.  Some are on the brink of default with their sovereign debt, forcing them to seek loans from the IMF.  Others are rapidly devaluing their currencies.  Either  path demonstrates signs of extreme financial stress.

There is no end in sight to the problems with real estate, which led us in to this mess.  We have yet to see a meaningful bottom in housing and now commercial real estate is suffering.  GM is on the verge of bankruptcy with few alternatives and to top it off global GDP will likely shrink the first time in decades.

Froth at the top

On a technical basis the S&P 500 seems to be overextended.  It has been overbought too quickly for most of the momentum to be sustainable.  In the last week we’ve seen a lot of that momentum fall to the wayside.  While consolidation is normal, we can’t with any confidence declare this as more than a bear market rally to which an abrupt and painful end may be in sight.  The bank stress tests are expected to start being released to banks this Friday and to the public in early May.  The old adage “Sell in May” could be a very meaningful pronouncement for this Summer.

Keep your powder dry

I recommend using this rally as an opportunity to raise cash, sit on the sidelines and wait for a good buying opportunity for the long term.  Short term the best position is a short bias.  I don’t feel that being constructive after such a massive build up, especially when some of the larger gains have been on light volume, is warranted.  Possible support exists at 850, 830, 800 and 775.  At this point it is conceivable that we also retest the lows in the 660s over the Summer depending on how severe some of the interim problems become.

Overnight the tone of futures markets has been pretty negative, pushing the major indexes to levels that could retest the trend line support at open if we stay this low.  The S&P has been flirting with 820, a very key level that if significantly violated to the downside, 813 and 800 remain as important support levels.  After 800, we have a vacuum that could reach the November lows.  Of course a violation of 820 on the downside will be seen as a breakdown of the modest uptrend and that could catalyse a wave of selling.

One discouraging sign is since the small rally in early January, every time the S&P 500 has bumped the 50 day moving average we’ve seen a wave of selling.   Market participants are not commiting to long term positions, but range / trend trading short term and this action is increasing volatility.

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!

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.

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.

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.

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.

Examining a longer term chart of the S&P 500 confirms that we are still in a falling wedge pattern, despite recent gains. Should the rally give way here, many traders will begin selling in to the weakness.

We could see the S&P climb as high as 900 without fundamentally violating this pattern. Support areas are shown with horizontal lines on the right side.

Why have we witnessed four up days of trading that rocketed from the lows of 741 to nearly 890 on the S&P 500? Is it the start of a new bull market? This would be a very pleasant scenario, but bear market rallies can last days or sometimes even weeks and months. The most violent rallies, like those as of late, are generally short lived. The last time the market was up four days in a row was April, 2008.

How are bear market rallies possible?

Lately we’ve seen anything from government appointments to bail outs of multinational banks significantly lend to positive momentum. This is quite a contrast from the traditional inspiration of good earnings or economic data.

Bear market rallies are not created by investors buying to commit capital in to a stock for the long term, but instead by short covering and trading. The short term horizon of the participants and the lack of fundamental positive catalysts usually lends to these rallies collapsing to worse levels than they had climbed from, rather than a constructive bottom forming process.

When will we see the bottom?

A) The worst must be over: House prices are still dropping, unemployment is rising, consumer sentiment pushing all time lows and credit availability is tight. There is likely another leg down coming in both commercial mortgage backed securities and consumer credit card defaults.

B) There must be a positive catalyst within sight: Green energy has been promised to be the next bull market. Is there demand for these measures when oil is at $50 a barrel? The other question is, after committing half of last year’s GDP to financial bail out programs, how will the Federal Reserve and US Government continue to finance their spending? More importantly, will foreigners continue to lend to a less credit worthy nation?

C) The Federal Reserve must complete lowering rates and change to a neutral or tightening bias: The next Fed move will likely be another rate cut. To Bernanke’s Fed, deflation is still a bigger threat and he has the helo running full time dropping cash. Until this reactionary behavior is over, there is no sign that we are out of the woods.

D) Businesses must begin buying back shares: Many buyback programs have been halted, not accelerated. We have not seen corporations step back in and buy back their own shares. We also haven’t seen many insiders provide substantial equity commitments in their companies as of late. This is an important component of building a sustainable bottom.

E) Risk indicators must begin to show signs of significantly decreased aversion: The Japanese Yen, crude oil, one and three month T-bills (and lately even the long bonds) have all shown us that the flight to quality and away from risk (or growth) remains. The VIX is still above 50 and has major support at 45. Even gold prices are back above $800. Fear still seems to be a greater motivation than greed.

What are the charts saying?

The above S&P 500 chart is not confidence inspiring. The trend lines illustrate the wedge patterns and the horizontal lines show major resistance areas.  Currently the stock market is bumping in to major resistance. My indicators confirm this rally is overbought and due for a correction soon. 

Where are we heading next?

Based off the above analysis, I don’t feel this rally will get much above 900. Instead, we need to retest the intraday low of 741 on the S&P in the next few weeks.  There will probably be support areas on the way down at 875, 850, 830, 800 and 776. If the 741 low doesn’t hold, 600 is the next level of major chart support.

If you’ve made some money on the rally, don’t fall in love with the upside.  Remember that we still have a lot of problems to work through.  Folks with investments should use this as an opportunity to raise cash. If you’re looking to trade this rally, you may want to begin adding to short positions.  FinViz.com has some great tools for screening stocks if you use technical analysis to find your trades.  Good luck and stay safe!

With a week full of potentially sour economic data and political uncertainty, the market may be poised to resume its downtrend and give back much of its gains.  See our chart of the S&P December 2008 futures:

The chart above shows the potential for the downtrend to resume as the futures have considerably weakened off their overnight rally, which retested Friday’s highs.  We have had a week of mostly gains, with back to back up days.  In this kind of bear market environment it is doubtful that the rally can last too much longer.

Coordinated efforts to stablize global markets are now underway by various international economic industrial and emerging powers.  Futures are up 3% in anticipation that this will increase investor confidence.  We may see an interim bottom formation as a result.  Watch closely and trade carefully.

After yesterday’s record-making sell off of equities, we see US futures rallying about 3% premarket today.  That’s less than half of what they lost yesterday in value, but it is an impressive gain.  I don’t think it will last, though.  We’re still in a bear market where rallies should be faded and this is no different.  Watch for weakness midday.

Looks like the equity markets in the US are continuing the global sell off.  I doubt any legislation will patch up the hole left by the implosion unregulated OTC derivatives.   On the S&P 500 December futures contract (ES), my system shows 1176 as Support 1 and 1162 as Support 2 for today.  The pivot is coming in at 1198 and R1 is just about 1213.  This gives us a very large trading range for today, but really only room to sell off to as low as about 1150 (near the September lows).

Risk aversion from overseas is increasing as we see the carry trade unwinding dramatically from a high of near $107 overnight to $104.80 now.  The flight to safety of gold and bonds continues as equity investors are being punished for holding the lowest quality paper of the corporate capital structure during this crisis.  Gold is testing the key $900 resistance level.

With the global economy poised for a recession, it is no surprise that energy prices are dramatically lower on the day.  Oil and natural gas are off over 5% as traders speculate energy usage will contract and inventories may grow.

The now familiar weekend bailout is once again underway. The Congress is approaching an agreement, which is ultimately less awful than Paulson’s completely ambiguous blank check, but still not ideal.  If passed, the temporary boost of confidence could cause global equity markets to rally in the short term, but reality will catch up as the global recession looms.  I don’t think we’ll see anything but lower highs in the S&P, but we could see a 200DMA retracement.  Watch key resistance levels around 1250, 1275 & 1300 on the S&P.  If 1300 is broken, watch the 200DMA as resistance and look to build short positions if it is unsuccessfully tested.

We will probably see the bill pass by the weekend and with it will come a short term renewal of confidence that may boost equity indexes back to important levels of resistance at the 50, 100 and 200 day moving averages.  Overall, this is very bad news for the average citizen and their children who will foot the bill of the worthless paper that’s traded for cash.  US debt may face a downgrade as a result, causing further disruptions in credit markets and weakness in the dollar as foreign investors seek to diversify their money in safer investments.

Wall Street would have us believe that the rally is going to last, the bottom is in and today’s action with the Dow up at the high around 300 points shows us that certainly there is some positivity around the notion that the government will be the universal backstop to bad debt and other associated instruments.  Meanwhile, Washington Mutual’s stock is plummeting 30% at the lows of the day as the company struggles to survive.   If no one buys them, they will surely fail and cause another massive disruption.  Isn’t Washington Mutual the last savings and loan bank that has public stock?

We see equity indexes behaving as though the carry trade is back in full effect now.  As the Yen weakens against the  US dollar, we see funds pouring in to the S&P futures.  It’s a simple way for the Japanese central bank to support American market stability, while at the same time positioning their exports to be more attractive to American consumers.  Everyone wins, right?  Not if the rally is predicated on the notion that relief is within reach, which as of now it seems to be.

Remember that the SEC’s short selling ban expires October 2st and nearly 1000 companies will be open game for short sellers again unless the SEC creates new policy to address short selling.   October also brings the height of the ARM option loan resets to higher interest rates.  We could see a large spike in foreclosures and further deterioration of mortgage backed securities. There’s also the fundamental question of where valuations should be if we do return to a stable market.  Most traders would probably agree that given the deleveraging necessary to return to sustainable balance sheets, asset values are poised for further deflation.

We’ve seen bonds outperform nearly every other asset class, as the flight to safety has been fast and furious.  The short end of the yield curve is yielding 0.335%, which is actually up from the lows of the year.  The TED Spread is at record high levels, showing the stress in the credit markets is exacerbated by the uncertainty surrounding the corporate welfare bill for financial companies.  The current trend in equity indexes is lower with no sign of abatement.  Most emerging markets have been deeply affected, with China down 60% from the peak of last year to the trough of this year’s lows.  Russia’s financial crisis worsened to the point where the markets were shut down for days and in India and Brazil we’re seeing inflation continue to plague the central bank policy, causing an abrupt departure away from steady growth.

The world is in limbo right now.  Are we going to let institutions fail as capitalism would demand or will we socialize the entire free market in favor of stablizing a fearful world in the aftermath of the biggest asset inflation bubble in world history?  While the US Congress debates these issues the markets are deteriorating, as they should, given the uncertainty that forward-looking traders and investors have to factor in every day.

Right now we are on the precipice of the greatest global financial crisis the world has ever seen.  Most people are beginning to wake up to that.  We’ve seen some liquidation of mutual funds in retirement accounts, money markets become unstable because of Lehman’s collapse and AIG, the world’s largest insurer, have to be taken over by the US Federal Reserve Bank, because of balance sheet insolvency from “mark to make believe” accounting practices.  While legislators debate what implications this bill may have and how to oversee it prudently, I fear that this is by far the worst approach to solving a problem that stemmed from bad risk management and greed.  You cannot bail out the biggest banks with debt that is created out of borrowing at interest from the Federal Reserve and expect the problem to be eased.

Every government and Fed bail out so far and in the foreseeable future relies off of using public funds to bail out private sector mismanagement of capital.  Suddenly the entire financial sector’s balance sheets are reminiscent of Enron and we’re celebrating this by rewarding their worthless paper with billions of dollars from an already heavily debt-burdened Treasury balance sheet. We can’t expect this one to be any different.  Sure it may address short term credit market confidence issues for just enough to get us through another quarter, and to a new elected government in 2008, but it is not a solution.  It is a bandage on a gaping axe wound.  Eventually limbs will have to be lopped off because the infection wasn’t handled by Dr. Ben.  This is what I fear is next.

Instead of stemming the risk taking, the policies suggested and enacted thus far have actually created the opposite effect.  We give banks easy access to cheap capital as the Fed cuts rates, the dollar weakens and all of these banks target commodities as an investment, instead of putting the money to work back in the US economy.  Of course their argument is that they have a fiduciary responsibility to generate capital for their investors, and that allows them to operate in a completely apathetic manner towards the overall wealth of America.  Instead, they invest in metals, energy, grains, etc and the rally is the biggest and boldest in decades.  It was no coincidence that when credit became harder to access, hedge funds started imploding and the banks that benefited from the rally on the way up started taking profit or reversing positions while the economy slowed down, that the rally completely ceased and reversed.  The correction, like the rally, was the unprecedented in its scale and veracity.

In the midst of incredibly expensive short term capital, market participants that relied off leverage to create profits are imploding left and right.  Many models, like the ones employed by Bear Stearns, Lehman Brothers, AIG, Washington Mutual, Wachovia, etc. will not function in a world where confidence has eroded because of excessive greed and terrible risk management.  Many smaller boutique firms that receive less media coverage have also been facing redemptions, funds have been closing down at an alarming rate.   At the end of the day, there are less market participants and those remaining have less capital to employ strategies.

Many elements of the market system are changing very fast.  Be careful trading.  The risk hasn’t been higher for a long time.  Short term strategies seem to be the most feasible, but keep your eyes glued to your terminal!  I’m keeping my portfolio in cash with occasional conservative short term trades when the opportunity presents itself.  Good luck!