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Market Briefs & Sentiment Outlook (MBSO) http://www.market-harmonics.com
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May 26, 2008 Unfamiliar With Elliott Wave Terminology?
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Market Briefs End
of the Stock Market Recovery? I should preface my remarks by stating our view that U.S. stocks launched a new - and still unfinished - bear market in October 2007 (July 2007 for small cap issues). As such, we consider the recovery from March 17 to be a bear rally within this larger bear market trend. For us, the real issue, therefore, is whether or not this recovery has concluded. To answer that question, we'll consider the evidence from the Elliott Wave patterns and Fibonacci trends we're observing in the market these days. While time is probably the least reliable factor in our analysis, it's still worth noting some Fibonacci relationships that have occurred with respect time and price. For instance, a number of the stock averages retraced nearly 61.8% of their declines from October-March in 63 days. 61.8% is of course the key Fibonacci retracement ratio in Elliott Wave analysis. The 38.2% Fibonacci retracement ratio is also a key benchmark, and on the total market index, the rally from March 17-May 19 took a little more 38.2% of the time than the October-March correction did, suggesting another possible Fibonacci time/price relationship. Since we regard the October-March decline to be Wave (1) of a five full waves to be traced out in an unfinished bear market, these Fibonacci relationships are not uncommon for a Wave (2) rally with respect to price and time. While second wave rallies can potentially retrace most of the first wave decline, they just as frequently don't retrace it, and they never exceed the start of it. Taken alone, these are interesting price/time coincidences. Whether or not they become more significant than that is ultimately a matter of how the current Elliott Wave patterns in the market are unfolding.
Although the recovery managed a near 62% retracement, this chart of the Dow-Wilshire 5000 shows that the rally from the March 17 low to the May 19 high has traced out in overlapping patterns, indicating the advance has been corrective. Since a corrective recovery moves counter to the larger, underlying trend, it argues that the larger trend is still pointing down. This supports the case that the advance has been a bear rally, and would also refute the argument some have made that the March 17 lows were the launch point for a new bull market. Unlike first wave patterns, which develop in five stages, second waves subdivide in one or more patterns of "threes;" hence, we apply the ABC labels to the rally. In light of the retracements discussed earlier, there exists the possibility that Wave (2) may have topped on May 19. Some further evidence comes from the Nasdaq.
While the recovery in the Nasdaq since March 17 was a little more robust in its development, the depth of retracement was nevertheless comparable to that in the Dow-Wilshire 5000, and, as we see above, a similar overlapping ABC pattern is detectable. As such, it could also have produced a Wave (2) top in the Nasdaq. The implications for the stock averages would be stark if in fact the Wave (2) rallies are over, as it would imply that as of May 19, a Wave (3) decline is in effect. Wave (3) should prove even more damaging to stock prices than the Wave (1) decline of October-March, which produced a peak to trough drop of 20.6% in the Dow-Wilshire 5000. Ultimately, two factors will confirm whether Wave (3) down has launched, or if the market will dodge the bear market bullet for a little bit longer. One is the survivability of the March 17 lows, which should remain intact if current pullback remains just a pullback. In that event, then a new ABC rally would follow the pullback (this is denoted by the "ALT X" wave in the charts, which unites the two separate ABC patterns). The other factor is market sentiment. Various measures of Put/Call data, for instance, have retraced to levels that have preceded market declines. That by itself would not necessarily signal the launch of a Wave (3) down, but it does tell us minimally that the market is likely to come under further pressure, and it could be the sign of a Wave (2) top. We'll look at these issues in more depth in the Sentiment Outlook discussion below. Before closing the Market Briefs, we update our look at the sector that helped catapult the new bear market - financials. As we noted in an earlier edition of the MBSO, financials were likely to stage a recovery. Like the stock averages, the sector completed a 5-wave decline pattern. Many financial stocks were deeply oversold, and sentiment was excessively bearish. A recovery rally, therefore, was fairly predictable. Yet, as the charts below reveal, the recovery has been sub par when compared to the broader market averages.
We present above weekly and daily views of the Financial Select Sector ETF (symbol: XLF). While the charts are labeled a little differently from the major stock averages, the wave patterns are essentially similar, and more significantly, the import is basically the same. Unlike the 61.8% retracements in the broad averages, XLF, which is composed of major commercial and investment banks and broker-dealers, only mustered a 38.2% retracement off the March 17 low. The ETF has also mostly sold throughout May, and has already given up more than half of its gains. The possible outcomes for the decline are also comparable to what we discussed earlier for the broader averages, with the March 17 low of 22.29 similarly key to whether or not the recovery in financials is likely to extend. Also significantly, the trading action in XLF provides perhaps a keen insight and useful barometer of market sentiment towards the financial sector - and the Fed's massive efforts to help rescue it - including a slew of emergency lending programs, and a 300 basis point cut in the Fed Funds Rate over an unprecedented seven months. Those who are convinced the Fed will turn the tide for the financial markets are advised to study this chart and the meager recovery this collective group of financials has made in the past two months. Thus far, the market isn't buying it. And Speaking of Financials... In a May 21st article by the Wall Street Journal's Susanne Craig ("Trouble Hid in the Hedges") it was reported that the hedges banks have used to offset losses in real estate and other securities haven't been doing their job lately. These hedges, where the brokers bet against indexes that track markets such as real-estate securities and leveraged loans, were helping to limit losses over the past year. However, following the stock market lows of March 17, Ms. Craig notes that "some of these hedges came unglued." The article also noted that the biggest loser by far appears to be Lehman Brothers Holdings Inc., "where losses from both write-downs on assets and ineffective hedges will likely range from $1.5 billion to $2 billion, according to some analysts." Also presented in the article was the chart below (which we have embellished a bit) of the CMBX Index, which tracks the market for commercial-mortgage-backed securities or loans. Per the article, the CMBX rallied as much as 50%, while the securities the banks were hedging rose much less, or in some cases fell in value.
In studying the chart, the apparent Elliott Wave pattern stuck out like a sore thumb. Wave analysis also allows us to make some interesting observations. For one thing, what's uncanny here is that this index is moving inversely to the stock averages. For example, the CMBX topped in March, right when stocks bottomed. It also produced a 5-wave uptrend from last October, while stocks produced a 5-wave downtrend. What will be interesting here is whether the larger degree Wave (2) in the CMBX has completed its downward corrective pattern, in contrast to the upwardly corrective Wave (2) pattern in stocks. Alternatively, and as we discussed for stocks, Wave (2) in the CMBX could possibly extend. For the CMBX, a violation of the top of Wave (1) would indicate that a Wave (3) uptrend is in effect. Depending on which scenario plays out, the hedges should start to rise in value again, either on a short-term or longer-term basis. It's just speculation on our part, but what would be the most ironic outcome relative to the CMBX Index is whether the banks now decide to drop their hedges - just at the time when they may regain profitability, especially if Wave (3) is about to launch. That idea may not be so far fetched if the banks, faced with reporting yet another series of losses, drop them as a way to assuage further investor concerns. Such is the contrarian nature of market sentiment. As Ms. Craig sums up in her article, "... a new round of losses, albeit smaller than in quarters past, does little to help rebuild Wall Street's reputation for managing risks." Sentiment Outlook When we looked last month at the action in the CBOE Put/Call ratio for Equity Options, we noted that the ratio had achieved all-time highs in our data, displaying deeply bearish sentiment among retail investors. As I commented in April, "any significant and continued unwinding of the Put interest being reflected here would undoubtedly be bullish for the market near to intermediate term." Since that time, the Dow-Wilshire 5000 recovered nearly 62%, as I noted earlier. The charts below show what has since happened to the Equity Put/Call ratio. Then...
...And Now
As of May 22, the Put/Call ratio for Equity Options had dropped by some 27%, and as expected, the implied unwinding of Put interest produced a favorable climate for stocks to recover off the March lows. There are now two new developments that urge some caution for investors. The first is that the ratio descended near the low readings of last October, which preceded the massive selling that followed. The second development is that the Rate of Change in the ratio (just above) began to rise last week from one of the lowest readings ever registered. This indicates a strong potential for the uptick in the Equity Put/Call ratio to gather momentum, and such a development would prove bearish for the market.
Lastly, the sharp drop in the overall daily Put/Call ratio was simultaneous with a drop in implied volatilities for options (the blue line). This isn't surprising, of course, as it followed the reduction in Put interest that earlier told us the market was likely to rally near to intermediate term. A fall in volatility, especially one as sharp as this, suggests that investors are again becoming complacent. This most recent fall slightly exceeded the reading made on October 9, 2007, just two days before the bear market decline in the Dow-Wilshire 5000 commenced. I mentioned earlier the factors we'll be looking at to help us determine whether or not the key March 17 lows are sustainable, and while it does remain possible for the stock market to dodge the bear for a little longer, these latest developments in the sentiment climate should nonetheless be regarded as red flags by investors.
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