Action-Reaction & Parameters of Interest

By Frank Barbera CMT. July 22, 2008

In today’s update, we touch simply on a few key elements of today’s market with an eye on setting up some ‘parameters of interest’ for the weeks ahead. It appears, given the large counter-trend rally in financials, that the stock market indices have made a material short term low ushering in a period of relative calm and stability likely over the next two to three weeks. While this may sound like a positive, this period of stability is likely to be much shorter than the period seen between March and May, and could be followed by a period of far more intense volatility heading into what is usually the worst months of the year in September and October.

In our view, we believe the upcoming presidential election will have zero positive, stabilizing effect on the equity markets. Instead, markets will continue to be ruled by the underlying economic and financial problems which are heavily entrenched and likely to get progressively worse. The façade of a bounce and a relative calm on this occasion is especially poorly supported.

Take a look at the action today in Wachovia (WB), where the company announced a staggering $8.66 billion dollar loss for the most recent quarter, a loss equivalent to $4.20 per share. In addition, WB notched $6.1 billion in write downs, cut the dividend by 87% from $.375 to $.05 and announced job lay offs of 6,350 workers, about 5% of the companies workforce. Loan loss provisions exploded by 3100% showing that management was entirely blindsided by the collapse in housing and mortgage related debt. Yet, the stock reaction opening down hard and then up big as Wall Street cheered the fact that WB will not be issuing more stock in order to raise additional capital is nothing less than a sick joke. With the stock ending up +3.25 at $16.43, a gain of 24.43%, what message is the market sending to management? That it did well? Or perhaps the message goes something like this: Wall Street to Bank Management: 'Well, we know you blew it royally, but now we understand that you understand that you blew it royally, and as a result, since you’re going to extract this extra pound of flesh from your workers by chopping heads (and not asking us for help), you have temporarily earned back our confidence and we reward you with a 25% stock gain…'

Is this sick or what? How on earth can a bank turn in such an utterly disastrous performance, and find Wall Street cheering their shares the very same day? Perhaps this is the proverbial ‘bad news’ bottom, eh? If it is, this is precisely the kind of warped mindset which helped create this entire mess in the first place.

However, in our view, in a case like Wachovia there is not a chance that with vanishing liquidity in the capital markets, especially for mortgage backed securities, that future quarters will contain anything but more explanations, and further large scale write-downs. The bulls jumping on board this ‘pipe-dream’ in today’s market are very likely in for a very sad outcome over time. Yet, in the short run, they certainly carried the day today, as the façade of hope has been once again incorrectly restored.

Above: Wachovia (WB) stages a bounce. Will the next big thing, be a sideways range?

Looking at the charts, in the case of Wachovia, we see a stock heading for a classic fibonacci retracement with $18.42 a perfect .618% retracement of the preceding down move. Given the violent upside action over the past few days, it is very clear that a huge short squeeze is underway. Upside momentum at the moment is very high and that probably means the stock will “hold up” into early August, with a lot of sideways volatility carrying prices in a fairly wide sideways range. However at some point, perhaps a few weeks down the line, after an initial sell off and after a second failing rally attempt, prices are likely to reverse once again and begin moving back down toward the lows. It is that next serious trend reversal where the news front will once again grow dim and where risk in the overall stock market will move to unprecedented heights.

A look around the banking sector still reveals many price gaps ‘open’ below the market. With the stock market as a whole up the last few days, the bulk of that strength has been the financials which have experienced this hugely outsized rally to the upside. However, it is highly doubtful that the financials have many more “UP” days like those just seen left within them. It has been a monumental bounce, and a monumental squeeze, but in the short run it will have likely come back up “too far, too fast.” While the precise form is impossible to know, our strong educated guess is that the next ‘Action-Reaction’ mechanism will be to correct the upside over-exuberance within the financials evident over these last few days, and certainly evident at today’s close with changes like: BAC up 13.45%, Citi +6.04%, Lehman up 10.64%, and Merrill up 10.33%. Granted it may be a few days before the upside momentum allows for a meaningful price decline to take root, but we are in a climate where from here on, high volatility is likely to beget only higher volatility.

Above: Bank America (BAC)

Above: Citicorp (C)

Thus, one of the parameters we will be watching for very closely in the weeks ahead is this: Do the financials start to swing sideways from here? Do we start to see some backing and filling patterns and at some point, some failing lower highs? At today’s close, we note that on a very preliminary basis, it looks like both the McClellan Oscillator and the Up to Down Volume Ratio (S/T) are both either back to fully overbought condition, or rapidly closing in on a fully overbought condition. This suggests that an exhaustion point could be close at hand over the next few days, where prices open higher and then close flat, or close lower. That type of downside reversal day appearing on a number of financial daily charts would be a strong indication that a climax short covering high may be in place. From there, prices then normally sell off, and then following a sell off, normally try to retest the highs with a failing rally.

Above: GST Banking and Financial Service Index with Daily McClellan Oscillator for Financial Sector.

Above: GST Banking and Financial Service Index with Daily Short Term Ratio of Up to Down Volume.

Above: Fannie Mae Hourly, - note huge swing from oversold to overbought at Point A, downside reversal to current price of $12.05 which could extend a bit further near term. Key to watch for, a failing rally to Point C and then a breakdown to lower lows below whatever low is left in this time period (Point B). At that point, a top is in place and retest of prior lows could come to the fore and with it a resumption of primary bear market.

A good example of what we may see exhibiting itself across the broader range of banking and financial shares is the trading pattern seen recently in the GSE’s. These seem to be leading the financial sector both up and down, with high volatility turns coming fast and furious. Just look at FNM, where the share price rocketed from a low of $6.82 on July 15th to a high of $18.48 on July 21st for a rally of 171% in four days. In the chart below, we highlight the downside reversal day which seems to have halted that rally seen on Monday of this week, July 21st. We also point out the sequence that was seen at the bottom, which was an upside reversal day on the 11th of July that was followed by a retest of the lows into July 15th, which in turn gave rise to the four day advance.

Over the next few days, it will interesting to see if FNM and/or FRE weaken a bit further and then stage a ‘retest’ of the highs advance, which ends up failing below the peaks seen on Monday the 21st. We try to illustrate this concept in the hourly chart above with a Point C failing rally on FNM potentially back up over $15 in the near term. To be sure, no guarantees in our OPINION, and certainly nothing that any sane person including ourselves would even consider trading on. Our point here is to see if a pattern begins to take shape in the world of financial stocks, wherein one by one, we see (a) strong rally (i.e. distribution) capped by downside reversal days followed by (b) a period of weakness followed by (c) a second rally phase that peaks below the first and then rolls over.

Above: Daily chart Fannie Mae (FNM) – the view from the Daily chart, note downside reversal day to right of center, and upside reversal day at the low, left of center. The upside reversal was followed by a test of the lows, and therefore, we would not be surprised to see downside reversal followed by a failing test of the highs.

Once this type pattern prevails on the charts for most financials, we can then start to assess how vulnerable the overall stock market could be to a resumption of its primary trend decline. In our work, Energy stocks are also a major consideration, and are currently lagging the rally. To this end, Energy may end up being the last group to experience a counter-trend bounce that would place them in the rear-guard which is their normal position.

For the time being, it is not yet clear that Oil prices have bottomed the recent decline, but they do appear to be getting rather close. In the case of the XOI, we must still allow for the possibility of one more stabbing move to the downside toward $1275 if Crude Oil decides to lunge toward the low $120 area. However, we suspect that if there is a final wash out in Crude Oil, that decline will be seen over the next few days, setting up the energy complex for a recovery rally starting toward the beginning of next week. In the case of the XOI, which is now a hefty percentage of the S&P, a multi-week recovery bounce back up toward the 1450 zone looks like it should have a pretty good chance. Once financials have turned down and any counter-trend rally in the Energy stocks is far along, we would be looking for the prospect of a more important short to medium term peak in the S&P and the growing prospect for an S&P breakdown to new multi-month lows. For the S&P the 1270 to 1280 level is medium term overhead resistance and it will be fascinating to see if both the financials and the energy stocks can self correct their prior declines with the S&P remaining below 1280 the entire time.

Above: XOI Index Daily with strong support at 1275-1300, a counter-trend rally in Energy is also likely

Above: GST Banking & Financial Services Index 10 years.

A final thought on the Financials comes from a long term view of the GST Banking and Financial Services Index, which with today is much closer to the underside of the 2002-2003 lows. In my view, these prior lows are likely to be very powerful overhead resistance suggesting that we should be within a day or two of the peak in the rally for Financials. Once Financials roll over, we may see Energy shares begin to recover and an offset will take place within the S&P with weakening financials price capping the S&P below 1280 notwithstanding a bounce in Energy shares. If all of this sounds a little too complex, relax; the market is in a sideways ‘time out’ phase, which is likely to run a few more weeks. In putting together this piece for today’s Wrap up, we wanted to put down on paper some background ideas which may be handy to refer back to within a few weeks time, perhaps in order to help position capital for the next move down in this still developing bear market.

That’s all for now,

Frank Barbera

© 2008 Frank Barbera

Contact Information

Frank Barbera CMT
Editor, Gold Stock Technician
PO Box 48072
Los Angeles, CA 90048
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