The Dollar, Weak Earnings Indicate a Top is Near For The S&P 500

Can we still look to the financials to guide us on market movements?

Earnings season is now upon us and so far the only major earnings component that has been released is the J.P. Morgan earnings report that came in Friday before the market opened. After the report was digested by the marketplace, prices fell dramatically.

While the charlatans in Washington try to sell the American public into believing that the U.S economy is starting to firm up, the underlying truth is that the recovery has been relatively week. If it were not for the massive liquidity injections provided by the Federal Reserve through multiple quantitative easing adjustments, risk assets would likely be priced significantly lower.

Inquiring minds combed through the data provided in the J.P. Morgan earnings release and a few major outcomes were placed front and center. Earnings disappointed overall due to a massive decline in investment banking activity. Investment banking profits represent a large portion of all of the major banks’ earnings.

On Friday the guys at Zero Hedge provided the following chart in its article titled, “Charting Disappearing Investment Banking Revenues And Profits, JPM Edition.” The chart below illustrates the massive decline in investment banking revenue:

To make the chart a bit easier to follow, the blue bars represent investment banking revenue. It is rather obvious that investment banking revenue is in free fall having dropped nearly 50% since the first quarter of 2011. In addition, I would point out the sharp declines in total net income (purple) and the massive decline in equity market revenue (green).

It is without question that the other major banks that have a large investment banking presence are likely to experience similar revenue losses. A significant reduction in investment banking gross revenue puts tremendous pressure on total bank revenues in this quarter and looking ahead.

I am of the opinion that major money-center banks like Bank of America and Citigroup are likely to experience similar revenue reductions. We will know for sure in the coming weeks as most of the large banks are set to report earnings in the near term. Clearly this expected reduction in overall revenue will likely have a major impact on the financial sector of the economy.

The financial complex is absolutely critical when looking at broad index returns. It is common knowledge that broad indexes such as the S&P 500 and the Dow Jones Industrial Average struggle to rally when the financial complex lags. The same can be said for the semiconductor sector as well.

Recently financials (XLF) and the semiconductor (SMH) sectors have worked considerably higher on relatively light volume. Both XLF and SMH are trading into major resistance and both are starting to show signs that they are nearing a potential top  The daily charts of XLF and SMH are shown below:

XLF Daily Chart

SMH Daily Chart

Both the XLF and SMH daily charts illustrate that a major top may be forming in both sectors. It is widely noted that if the financials and semiconductors are not showing strength in a rising market, a correction or major reversal may not be far away.

I have been writing about the potential for a major top to be forming for several weeks now and I find that I am not in the majority in this viewpoint. Recent sentiment and momentum in U.S. equities demonstrate that we are very overbought at this time. Retail investors are extremely bullish and the Volatility Index (VIX) is trading near recent lows.

I am unsure whether this is a major top that leads to strong selling pressure or whether a correction is a more likely outcome. What I do know is that tops are a process, not a singular event and at this point more and more evidence is supporting the viewpoint that equities may be getting tired and some profit taking is likely.

In addition to the lackluster price action in the charts above, earnings releases have been revised lower in the 4^th quarter of 2011. In fact almost 3.5 companies have announced earnings revisions to the downside for every company that has indicated a stable to rising earnings announcements. This type of scenario has not been present since the first quarter of 2008 which as we know was not exactly a great time frame to be looking to put cash into risk assets.

Furthermore, Goldman Sachs analysts came out with the following commentary, “While the 4^th Quarter is typically the strongest quarter for earnings, estimates have fallen 9% since the summer and are now below both realized 2^nd and 3^rd Quarter results.” Goldman Sachs is also expecting significant price pressure coming from a weak U.S. economy and the fears of a European recession in 2012. Overall, the estimates are far from bullish and are in fact quite concerning when looking at the current valuation of U.S. equities.

The impact that a stronger U.S. Dollar will have on domestic companies which are used to having a competitive advantage when looking at earnings due to currency adjustments could produce negative surprises. Typically positive earnings adjustments are likely to be revised to the downside as the U.S. Dollar has rallied sharply higher in light of the weakening Euro currency. The weekly chart of the U.S. Dollar Index is shown below:

The U.S. Dollar Index is consolidating directly beneath resistance which is generally seen as a bullish development. I expect a breakout over new highs is only a matter of time. It is unlikely that in the long term the U.S. Dollar can rally while stocks trade flat or work their way higher. While this is always possible, the likelihood of that scenario is unlikely due to earnings pressures that would occur if the Dollar pushes higher in the intermediate term.

In addition to the variety of above mentioned factors which could have a major impact on equity valuations, the S&P 500 Index is trading into major resistance. Unless the S&P 500 Index can work above the 1,325 area it is unlikely that a new bull market has begun.

If the S&P 500 Index manages to work above the 1,325 level then my analysis may be proven completely incorrect. However, right now the S&P 500 Index has a lot of overhead resistance at the 1,292, 1,300, and 1,310 price levels. The daily chart of the S&P 500 Index is shown below’

Ultimately we are coming into the final week for the January options contracts which are set to expire at the close of business this coming Friday. I would not be shocked to see some volatility late this week and potentially even higher prices for equities.

However, my expectation is that once the January expiration hangover is behind us, increased volatility and lower prices are likely ahead for U.S. equities. The earnings announcements this week will likely have a large impact on the price action. Heads up, risk is exceptionally high!

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Evidence Supports the Bears’ Case for the S&P 500

I am not one to discuss fundamentals or macro views, but this situation in Europe is beginning to morph into a media frenzy. Price action in the marketplace is changing rapidly in short periods of time based on the latest press releases coming from the Eurozone summit.

I cannot help but comment on the seemingly arbitrary actions coming from this high profile meeting. Nothing has happened that market participants were not already privy too. The European Union is going to strengthen their EFSF fund by levering it up roughly 4 : 1. I have yet to hear how exactly they plan on doing this, but this action was no surprise to anyone that has read an article about the sovereign debt crisis in the past month.

There was also discussion about backstopping European banks’ capital position. Since European banks are holding billions (Euros) of risky sovereign debt instruments, it would make sense that their capitalization is a primary concern of Eurozone leaders based on current fiscal conditions. I would argue that the banks should be well capitalized regardless of economic or fiscal conditions in order for a nation to have a strong, vibrant economy that has the potential to grow organically.

The final piece of this week’s political nonsense involves write-downs on Greek debt in the neighborhood of 50% – 60% in order to stabilize Greece’s debt to GDP ratio. Apparently Eurozone leaders want to structure the write down so as to avoid payouts by credit default swaps which act as insurance against default. How does a bond take a 50% – 60% valuation mark down without a creating an event that would trigger the payout of CDS swaps?

If a write down of that magnitude does not trigger the CDS swaps, then I would argue they are useless as a tool to hedge against the default risk carried by sovereign debt instruments. If the CDS swaps do not payout as projected by European politicians, the risk assumed by those purchasing government debt obligations around the world would be altered immediately.

The impact this might have on the future pricing of risk for government debt instruments could be extremely detrimental to their ability to raise funds in the private market. Additionally, the write downs would hurt European banks’ capital positions immediately. If the CDS swaps were to pay out, bank capital ratios would suffer as those who took on counter party risk would be forced to cover their obligations thereby straining capital positions even further potentially.

Price action today suggested that the equity markets approved of the package that European leaders were working on. However, the biggest push higher came when news was released that China was interested in purchasing high quality debt instruments as a means to help prop up poorly capitalized banks and sovereign nations in the Eurozone through an IMF facility.

The market did an immediate about face which saw the Dollar selloff while the S&P 500 rallied higher into the close reversing a great deal of Tuesday’s losses. Inquiring minds wish to know where we go from here? I would be lying if I said I knew for sure which direction Mr. Market favored, however that did not stop me from looking for possible clues.

It has been a while since I checked out the short-term momentum charts that are focused on the number of stocks in U.S. domestic equity markets that are trading above their 20 & 50 period moving averages. The charts below illustrate the current market momentum:

Equities Trading Above the 20 Period Moving Average

It is rather obvious that when we look at the number of stocks trading above their 20 period moving average that momentum is running quite high presently. This chart would indicate that in the short-term time frames equities are currently overbought.

Equities Trading Above the 50 Period Moving Average

A similar conclusion can be drawn when we look at the number of stocks trading above their 50 period moving averages. It is rather obvious at this point in time that in the short to intermediate term time frames, stocks are currently at overbought levels. This is not to say that stocks will not continue to work higher, but a pullback is becoming more and more likely.

Additional evidence that would support the possibility that a pullback is likely would be the  recent bottom being carved out in the price action of the U.S. Dollar Index. The U.S. Dollar has been under selling pressure since the beginning of October, but has recently started to show signs that it could be stabilizing and setting up to rally higher.

The daily chart of the U.S. Dollar Index is shown below:

The U.S. Dollar Index is sitting right at major support and is oversold based on historical price action. If the Dollar begins to push higher in coming days and weeks it is going to push equity prices considerably lower. Other risk assets such as gold, silver, and oil would also be negatively impacted by higher Dollar prices.

Members of my service know that I focus on several sectors to help give me a better idea about the broader equity markets. I regularly look at the financial sector (XLF), the Dow Jones Transportation Index (IYT), emerging markets (EEM), and the Russell 2000 Index (IWM) for clues about future price action in the S&P 500.

During my regular evening scan I noticed that all 4 sector/index ETF’s are trading at or near major overhead resistance. With the exception of the Dow Jones Transportation Index (IYT), the other 3 underlying assets have yet to breakout over their August 31^st highs. The significance of August 31^st is that is the date when the S&P 500 Index put in a major reversal right at the 1,230 price level before turning lower. It took nearly two months to regain the 1,230 level and its significance continues to hold sway.

The daily chart of IWM is shown below illustrating its failure to breakout over the August 31^st highs:

The chart above illustrates clearly that IWM has failed to breakout above the August 31^st highs. I am going to be watching IWM, XLF, & EEM closely in coming days to see if they are able to breakout similarly to the S&P 500. If they start to rollover, it will not be long before the S&P 500 likely follows suit.

Currently the underlying signals are arguing for lower prices in the short to intermediate term. While it is entirely possible that the S&P 500 rallies higher from here, it is without question that current market conditions are overbought in the short to intermediate terms.

Key sectors and indices are not showing follow through to the upside to help solidify the S&P 500′s recent break above the key 1,230 price level. Additionally, the U.S. Dollar Index is currently trading right at key support in addition to being oversold. At this time I am not playing the S&P 500 in either direction, but I will be watching the underlying price action in the U.S. Dollar Index closely. I will be watching for additional clues in the days ahead.

Market and headline risk is high presently.

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Chris Vermeulen & J.W. Jones

Is The SP 500 About to Stage a Multi Month Rally?

J.W. Jones of Options Trading Signals tells us where he sees this market headed...... 

The S&P 500 must have taken notice of the multitude of headlines coming at market participants and proceeded on a path of pure chaos. Since October 4th, the S&P 500 Index (SPX) managed to trade in a range that spanned from 1,074 to as high as 1,171 in 4 days. To put the past 4 days price action into perspective, the S&P 500 Index rallied 97 points or 9% in less than 96 hours.

Since late July, market participants have been dealing with a whipsaw that has been wrought with headline risk coming from Europe and huge swings in the price action of the volatility index. A few short days ago I was calling for a bounce higher in the SPX as every time frame was oversold. After the jobs number came out Friday morning domestic equities rallied sharply higher and in the short term prices were excessively overbought prompting some profit taking.

Around lunch time the news wires broke that Spain and Italy had their sovereign debt downgraded by Fitch Ratings. The downgrade put U.S. banks under pressure quickly and the price action started to rollover. By the end of the day price action was starting to work higher but a sharp selloff played out in the final 30 minutes of the session putting the major indices back into the red at the closing bell. So the real question that lies ahead is where do we go from here?

There is no easy answer to that question as the headline risk coming out of Europe over the weekend could have a dramatic impact on prices on Monday. Just as a reminder, U.S. bond markets will be closed on Monday for Columbus Day, but equities markets will be open as usual. At this point in time my short term bias is to the downside.

It would be healthy to see the S&P 500 roll over here and find a key support level where buyers step in and support prices. A higher low would be constructive and could lead to a more prolonged intermediate term rally which could last into the holiday season. However, before we can see any sort of rally we need to see a bottom form. While I do believe we have initiated that process, until I see a higher low carved out on the daily chart I will consider the current price structure to remain bearish.

In order to break to new lows, the SPX would have to push through several layers of support. I am of the opinion that we are unlikely to see the recent lows broken, but the chart below illustrates the key support levels going forward. A test of the 1,040 – 1,050 price range remains possible, but the price action the past week makes it seem less likely. Within the context of a hyper volatile period of time, just about any possible outcome remains feasible. The daily chart of the SPX below illustrates key support levels for the index:

In addition to the weak price action into the close on Friday, several other clues are pointing to potentially lower prices in the near future. Members of my service know that I focus daily on several underlying ETF’s which help me get a grasp of the overall market conditions. On Friday, the financials (XLF), the Dow Jones Transportation Index (IYT), and the Russell 2000 Index (IWM) all showed relative weakness against the S&P 500. The chart below illustrates the relative performance on Friday:

The financials and the Dow Jones Transportation Index are excellent sectors to monitor when trying to determine the future price action of the S&P 500. Most of the trading session on Friday the financials (XLF) were exhibiting relative weakness versus the S&P 500 Index. Later in the session, the Dow Jones Transportation Index (IYT) started to roll over as well and once both ETF’s were under pressure it was not long before the S&P 500 Index flipped the switch to the downside.

The financials (XLF), the Russell 2000 (IWM), and the Dow Jones Transports (IYT) all put in large reversal candlesticks on the daily chart by the close of business on Friday. This is an ominous signal that lower prices for domestic equities may be forthcoming. The fact that key sectors are showing signs of weakness is a negative omen for the S&P 500 and the early part of next week. However, there is a bright side to this scenario.

If support levels can hold up prices next week and we see a higher low on the daily chart form, the bottoming process could be underway which could lead to a strong rally into year end. Obviously a probe to new lows is possible, but I believe that we are in the beginning stages of forming a bottom and a base for a rally to take shape.

If support levels hold up prices, a bottoming formation will likely get carved out on the daily chart of the SPX. The chart below illustrates two potential outcomes that could cause prices to rally sharply. In one case, a higher low is formed and we see prices take off to the upside. The other scenario involves an intraday selloff down to the 1,040 – 1,050 price level that gets snapped back up and a huge reversal candlestick would be formed. These scenarios are common during bottoming processes. The daily chart of the S&P 500 Index is shown below with the two scenarios highlighted:

The other scenarios would involve prices blowing through support and possibly knifing down to test the S&P 500 1,000 – 1,008 support area. While I find this scenario to be less likely at this time, anything could happen in this trading environment.

The key in the short run is the utilization of defined risk through the use of stop orders. In addition, a trading plan with stop orders and profit taking levels planned ahead will help remove emotion in a volatile tape. The price action is wild, but from my perch the likely scenarios all involve some short term selling pressure. If my analysis is right, this could be a huge turning point for price action the rest of the year.

The next few weeks are going to provide us with clues about the rest of 2011. 

The question traders should really be asking is whether support will hold, or will we break below the recent lows? Right now, the upside looks limited, but in this trading environment the best thought out plans can turn out to be useless if price action does not cooperate. Be nimble and define your risk, as volatility is not likely to subside anytime soon.

Subscribers of OTS have pocketed more than 150% return in the past two months. If you’d like to stay ahead of the market using My Low Risk Option Strategies and Trades check out OTS at Options Trading Signals.com and take advantage of our free occasional trade ideas or a 66% coupon to sign up for daily market analysis, videos and Option Trades each week.

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Modern Music, Options, the SPX, the XLF and your Mood!

What could modern music, options, the SPX, the XLF and your Mood have in common? Let's have options guru J.W. Jones tell us......

Before getting into the broader markets, I thought it was pertinent to share with readers that recently I have noticed a trend in alternative music, also known as modern rock. As a fan of music in general, I have noticed that more modern and mainstream music is starting to underscore the deterioration in social mood. Mainstream songs are having a resoundingly similar lyrical undertone which outlines the “us against them”, “rich versus poor”, and the political class versus everyone else.

While I am not a sociologist nor do I have any real training in the area, the underlying tone in a lot of artistic mediums highlights the current chasm between the haves and the have nots. While some might argue that it does not matter, if you as a reader, trader, or investor believe in behavioral finance you might agree that social mood matters a great deal. After all, the entire premise of technical analysis is an attempt to quantify market participant behavior at specific price levels.

Social mood is but one catalyst that can have a dramatic impact in price discovery, and thus must at the very least be monitored. Current music trends are literally screaming loud and clear that the average American can relate to the undertones and messages of song lyrics with the same resounding tone as the Rise Against lyrics listed above. Believe me, it may not matter right now, but it will matter and when it does it will likely be too late for financial markets.

Now that I have my little rant out of the way, why don’t we take a look at where the S&P 500 has been, where it is now, and where it might be going. Currently price action in the S&P 500 is sitting on the edge of a fence. We could be looking at an intermediate bottom or it could end up being a bull trap. As for me, my recent prediction for lower prices has indeed come to pass, but from hereon I have no real idea where price action is headed. Mr. Market is leaving a few clues behind which I will outline, but anything is possible. We have seen stocks climb a wall of worry for nearly two years now so there is precedent for a rally from this current point of indecision.

The daily chart of the S&P 500 listed below illustrates key technical levels on the daily chart, however readers will notice that we are currently caught between a ton of overhead resistance and a key support level. Until we see price move in either direction with volume confirmation, I will be sitting on the sidelines.

Another key chart to consider is the SPX weekly chart. A quick glance at the slow stochastic readings at the bottom of the chart reveal that the S&P 500 might have additional downside left before the market is able to form a solid bottom. If that is true, we could see the SPX test the 200 period moving average on the daily chart which would be around the 1186 price level. Additionally, the 50 & 200 period moving averages on the weekly chart correspond with the 1180 price level which is likely not coincidental. The level also corresponds with key resistance areas going back to the November 2010 lows. While a downward move that large seems a bit extreme to me at this point, anything is possible.

As can be seen from the chart above, price action is currently sitting above the 20 period moving average on the weekly SPX chart. Key support levels are around the 1225 and 1180 price levels. I would also point out that a Fibonacci retracement of the recent pivot high to the recent pivot low gives us a possible 1.618 retracement around the 1190 price level. Additionally, the slow stochastic on the chart above is eerily similar to levels that were seen on the weekly chart back in May of 2010. Will price action work lower? Will the weekly slow stochastic reading kiss the 20 level?

At this point, a few of you might think I’m outlining the case for lower prices in the equity market. I honestly have no idea where price is going from here, I’m just outlining some key aspects that I have found in my analysis to the downside. The upside is just as likely and we could see the SPX price bounce off of the 20 period moving average on the weekly chart and a challenge of the recent highs could play out. Should recent highs give way to breakout, the SPX would likely test the 1,400 price level at some point in the future.

If we look at the VIX for any clues, all that can be seen from that chart is a spike higher and a subsequent selloff as fear and uncertainty leave the marketplace. The VIX is currently arguing for higher prices in equities, however the financials represented by XLF are the fly in the proverbial ointment. The banks were unable to attract a bid on Monday’s strong advance and they experienced additional selling pressure on Tuesday.

In fact, the XLF’s daily chart shown below reveals a key test and subsequent failure.

A quick look at the XLF daily chart and it is rather obvious that price action in XLF has been weak in the past two sessions. Price moved higher off of the recent lows, tested the 20 period moving average and rolled over. Price is currently below key support levels, but we could witness a reversal on Wednesday. I am going to be watching the financials (XLF) quite closely in coming days as I believe the banks will provide traders with clues as to which direction Mr. Market is favoring. Right now it would appear that Mr. Market is favoring lower prices, but that would seem a bit too easy from these eyes.

We could consolidate at these price levels for a period of time. The volume on Monday and Tuesday was light and we have non confirming signals showing up in a variety of underlying indices. I am unwilling to accept any directional risk at this point. I will let others do the heavy lifting while I sit safely in cash and watch the price action play out.

The price action will eventually give us a confirming signal as to which direction prices will be heading, but right now I believe the prudent thing to do is remain in cash and wait for Mr. Market to signal which direction he favors. We are either sitting at the beginning of a major move higher or we are at a precipice and prices are about to plunge. Either way, risk remains high and the risk/reward is simply not there to warrant an entry. As I have said many times, sometimes the best trade is no trade at all!

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