On a day when Marketwatch warns…

We first started this back on December 12, 2007.  From the NY Fed’s research publication Current Issues in Economics and Finance, Apr 23, 2010:

We took Euros and Swiss Francs and Japanese Yen and NZ Dollars that no one wanted and gave them US Dollars in exchange.  These central banks could loan these valuable greenbacks to their financial institutions who would (theoretically) lend them out to (theoretically) worthy borrowers — keeping liquidity alive and jumpstarting the economy.  It would also (theoretically) put a floor under the foreign currencies’ values and keep them viable in the global finance marketplace. 

Back then, financing had dried up because several large banks, investment banks and a hedge fund in insurance company clothing (AIG) had failed or were in the process of failing.  They were failing because of a newly developed but widely circulated idea that loans ought to be backed by adequate collateral.  Those that weren’t probably weren’t worth all that much.

Today, financing in the Euro zone has dried up because the Euro zone, itself, is in the process of failing.  Some foreign and Euro-based investors are convinced that making loans there is throwing good money after bad.  As I blogged a few days ago:

Deposits by financial institutions in Germany off 12% since Jan ’10, 24% since Sep ’08.  France, oddly, not as bad at 6% and 14%.  Italy off 1% in retail dep’s (serious money’s already gone), 13% ($100B) by financial insitutions.  In other words, banks don’t trust each other.

Fitch says US Money Market funds cut lending to Euro banks 20% in last 3 months (Germany-42%, French-18%, Spain and Italy 97%.)  At $1.5 Trillion, MMF’s are a vital source of funding. 

The ECB can’t make up for all that, but it’s trying.  Italy – EUR 85B in three months; Greek and Ireland – EUR 100B each in August; Portugal – EUR 46B in July; Spain – EUR 52B in July.  Total lending so far = 7X Euro zone central banks’ combined capital.

Total exposure in loans from other Euro countries to PIGS: $1.7 Trillion.  Lots more in guarantees and derivatives.  

Total swaps outstanding under the 2007 program peaked at $580 billion in December 2008.  At the time, this represented about 25% of the Fed’s total assets.  The program was officially terminated in February, 2010.  As the April 23 Fed article points out, market conditions had improved and financial strains had abated.

Two weeks later, on May 9, the Fed announced…

Apparently the system wasn’t quite ready to stop sucking the liquidity teat.  The ECB immediately drew down $5.5B, bumping that to $500B in both August and October 2010 and finally zeroing it out in March 2011.

All was fine until last month, when the Swiss National Bank unexpectedly drew down $200B.  It was followed the next week (Aug 24) by the ECB and another $500B.

Then, today’s news, and a 20-point SPX rally.  Is this really that great a development?  Let’s look at how both the dollar and the stock market performed following previous manipulations.

                                                                         SPX              DX

                       December 12, 2007                 1512              75.92
                       low/high next 3 days               1445              77.49
                       low/high next 35 days             1270              77.85

                        May 9, 2010                            1164              83.07
                        low/high next 3 day                1156              85.57
                        low/high next 30 days             1011              88.91

                        Aug 24, 2011                          1208              73.72
                        low/high next 3 day                1121              74.55
                        low/high next 35 days             1121              78.30
                                  (so far)

Bottom line, each intervention did diddly squat for stock investors.  Today’s rally isn’t justified. 

But, more importantly, we need to consider the more serious implications.  The Euro zone is obviously on life support.  The entire scheme is hanging by a thread, and we’ve been brought in to stitch it back together.  We, who just last month were in danger of defaulting on our own debt.

The Fed’s balance sheet, only $885 billion in Dec 2007, has ballooned to nearly $3 trillion.  And, every time we bail out another entity, whether it be Bank of America, General Motors or the ECB, we minimize the effect markets have on lending and borrowing and saving.  We impose a rationale which, in the long run, not only delays the inevitable but exponentially raises the stakes.

And, what happens when one of these sterling borrowers goes under?  The Fed article goes to great lengths to explain that we’re not taking crappy foreign loans as collateral.  No, we’re simply taking the currency backed by lenders who make the crappy foreign loans — loans that no lender in his right mind would make.  So much better, no?

The Fed Reserve article (published when the Fed thought the worst was behind us) details what happened the last time we did this. 

The McClellan Oscillator has been around for a while.  As Stockcharts.com says, it puts momentum in the AD line.  I first noticed a particular pattern while looking at the 2007 comparisons to 2011 in SPX.

In short, when the indicator bounces sharply higher after a distinct low, draw a trend line that connects the low to the subsequent dips.  When it breaks that trend line, there’s a pretty good chance we’re putting in a high.

It works best when the starting point is relatively low, say -200, the number of touches is 3 or more,  the shape of the indicator is very convex relative to the trend line, and the indicator makes it to +200 or so.

When each of these conditions is met, I’ve yet to see an instance where it didn’t result in a pretty healthy drop.

Here are a few examples from the past five years using COMP.

Dec 07

Nov & Dec 09

Jun 10

And, the latest examples…  Note the most recent case corresponds to the Aug 31 interim high.  The previous one belongs to the Jul 8 high, which I view as the beginning of the end of the latest bull market.

In both cases, the market high was quickly followed by another slightly lower high that registers as a (post-trend line break) lower peak on the MCO indicator.  It typically comes in at around 100.

Jul and Sep 2011

In many previous cases, it’s this second, lower high which marks the start of the most dramatic phase of the downturn.  It was certainly true in 2007 and in Jul 2011.

I’ve thrown a few other goodies in that last chart.  I’ve drawn in another way of looking at the downward sloping channel.  Beginning with the pattern high, it intersects with a horizontal support line which also happens to be the broken neckline for the gigantic head & shoulders pattern that just played out.

Here’s the view from 20,000 feet.  Note that the three upward sloping TL’s are actually fan lines originating at the Mar 09 lows.  The old adage with fan lines is “three strikes and you’re out” which means, the next drop below a fan line will be the most memorable.

Fan Lines

So, where does SPX stand with all this?

Should be a memorable next few days.

UPDATE: EOD

The Euro Mess is getting out of hand…

Deposits by financial institutions in Germany off 12% since Jan ’10, 24% since Sep ’08.  France, oddly, not as bad at 6% and 14%.  Italy off 1% in retail dep’s (serious money’s already gone), 13% ($100B) by financial insitutions.  In other words, banks don’t trust each other.

Fitch says US Money Market funds cut lending to Euro banks 20% in last 3 months (Germany-42%, French-18%, Spain and Italy 97%.)  At $1.5 Trillion, MMF’s are a vital source of funding. 

The ECB can’t make up for all that, but it’s trying.  Italy – EUR 85B in three months; Greek and Ireland – EUR 100B each in August; Portugal – EUR 46B in July; Spain – EUR 52B in July.  Total lending so far = 7X Euro zone central banks’ combined capital.

Total exposure in loans from other Euro countries to PIGS: $1.7 Trillion.  Lots more in guarantees and derivatives. 

UPDATE:  4:05 PM

Whew!  That was close, but we closed at 1188.67 — safely back within the descending channel.  So, today’s action will go down as a shadow — a reversal at just past the .886 Fib level.  Importantly, it leaves the completed H&S; pattern intact (or, we might get a new, larger one in the bargain.)

We did get a slight bump up in the MACD, but the same happened on July 22.  The daily RSI trend line is intact, and MCO reached a new intra-day high today — an important indicator that I’ll hopefully have time to touch on later.

EOD for DX, with a reversal right at the lower Fib level.  Keep an eye on news out of Euro zone through the night.

UPDATE:  3:55 PM

DX reversed where we thought it would, started the SPX reversal.  Spitting distance from 1190…

UPDATE:  3:20 PM

We’ve overshot the .886 Fib level by a couple of points at 1198.63.  It just happens to coincide with the descending channel line if redrawn to include the shadows from the Aug 31 and Sep 1 candles.  Will today’s runup be a shadow?  We have about 40 minutes to get back below 1190.

UPDATE:  3:00 PM

Check out DX.  It’s working on a giant Bat pattern and recently stalled at the .618 level on its way to Point D at .  Since then, it’s traced out a bullish flag, and is now within a heartbeat of the .50 level, which could very well signal the end of the retracement.

Here’s a closeup.

And, an even better look.

In a perfect world, the bounce off the .50 level will coincide with the SPX’s touch of the .886 Fib at 1196.61.

UPDATE:  1:55 PM 

We got the gap fill, and then some.  Don’ t be alarmed, as this is probably an overshoot — much better punctuation for the move ahead.  Look at Aug 31 and Sep 1 for recent examples.

The .786 Fib is at 1189.78 and makes a great turning point from a harmonic standpoint.  Even better, assuming this is a Bat pattern, is the .886 at 1196.61. 

UPDATE:  1:15 PM

Moment of truth… I think it’s really cool that the rising wedge apex, gap fill and regression channel midline are all within .50 of each other.  The descending channel could be right there, too; hard to draw it with absolute precision.

Take a look at the midline’s performance over the past several weeks.

UPDATE:  11:35 AM

This is the hardest part of calling every top, watching the backtest of the rising wedge.  In this case, it could go up and close the gap at around 1184 as mentioned below.  But, it doesn’t need to.

Here’s the 60-min chart:

And, the 5-minute:

The regression channel has been updated.  The midline looks to be right where the gap fill is:  1183.4.

UPDATE:  10:55 AM

I won’t be surprised if we take one last stab at 1184 to close the gap and complete a better looking wave count.  Also marks the SMA 10.

UPDATE:  10:00 AM

The McClellan Oscillator just flashed my favorite crash signal — the same as July 22, 2011 (but better) and December 26, 2007.  It’s the dotted yellow line in the bottom study.

Here’s the same indicator on December 26, 2007.

The only question is whether the market makers can keep things afloat through OPEX this Friday.  I think they let it peak a little early, which in itself is an indication of the downside pressure baked into this market.

Here’s an updated close up of the daily chart:

And, the five-minute chart, with the requisite other-shoe-dropping divergence.

ORIGINAL POST:  9:30 AM

While we’re waiting for the other shoe to drop, here are my leading candidates for the turn.

•  regression channel midline: 1181

• 10-day moving average:  1184

• gap fill from Sep 8:  1183.34

• .618 Fib level:  1178

• .786 Fib level: 1189

• inverse H&S; target: 1181

• descending channel boundary:1185

Take your pick, but I’m thinking 1181-1184 ought to do it.

UPDATE:  2:15 PM

Checking in on our regression channel and requisite rising wedge (the exclamation point!)  So far, so good.   Looks like we should get to 1182 – 1188 before the fun starts.

We should expect to see more divergence on the 5-min RSI and possibly the histogram soon.

UPDATE:  12:45 PM

Euro got a little bounce from Merkel’s interview this afternoon:

I see… we have nothing to fear but acknowledgement of the bloody, horrid reality itself.

Geithner is even taking the unprecedented step of attending Friday’s meeting of the EU finance ministers in Poland… ’cause nothing settles nerves like a guy who arranges train wrecks racing to the scene of the next train wreck.

Meanwhile, has anyone checked in with the people of Greece?  Last I heard, they had no interest in yet more austerity so that the world’s bankers can limit their losses.  I’ll say it again, the 2007-2009 crash (will we call it the mini-crash?) was the result of several failed companies.  This time, we’re talking countries.

I remember something from a psychology class I once took.  Kubler-Ross, the five stages of grief.   I think it was: (1) denial, (2) anger, (3) bargaining… then… what was that next one?

Oh, yeah.  Depression.

UPDATE:  12:15 PM

Little H&S; just completed on the 5-min chart… calls for a return to 1146-ish.

UPDATE:  11:30 AM

A closer look at the dollar…   DX has traced out three points of a perfectly formed Bat pattern, which calls for an 88.6% retrace from the top.  The bullish flag we’ve formed over the past couple of days is right at the .618 level.   Our target is 80.635. 

That might seem high, given how quickly DX has risen to its present height and the fact that its RSI looks overbought already.  But, consider what happened the last time the stock market fell apart:

And, back then, the EUR was considered a great alternative to a sketchy dollar.

UPDATE:  10:30 AM

The daily RSI is drawing closer to the trend line that signals ongoing divergence.  The next touch should mark the end of this rally, although it’s possible we’ll stop short.  Also, note we’ve stalled at the SMA 20 at 1176 (the SMA 10 is at 1188, @ the upper channel line.)  And, the histogram is also showing divergence — with a 4th shorter bar in a row to go with the two-day rally.

The 60 minute RSI has hit its TL and is working on a nice reversal candle.   I think the rally is either over here or we might go up and tag 1188 first.  Either way, the jig is just about up.

ORIGINAL POST:  9:00AM

I’m watching credit and currency markets this morning.  Italy just auctioned EUR 6.5 billion at 5.60%, an all-time high since the Euro’s introduction.  Bid to cover was a wretched 1.279.

Hopes that China would come to the Euro’s rescue appear unfounded.  And, French banks continue to hit the windshield at high speed: asset sales all around, BNP rumored to draw no bids from money market funds, and Moody’s downgrades on the way.

Meanwhile, the dollar has traced out a bullish flag, to go with EUR’s bear flag:

UPDATE:  3:00 PM

Had a little more time to study this…   It’s open to interpretation, but here’s what I’m seeing.  I’ve stacked the Feb – May 2011 top over this 5 week consolidation and compared them point by point.

There are a few discrepancies, but nothing that concerns me too much. 

The biggest question is whether the channel down from Jul 22 should include the upper shadows from Aug 31 and Sep 1.  If not, then Point 8 — when contained by the channel — will land around the regression channel midline at, say 1185.

If we include the shadows in drawing the channel, then Point 8 would be a little beyond the midline, at around 1200.  In many past topping patterns such as 2001, the midline defines Point 8.  In 2007 and 2011, however, the market overshot the midline.  I suggest it will be largely a function of the momentum we have going once the reversal occurs.

Speaking of reversals, note that this little drama — which will no doubt draw a huge amount of attention due to its being “completely unexpected” — will fall short of the the Sep 8 high at 1204. This is significant, as once we reverse off Point 8, the subsequent drop will complete a new, larger H&S; pattern that points toward 1016.

And, the kicker — the Butterfly pattern we’ve been watching.  The 1.618 extension is only a few points away at 1021.

UPDATE:  11:30 AM

I’m intrigued by the idea of the consolidation action we’ve seen since Aug 9 playing out as a fractal of the larger topping pattern from Feb 18 – July 22.  First, a look back:

 

ORIGINAL POST:  9:30 AM

Global markets off, with the SPX plunging below Fan Line C as we discussed Friday.  The H&S; pattern has been completed, and we’re well on our way to point D on the large Butterfly pattern.

We should see a backtest of Fan Line C, as the futures did yesterday.  And, there’s the possibility that we’ll head back up for another test of the channel, but the next move of any substance is the mid-1000’s.

POSTED:  2:40 PM

This little pause brought to you by Fan Line C.   Don’t worry, RSI and MCO promise plenty more downside to come.

The H&S; completion is up ahead at around 1146.

You can’t make this stuff up.

Seriously, it’s got all the elements of a Hollywood drama.    From today’s WSJ:

Jürgen Stark, chief economist (and chief hawk) of the ECB, just quit over the ECB’s decision to ramp up their version of QE.  It leaves three Italians on the governing council versus only one German.

That’s like putting the former head of Halliburton in charge of military purchases or the CEO of JP Morgan on the Board doling out TARP money, or…. you get the point.

The ECB’s continued existence depends on the Germans.  As Germans everywhere are wondering why they should be doling out their (sagging) Euros to their spendthrift cousins, this is one of those important plot twists.

If Trichet insists on whipping out the debt bazooka to battle what’s clearly an issue of too much debt already, Stark’s defection might end up looking like a fractal for the ECB itself.

Thank God we have no such problems here in the US, right Ben?

Bears have been amply rewarded by the large H&S; pattern that completed in early August.  The new ones now shaping up will make that one look puny by comparison.

Pure speculation, but if the H&S; and Butterfly patterns play out on the daily chart [The Big Picture] we would complete a larger H&S; pattern.  The initial target would be 820, but along the way we’d create a new neckline indicating 743.  Seen here on the weekly chart…

Also, note how clearly the wave count is laid out on the weekly RSI.

I took the day off from tree-watching to develop a better view of the forest.  Here’s what I came up with.

First, recall that harmonic patterns are what brought us to this point in time.  They occur on a regular basis, and are believed to play out successfully about 70% of the time.  Here’s one of the first ones I posted about last May, a Gartley pattern that came within 1.5% of predicting the 2011 pattern high.  It called for 1381, and we topped out at 1370.

Some investors are mystified by harmonic patterns.  But, they’re really just a series of failed breakouts that retrace at Fibonacci levels.  Prices start with a move from a turning point called X to another turning point called A.  From A, prices attempt to retrace the just completed move, but fail — typically making up only 38.2% to 88.6% of the distance.  This is point B.

Prices then reverse again, trying to retrace the just completed move.  Again, they fail, only retracing 38.2% to 88.6% of the distance — our point C.  Here, they reverse again and try to get back to the starting point X.  In some harmonic patterns, such as Gartley and Bat patterns, they fall short — retracing only 78.6% to 88.6% of the original XA leg.

In others, namely the Butterfly and Crab, they zip past X and establish D at an extension of the BC and/or XA leg.  The retracement that establishes B typically tells us whether we’ll stop short of or extend beyond X.

When they reach point D, harmonic patterns reverse.  Here’s an updated look at that first Gartley from May.  Note how prices reversed at the .786 Fibonacci retracement, falling first to the .50 level before rebounding to the .618 level at 1230 on Aug 31.

The primary target for a Gartley pattern is the .618 retracement of the AD measurement.  In the case of SPX, that means 935.  Gartley’s don’t always reach their targets, and many traders just play the reversal and grab a few points without worrying about the long term targets.  But, for forecasting purposes, we assume the .618 retracement unless other factors come along and exert greater influence.

It’s always helpful to have confirmation, such as trend lines, other harmonic patterns, technical indicators, chart patterns, candles, correlated instruments and even fundamentals.  In the case of SPX, we have many.  Let’s start with Fan Lines.

Fan lines are nothing more than trend lines drawn between important turning points (highs and lows) in price.  They’re pretty easy to see from looking at a chart.  For SPX, some of the most important emanate from the Oct 2007 high of 1576, intersecting with important turning points over the last year or two.  I’ve labeled them on the above chart with letters A-G.

Like all trend lines, they often go on to influence future price movements.  Fan line B started off as a trend line connecting the opening prices on October 11 and 15, 2007.  It then remained irrelevant until early January 2011, when it influenced several days in a row.  Then, on Mar 16, it halted a 90-point slide from the Feb 18 high.

In so doing, it achieved elevated status — a potential influencer of future price movements.  It played such a role on Aug 31, putting a lid on a powerful 130-point advance.   Because it stopped both a powerful decline in March and an even more powerful advance in August, it joins the fan line Hall of Fame — and it hasn’t even retired yet.

The best fan lines mark major “steps” in price action.  In declines, they serve as support to a certain point; then, when prices finally push below them, they serve as resistance.  In price advances, the order is reversed.   Fan lines 1, 4 and D are great examples — along with B, of course.

I’m always very interested in intersections of important fan lines, as they frequently mark major turning points.  Fan lines 4 and D intersected on Aug 31 at what was also: (1) a trend line from horizontal support (from 3 years ago, no less); (2) a trend line from the Feb 18 high; (3) a trend line from the Jul and Aug 2010 lows (#4); and,  (5) a channel from the July highs.  A five-way intersection draws my attention every time — especially when it’s confirmed by other elements.

Let’s assume for the moment that Aug 31 marked an interim high at 1230.  What kind of confirmation might we have?  For starters, the channel SPX has followed since the July highs passed through the closing price of 1219 on Aug 31.  Tomorrow, Sep 8, it passes through 1200 or so.

We’ve also established four of the five necessary points for a Butterfly pattern, with Aug 31’s 1230 high being point A and today’s 1199 high very close to a perfect point C.  Point B was a .786 retracement.  At 1203, C would be a .707 retracement.  The final point D would optimally be a 1.618 extension of AB, or 1056; although, a 1.272 extension at 1091 would also be acceptable.

It’s pretty obvious that a Butterfly point C at 1199-1203 would also serve as a great right shoulder in a Head & Shoulder Pattern.  Depending on where it crosses the neckline, such a pattern would have a target of around 1053 — almost identical to the 1056 Butterfly target.

Zooming out, we can see that both the 1053 and 1056 targets remain within the falling channel.  In fact, they are located right at the intersection of the channel, fan line E and horizontal support at 1056.  That’s three fan/trend lines combined with a Butterfly and H&S; target — another one of those nifty intersections.

While we’re at it, it’s worth mentioning a potential falling wedge setting up on the daily chart.  It terminates in 1030 area; though, we usually don’t reach all the way to the apex before a breakout.

Of course, if we do head down towards 1056, we’ll complete a very large H&S; pattern that indicates a downside of 820.  The neckline is essentially trend line #5.  This target, even lower than the Gartley target of 935 mentioned above, is completely consistent with my view that we’ll break 666 within the next six months.

A couple more things… I find it interesting that we’ve reached the vicinity of the downward sloping trend line on the daily RSI, and other technical indicators are possibly turning negative.  The daily histogram looks to be setting up for a lower high, while the 60-min is pretty clearly topping.  The put-call ratio and bullish percentage might also be rolling over.  While many of these indicators could still go either way, they appear to be on the cusp of a change, indicating a coming reversal.

If we break out of the channel, the short term bearish case gets a little dicey.  But, it all depends on where we close for the day.  Although the Butterfly looks fine with point C at the .707 Fib level, it would work just as well with a high of 1210 (the .786 level.)  So, again, we’ll see if we can close at or below the channel upper bound.  We’re in a very ripe bear flag pattern, and it should play out in the next day or two.

We appear to be finishing wave 2 of 5 of 1 down.  If so, wave 3 down should be more powerful than what we’ve experienced thus far.  If we clear the channel, it will likely mean we’re in wave 4 of 1 down, with a 5 of 5 to come.

UPDATE:  3:55 PM

SPX bumping that internal trendline.  Taking the rebound back as far as it can go without breaking the channel.  I’ll call today a draw.  Apparently both bulls and bears unwilling to extend themselves with so much at stake from Eurozone tomorrow.

UPDATE:  2:35 PM

The dollar continues to soar.  DX is up .737 at 75.906 and is closing in on the 200-day moving average at 76.504.   The last time DX approached the 200 SMA, it reversed hard, dropping 2.18 (2.8%) in two days and 3.57 (4.6%) in two weeks.

While I expect it to offer resistance again, we should retrace no further than a backtest of the falling wedge.  To fall further would require a complete turnaround in the Euro’s prospects, not very likely given the disastrous German legal situation.

SPX is locked in a channel and trying to complete a backtest of its would-be triangle.  If it can hold here at 1164, we should see much greater downside.

UPDATE:  10:40 AM

With the CHF rug pulled out from under them, gold’s one of the only games left for USD bears.  Cue the CME margin increase.

UPDATE:  10:20 AM

The ISM services numbers are just out, and on the surface look pretty positive at 53.3, up from 52.7 in July.

But, there’s significant weakness when you dig beneath the surface.  Most of the apparent increase comes from rising prices (double-edged sword, TSTL) and from rising exports (not so reliable in a rising USD environment.)  The “core” measures, business activity/production and employment both declined.

As we discussed with the manufacturing report last week, rising prices are great when there’s an expanding economy and increasing real income to apply toward purchases.  But, in a contracting economy with declining real income, increasing prices are a serious warning sign.

To QE fans everywhere, they underscore the serious inflationary issues that accompany the practice of pumping more cash into the economy.

UPDATE:  9:00 AM

Yesterday’s action in the European equities markets had the feel of a serious crack opening up underfoot.

In 2007/8, we had a nearly 2/3 drop in the SPX when a number of important companies failed (Lehman, AIG, Bear.)   Now, as we contemplate failing countries instead of companies,  we have to assume the downside is at least as great.

If the cash market follows the futures’ lead, it will complete another leg in a large, rather obvious bearish flag pattern.

The weekly chart also speaks volumes:

ORIGINAL POST:  10:30 PM

The dollar has broken convincingly out of its falling wedge, courtesy of the SNB’s decision to devalue the Franc by fixing it to the Euro.  We should expect a backtest at some point, but we’re off to a good start.

Meanwhile, follow-through to Friday’s weak equities markets in the futures…

The focus will be on the continuing crisis in the Eurozone (with an important German court decision due Wednesday morning), Tuesday’s ISM services report and Thursday’s employment numbers.