A Retest Of The March Double Bottom Low Is Likely – Option Traders – Stay Short.

June 27, 2008
Author: Peter Stolcers, Founder of OneOption

Yesterday's reaction to the FOMC's decision was nasty. Since its peak in May, the market has broken through key support levels at SPY 138 and 132. We can now see that the rally that started in March was nothing more than a bounce. On a five-year chart, a head and shoulders formation is clearly visible. We have broken through the five-year up trend line and we have broken through the neck-line of the head and shoulders formation. Technically, the market is very weak and my bias has turned to bearish. Inflation is running rampant around the world and today we learn that Japan's core inflation (excluding food and energy) rose 1.5% in May. China and India are running at a 9% annual inflation rate. As prices rise, central banks around the world are tightening credit. The Fed realizes that global rates are on the rise and they know that they will have to follow suit if they don't want the dollar to get crushed. They also realize that another round of mortgage resets is hitting homeowners right now. Higher rates would cause even more foreclosures and waiting another two months will help borrowers. The bond market has already factored in a quarter-point rate hike in September and another quarter point in October. Next week, the ECB is expected to raise interest rates by a quarter-point. Overseas markets were hit hard overnight in sympathy with our decline. Every week I review long-term charts of foreign markets and with very few exceptions, all of them look weak. The global expansion that was supposed to carry us out of a recession looks like it is in jeopardy. European financial firm Fortis announced that they will take a $13 billion write-down. This morning, Merrill Lynch and AIG announced that they will each take another $5 billion in write-downs. The bad news keeps coming and the depth of this financial crisis is still not known. We do know that it can spread far beyond subprime mortgages if the job situation changes. Next week's holiday-shortened trading will focus on the Unemployment Report. Last month, the unemployment rate had its biggest spike in 22 years. Initial jobless claims have been creeping up each week and the four-week average now stands at 378,000. Continuing claims also continue to rise and they are at 3.14 million. Next week's economic releases include Chicago PMI, construction spending, ISM manufacturing, the ADP employment index, factory orders, ISM services and of course the Unemployment Report. After this week's decline, traders will error on the side of caution and they will sell ahead of Thursday's number. Second quarter earnings season is around the corner and I believe it will be the straw that breaks the camel’s back. Inflation is biting into profit margins and producers have not been able to pass rising costs on to customers. Global expansion had been fueling earnings and it will show signs of deterioration. This quarter's numbers might be in line, but the guidance will be very cautious. The market is in an oversold state and we are likely to see a short covering bounce. I would be surprised to see the SPY above 138 the rest of the summer. The SPY 133 level represents resistance and the market might not even have enough strength to push through it. For today, I believe the bulls will step back and wait. There is no reason for them to stick their neck out ahead of a weekend, especially when we are heading into a holiday next week. The selling pressure could continue on Monday and the retest of the double bottom is likely. That is only 25 S&P 500 futures points away. A bounce is likely to come from that level. I am bearish for at least the next three months and I will be shorting any rally. During the next few days, I will be taking profits on my short positions. Retail, restaurant, gaming, hotel, airline, defense and consumer goods are all favorite areas to short. I would stay away from the financials for the time being. They are very oversold and I believe a short covering rally could materialize. image

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