Wedge Formation Signals A Breakout or Breakdown

February 19, 2008
Author: Peter Stolcers, Founder of OneOption

After an extended weekend, there are many crosscurrents that need to be navigated. Let's start with the financials. On the negative side, Credit Suisse took a $2.9 billion write-down connected with an overvaluation of assets. On the positive side, Barclays posted a solid number. Perhaps the biggest news came over the weekend when the UK nationalized troubled bank Northern Rock. That move put minds at ease, knowing that the possible collapse would not spread to other banks. Our government should make a similar move by shoring up mortgage and bond insurers. This act would do more for our market and consumer confidence than the interest rate cuts and tax rebate program combined. I don't like the fact that our government has to step in and clean up a mess that was created by financial corporations when they miss priced risk. However, I also don't want to see a financial collapse that could have been avoided. The financial sector has other crosscurrents as well. New York Governor Spitzer is giving Ambac five days to raise capital before he uses his power to strip the bond insurer of its municipal business. This company has painted itself into a corner and any capital will come at a very high price. We already know that Warren Buffett has a lowball bid in hand for the municipal bond portion of the business. Ambac scoffed at the offer. This crisis is coming to a head and it will be resolved soon one way or another. On a positive note, Deutsche Bank released good earnings last week and they did not have any additional subprime write-downs. Many CEOs have been fired and the write-downs have been aggressive. The "new guys" at the helm want to shine and they don't want any skeletons in the closet. They will be tempted to over exaggerate losses. On a completely different front, China reported a 7.1% inflation rate. The government wants to maintain its hawkish stance, but it is concerned that the economy might temporarily be slowing down due to extreme weather conditions. The country has been buried by the largest snowfall in 50 years. There are power outages in 17 of 21 provinces and transportation has come to a standstill. On the chart you can see that a wedge pattern has formed. This market is poised to either breakout or breakdown. I believe it will breakout. We have tested a relative support level above the capitulation low and the second rally is likely to take. Corporate earnings growth has come in at 11% if you strip out the financials. The fact that there are crosscurrents in the financial sector is a positive. A month ago, all news was negative. Tomorrow, the CPI will be released. A hot number could spell trouble. Wednesday afternoon, the FOMC minutes will be released and we will know the driving forces behind their 1.25% rate cut a few weeks ago. For now, I would favor the upside. However, I would make sure to use relatively tight stops since this market could swing either way. I have been telling you to get long agriculture, energy, mining and tech. You should have nice profits in all of those positions. Sell into this strength and pare back. image

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