12 Month Chart, Daily Prices - NDX ZigZag

The risks in the derivatives markets are growing

The Wall Street Journal published an article on titled “Credit Derivatives And Their Risks Are On The Table” by Henny Sender.

In the article, Sender advised that the Fed was gathering the big Wall Street players to discuss the rising concerns about risk in what is known as the credit-derivatives markets.

Sender goes on to make the case that the clearing structure of the dealers and hedge funds is not keeping pace with the exploding growth in these complex financial instruments.

Confirmations of these trades are falling behind the growth of the trades and the paper is stacking up both at the dealers and the hedge funds.

Quoting Sender, “The spotty record of confirmations can become a risk management issue in times of turbulence.”

Bernie Schaeffer has another excellent article entitled “The Aftermath of Katrina: What’s Behind the Market’s ‘Resiliency‘?”

In that article Schaeffer points out what he believes to be the underlying support for the stock markets in the face of the July London bombings and hurricane Katrina. That “put support” involves the tenuous stability between naked put options sellers and stock-hedged put buyers.

I recommend that you go to his site and read the details for yourself, but suffice it to say that there is a substantial and growing dynamic between the put sellers and buyers.

This interaction can be mutually beneficial as long as the markets remain calm and oscillate only slightly above the major put support levels, those being 120 on the SPY (1200 on SPX) and 38 on the QQQQ.

I believe that the “oscillation dampening effect” of that ever increasing put support volume can be seen in the chart.

Mr. Schaeffer goes on to correctly advise that a stock market crash would be a low probability situation, but that low probability event is made more risky by the inevitable reactions by both the put sellers and put buyers which would result following a dramatic market break below put support.

In effect, much follow-on selling of stocks would occur to attempt to stem the waterfall losses.

The stability of the markets would be at risk once the selling starts. Mr. Schaeffer also points out that a lot of complacency has been built into the markets due to the limited market reactions to the London bombings and hurricane Katrina.

Options trading, credit and other derivatives must grow in scope because of the decreasing market volatility as observed in the chart below. The derivative spring gets wound even tighter as the options participants seek more profit in a market whose trends get “flatter”.

But what event would it take to shatter the fragile market support? It may not be any single event, but the sudden break in the levee resulting from the slow motion effect of rising energy prices and the coming recession.

The forensic evidence for the Market Listener may be this week’s dramatic plunges in the Philadelphia Fed and the Michigan Consumer Sentiment indexes.

The complacency will not last forever.

The Nasdaq Composite Chart
The Nasdaq Composite Chart

The Technical Outlook

All major indices are sitting on top of their 50 day moving averages (DMA’s). And these indices are also just above their rising 200 DMA’s. The simple technical picture is that the indexes are holding just above these widely respected moving averages.

The Dow Industrials is having the most difficulty in holding above both 50 and 200 DMA’s. Volume has been above average for the last 2 weeks, but we must throw out Friday’s peculiar upside volume which was the result of the S&P 500 re-weighting.

The Trend Following Compliance

The NDX was down a mere -0.52% on the week, but this downward momentum has strengthened the possibility that the next ZigZag leg will be a down leg.

The NDX continues in its relative underperformance as evidenced by the NDX/SPX ratio chart on the next page. The chart appears to be telling us that technology will lead the next trend leg lower.

A Cash signal was issued to subscribers on Wednesday and a Sell signal was confirmed on Thursday of this week. The following charts tend to support the fact that the next trend leg will be down.

The Sell signal was weak on Thursday and was further weakened by the upside performance of the markets on Friday. The Sell signal remains in place until we get stopped out.

12 Month Chart, Daily Prices - NDX ZigZag
12 Month Chart, Daily Prices – NDX ZigZag

Our Fault Tolerant Cash Safety Stop is calculated to be 30 points above the NDX close at 1599 or 1629. However, since the week’s highs were in the 1616 range, I would use that level as my exit since any close above that level would likely lead to higher highs and would negate the down trend channel.

Our Early Exit line and stop loss level will be 1616. Limit your losses at all costs! And let your profits run.

What is the risk assessment?

The downside market risk (probability of a sell-off) is dominated by geo-politics, oil transport/refining and the very vulnerable consumer. The University of Michigan Consumer Sentiment index (Sept. Prelim) fell dramatically this week from Augusts’ 89.1 to 76.9. The upside/downside risk next week will be in how the markets interpret the FOMC announcement on Tuesday Sep. 20.

Our Trading System – What The Numbers Are Telling Us

On Thursday the Sell signal was put into effect before the close. We have had several signal changes in the last two weeks. This volatility in the markets is likely indicative of a market top.

We will continue to use our faster chart model until the topping pattern resolves itself one way or another. Our optimized fast MACD parameters will lengthen if this rally extends into late September.

The daily stochastic has turned down from overbought territory flashing a sell sign. The Ultimate Oscillator never reached the overbought 70 level before turning down. The down trend has barely started and was somewhat corrected by the S&P re-weighting activity on Friday.

All indices participated in the abnormal flurry of buying and selling of the S&P components in the last two hours of the day. The trend picture will be given more clarity next week after we get the FOMC announcement behind us.

What about Bonds?

The 30 Year T-Bond yield chart is shown below. If you look at the big 2-year picture, how could you infer that the ten-year yield is saying anything about “rising inflation worries”? It just doesn’t show up in this chart yet.

What About Gold?

The big inflation monger this week was gold. Newmont Mining and $HUI Gold Bugs index were up nearly 9% on the week. Where is it going and how far can this rally take us?

The $HUI/GLD ratio chart suggests that we could get some more relative strength from the Gold Bugs before we get into uncharted territory.

M3 Money – As expected the Fed was pumping a lot of money into the system post-Katrina. The numbers were huge and may have contributed to some market support this week. How long can the Fed pour gasoline on the smoldering inflation coals without causing a flame that gets out of control?