Daily Form July 27, 2007

Profit Patterns and Risk Management For Active Traders
Trade successfully without having to be right about the underlying market direction
FRIDAY JULY 27, 2007       06:46 ET

Looking through the charts this morning there are so many that deserve attention. In Wednesday’s column we looked at several that had violated key trend lines and following yesterday’s panic selling the ones that had avoided breaching critical levels have now joined the fray. The Nasdaq Composite (^IXIC) had held up better than the other indices until yesterday. As can be seen the index in just one session has now closed definitively below its upward trendline since March and the 50 day EMA.

One of the very few charts that is still not in this category is for the subset of the 100 largest companies in the Nasdaq (^NDX).

The main focus in the markets at the moment is the health of the financial economy and the possibility that many banks and financial institutions may be exposed to far more risk in their holdings of securitized assets than they thought (or understand!). Whether the big tech names can offer a safe harbour for fund managers that are drastically re-allocating their funds away from the more financially exposed sectors is one of many enigmas in the current market environment.

As often commented on before the Russell 2000 (^RUT) has been in the vanguard of the indicators that pointed to the impending weakness for the broader market. The break below 820 earlier in the week clearly revealed the rupturing of the bullish dynamics that had enabled the market to recover so nimbly from the late February sell-off.

Yesterday’s continuation of Tuesday’s downthrust brought the index through the 200 day EMA without any evidence of support. Some kind of bounce may well appear in today’s session but if the avalanche resumes perhaps the March lows near 760 will become the next level where buyers should be expected to appear.

One of the more remarkable changes that has been happening somewhat below the radar screen because of the turbulence in the equity market environment is the way that the Treasury market has pulled back from the peak in yields in early June. After peeking above 5.3% on June 13th the yield on the ten year note has now retreated by more than 50 basis points.

Yesterday’s surge in bond prices had a lot to do with a "flight to safety" and that may propel yields even lower but at some point Treasury traders will have return to the other factors that could be less benign for declining yields such a the continuing move up in the price of crude and the diversification posture of foreign governments towards becoming too exposed to dollar denominated assets.

One of the reasons why I focus so often on the ^XBD index (the broker/dealer index) is that it provides an insight into the financial economy. More than ever the global equity markets are best gauged by the underlying health of the financial system - the appetite for risk as expressed in credit spreads, the liquidity in the derivatives markets and the vitality of the hedge fund and private equity businesses. The investment banks have been suffering more than most during the recent turmoil and many of them have headed back towards their lows that were experienced during the last major episode of financial contagion in May/June of 2006.

Earlier in the week I showed a monthly chart of the mainstream banking sector ^BKX which even then was showing a clear breach of the uptrend through the lows since March 2003. (Yesterday’s market downthrust ratcheted the ^BKX down another, rather extraordinary, 5.6%).

At present the investment banking sector is not in a similar position of breaking below the trend since 2003 but, as the chart below reveals, the index has for the first time in four years come down to and appears to be likely to break below the 20 month EMA.

I cannot make up my mind whether to take some consolation in this fact as the investment banks, that are further up the value chain as innovators of the complex financial engineering products that have become ubiquitous in the financial economy, should perhaps be more exposed to derivatives than the mainstream banks. But on the other hand the money center banks are more connected to the Main Street economy and their current plight is perhaps more ominous in exposing the extent to which the whole economy is vulnerable to the fallout from synthetic loan blow ups and further unwinding of the carry trade etc.


The patterns identified below should be considered as indicative of eventual price direction in forthcoming trading sessions. None of these setups should be seen as specifically opportune for the current trading session.
For full details on time horizons, risk management and hedging techniques please visit http://www.tradewithform.com


The financial services sector fund (XLF) would have provided one of the best vehicles for playing the short side over the last few weeks as the banks and financial services sector has seen a mass exodus.

It is probably time to take profit if you have been smart enough to be on the short side since the series of lower highs were a classic sell signal. The short covering and inevitable bargain hunting that will be much trumpeted by some analysts and brokers in coming weeks should be seen as providing a good opportunity to re-establish short positions towards the end of the summer/early fall.

SONS  Sonus Networks Inc.  

A week ago I suggested that Sonus (SONS) looked good on the short side as the descending wedge formation appeared close to a breakdown. Even in the context of yesterday’s major sell-off the 16.5% drop would have provided a very nice return.

XLY  SPDR Consumer Discretionary Sector  

The continuing erosion of real estate values is going to affect the health of the consumer sector and the drops in XLY, the consumer discretionary sector fund are a further reminder of the true interface between the financial economy and the real economy - the purchasing power (nowadays largely influenced by the availability of credit and the ability to "release" home equity) and confidence of the consumer sector.

LEH  Lehman Brothers Holdings Inc.  

Amongst the investment banks, several are approaching the lows that extend back to the summer of 2006. Lehman Brothers (LEH), Bear Stearns (BSC) and Merrill Lynch (MER) are all candidates for a bounce at this level. Goldman Sachs (GS), as is often the case, is showing relative strength and may not need to revisit the equivalent level before it finds some support.

If the banks in general and the investment banks in particular don’t bounce soon the Fed will have to polish off its market rescue manuals and rehearse all of those speeches about the strength of the underlying market fundamentals etc.