The Gilmo Report

August 7, 2011

August 7, 2011

What did the market know, and when did it know it? By Friday night the answer to the first part of this question came forth when Standard & Poor’s announced that they had lowered the U.S. debt-rating from AAA to AA+ for the first time since such ratings have been in existence. Thursday’s surprising 512 point slide in the Dow, its 10th highest point drop ever, likely provides the answer to the second part of the question, Thus the issue of “forced selling” in response to what were at first hints and rumours put stocks, commodities and most other asset classes, including commodities, in a precarious state. On Wednesday, after the market had been down 8-9 days in a very steep, brutal sell-off, it appeared that a high-volume reversal to the upside might spark at least a 1-2 day rally, but this was not to be. Friday’s jobs number came in higher than expected, and this sparked a big futures rally on the open that, like Monday’s big futures gap-up when a debt-ceiling deal was announced, immediately fizzled out and reversed to the downside. Volatility was the order of the day, and the CBOE Volatility Index ($VIX), shown below on a daily chart, spiked as the market veered deep into the red, down over 200 Dow points, and then back up into positive territory, up over 100 Dow points, rolled over again in the last hour, and finally closed 60.93 points higher (on the Dow) by the closing bell. An exhausting day for the general market indexes!

CBOE Volatility Index ($VIX) Gilmo Report Chart

While the Dow closed up 0.54% on the day, the NASDAQ Composite Index, shown below on a daily chart, did not fare as well, closing down just under 1% at -0.94% on very heavy volume. The NASDAQ did find logical support at the 2500 level, as I’ve highlighted on the chart below, but resistance is now at the 2600 level, so any rally up to that level might become potentially shortable. Given that this report will go to press long before the futures open on Sunday at 6:00 p.m. Eastern time, I can only speculate as to how the market will react to the downgrade news on Monday morning. The wild card is trying to figure out to what extent the “AA+ news” is already discounted in the market based on the incredibly steep 12% break off the peak. Even if we get some sort of rally from these levels, assuming all the bad news is “in,” I can’t see the NASDAQ getting back above the 2600 level which is likely to provide material resistance on the upside given the severe technical damage this market has suffered so far over the past two weeks. Right now, cash is king, as I do not believe one can simply hop onto the short side here. Volatility is likely to remain very high here, either way the market moves, which makes anything but a short-term day trade, long or short, fraught with danger.

NASDAQ Composite Index Gilmo Report Chart

Like the NASDAQ, the S&P 500, shown below on a daily chart, bounced off its own logical support at around the 1180 price zone to close in “no-man’s land” between there and upside resistance at around the 1260 level. Friday’s action might have offered some capitulation selling, but the situation here is far too dire and dynamic to make any assumptions. Certainly, the market would be fully entitled to a reaction rally given its extreme oversold condition, but like the breaks of late 2008, and the Octobers of 1998 and 1987, extreme oversold conditions coming into play so quickly can simply be a forebearer of even worse selling to come. This recent market break is much worse than anything we’ve seen since last summer, and the odds would favor continued corrective action, with the possibility of an outright bear market phase developing given the amount of technical damage that has been done. There is absolutely no way to get bullish here without first seeing a bottom and rally attempt of at least three days, if we are using follow-through day rules as our guide, and right now that seems to be quite a stretch as far as I can see. In my view, the best profit opportunity will come once we do see a shortable rally come into view, so all we can do is see how things play out this coming week.

S&P 500 Gilmo Report Chart

If we do get any kind of a bounce here, whether that occurs Monday or later in the week, I would expect it to be similar to the bounce that the market experienced right after its extremely sharp break off the peak in late April/early May of last year, as we see on the daily chart of the S&P 500 Index from that period of late spring into summer of 2010. Despite the sharp bounce, the market ran into logical resistance at the 50-day moving average and promptly rolled over on its way to lower lows and an eventual and final bottom in early July 2010. At best, I believe we are looking at a correction of last summer’s duration and magnitude, but at worst I think we could be staring a serious bear phase that carries well into fall. To a large extent I think it depends on where the “AA+ news,” and other sovereign debt issues around the globe take this concept of “forced selling” as investors seek safe-havens and look to “de-risk,” as the media is fond of saying these days.

S&P 500 Gilmo Report Chart

Watching the Treasury market trade for most of last week going into Friday, one would have to say that at least the bond market wasn’t hinting at a U.S. debt-rating downgrade as money poured into Treasuries as a safe-haven. The daily chart of the Barclays 20-year-plus Treasury ETF (TLT), below, shows the mad rush into Treasuries throughout the week. That is, until Friday when the TLT reversed on huge volume, perhaps on some of the rumors of a downgrade that were floating around early in the trading day. Keep an eye on this on Monday, since Treasuries were, at least until Friday, the one bright spot in a market that was taking everything down, from stocks to silver to oil and most things in-between. If anything, gold has held up better overall during the past week, but in a real market melt-down it is not clear to me that anything would necessarily be safe. Certainly, we know that in late 2008, when the market split wide open, precious metals were taken down along with stocks. Cash is king, end of story.

Barclays 20-year-plus Treasury ETF (TLT) Gilmo Report Chart

In my prevous August 3rd report I wrote that given the positive action in the iShares Silver Trust (SLV) on Wednesday of this week as it cleared to a higher-high on a pocket pivot volume signature, I would expect it to hold at the very least the 20-day moving average, and preferably the 10-day moving average. In my view, the breakout to higher-highs on a pocket pivot volume signature should have implied further upside. But it appears that that forced selling is at play with the SLV putting holders of the white metal in the position of exercising any trailing stops at the 10-day or 20-day moving averages. As we see in the daily chart of the SLV, it did violate its 20-day moving average intra-day on Friday, but was able to hold above the rising 50-day moving average at 36.36. If you are using the 10-day or 20-day lines as your selling guides, support at the 50-day line now comes into play, while if you are using the 50-day moving average as your selling guide, then it still has not violated that level. In the short-term I would prefer to let the selling run its course and then see a new buy signal appear before looking to add-back or increase any SLV position just yet – it’s going to have to prove itself from here.

iShares Silver Trust (SLV) Gilmo Report Chart

Meanwhile, as I mentioned above, gold has held up much better than silver, and this is definitely something to take note of as it is proving to be the much less volatile, yet slower, and steadier “alternative currency” vehicle when compared to silver. As well, it is in a much better technical position having recently broken out to new all-time highs through the 151.86 peak of the base, as we see on the SPDR Gold Shares ETF (GLD) daily chart, below. The SLV has broken 9% off of its Thursday intra-day peak while the GLD is only 1% off its own intra-day Thursday price peak. In fact, on a closing basis, the GLD made an all-time daily and weekly high on Friday, in spite of Thursday’s high-volume reversal off the peak. Near-term one could use the 10-day moving average as a trailing stop on the GLD just to keep things tight. If the precious metals come down with the market, I would still look for them to eventually resume their uptrend after a period of time since sovereign debt issues are still unresolved and thus currency debasement will, over the longer-term, drive precious metals higher. If forced selling brings gold down, I would expect the 1600 price level to provide near-term support with 1559, corresponding to 151.86 on the GLD, being ultimate downside support.

SPDR Gold Shares ETF (GLD) Gilmo Report Chart

Last weekend I discussed five big-stock NASDAQ leaders that I felt should be watched closely in the event any kind of market rally ensued following the sharp breakdown we had seen in the previous week. It is useful, I believe, to take a quick “tour” of these stocks because before this week I considered them to be barometers of market health as well as likely areas where money flows might move quickly into given that these names were acting reasonably well during the first week of selling off the peak in the general market indexes. Conversely, we can now look at these stocks as being barometers of the market’s expanding weakness over the past week. (AMZN), which was holding up very tight after breaking out to new highs two weeks ago, exemplifies this in the straight-down break to the downside as it dropped below its 50-day moving average this week and closed just under the line, as we see on the daily chart below. Normally, I would view this as a late-stage failed-base (LSFB) and would look to short a maximum 50% retracement to 210 on any bounce above the 50-day moving average from here. (AMZN) Gilmo Report Chart

Apple, Inc. (AAPL), which had flashed a potential pocket pivot buy point on Wednesday, as I discussed in my report of that day, did not follow-through with a move above the 10-day moving average which I was looking for as confirmation of the Wednesday pocket pivot. Instead, the stock headed lower before finding support right at the top of its prior base, as I’ve highlighted on the daily chart below. I tend to look at the top of this recent base as more of a support “zone” that roughly extends from 365 down to 355. As we will see, AAPL is the only one of these five big stock NASDAQ names holding above its recent breakout buy point so far, but a breakdown through that key moving average would likely be a further bad omen for the general market going forward. Leading stocks, of course, can always have a sharp pullback to their original breakout point before going higher, but when AAPL is one of the only stocks left holding above such a recent breakout buy point, I am not so sanguine about trying to buy this on such a pullback. AAPL is a late-stage situation, but as a widely-owned stock it can come under pressure in a forced selling environment very quickly, as we have seen this past week.

Apple, Inc. (AAPL) Gilmo Report Chart

Baidu, Inc. (BIDU), another big stock NASDAQ leader, looked like it might hold its 10-day moving average last weekend, but this weekend it looks like a late-stage failed-based (LSFB). As we see on the daily chart below, BIDU broke out of a cup-with-hande formation in mid-July, and then followed up on that base breakout with a gap-up move to all-time highs when it announced earnings. However, that is as far as the stock has gotten on the upside as it has since broken down sharply, violating the base breakout buy point at around 148-149. BIDU managed to close at 140.99, above its 50-day moving average, currently running through 138.81, but below the trendline breakout that occurred from the cup-with-hande. I would watch for any upside move from here as being potentially shortable as an LSFB short-sale set-up using 147 up to 150 as an upside stop, as this coincides with a potentially shortable 50% retracement to the upside that would take BIDU right up into the 150 level and the 20-day moving average at 150.90.

Baidu, Inc. (BIDU) Gilmo Report Chart

In my last two reports I also discussed (PCLN), which had flashed a pocket pivot buy point on Wednesday, as we see on the daily chart below. This of course was immediately negated as the stock sold off hard on Thursday, breaking below its 50-day moving average on huge selling volume. Thursday after the close, PCLN announced earnings and the stock gapped up to 547 on Friday churning around for the rest of the day on heavy volume and closing pretty much mid-range at 527.81. As we can see on the chart, PCLN ran into resistance at the upper end of its range within the handle of this current cup-with-hande formation (highlighted area). PCLN, however, could not break out of this formation on a strong earnings report, and while we could interpret Friday’s action as a pocket pivot buy point off the 50-day moving average, it could also be interpreted as heavy-volume churning on a day when the stock should have broken out to new highs. I would watch for a break-down through the 50-day moving average from here as a potential LSFB short-sale set-up. (PCLN) Gilmo Report Chart

Last but not least, Intuitive Surgical (ISRG) was the fifth big-stock NASDAQ leader I discussed last weekend, and we can see that at that time a week ago the stock was finding support at its 10-day moving average as it formed a short flag formation following its big-volume gap-up move to higher highs after announcing earnings two weeks ago. Like the other four big stock NASDAQ leaders, ISRG split wide open over the past week and plummeted below its 50-day moving average, closing at 358.57, well below the 50-day line at 363.85. Usually, on an LSFB short-sale set-up, the stock will break down through the prior new-high buy point and its 50-day moving average. It will then try to bounce back up towards the 50-day line or the previous break-out point. Thus I would look for a feeble bounce from here, perhaps back above the 50-day moving average and towards the previous breakout point at around 378-384 as being potentially shortable. A move up to 382 would constitute about a 50% upside retracement to short into as well.

Intuitive Surgical (ISRG) Gilmo Report Chart

While these days I avoid getting into political commentary, I have to say that watching the financial TV stations this Saturday morning and listening to the reactions to the S&P downgrade from government officials, I find myself getting quite disgusted. All you hear are government officials babbling about “investigating Standard & Poors,” which brings to mind totalitarian, Soviet-style recriminations towards those who do not follow the party line, or that we need “more shared sacrifice,” which is essentially code language for squeezing more taxes out of those who already pay most of the taxes anyway as 51% of the population pays no taxes. “Shared sacrifice” is just another way of saying that since incompetent economic policies emanating from the Obama Administration and Congress have made so many less well off, we now need to also make poor anyone who has achieved success and become wealthy as a result of their own hard work. In the end, life goes on, I suppose, but the lack of real solutions or at least any admission from government officials that their current policies have failed, being set forth in response to the issues and problems that face the U.S. and global economies, would seem to argue for further market pain down the line from here. As I see it, if government officials can’t solve the problems borne of excess that exist currently, then the markets will settle the issue for them. The question then becomes which one you want to bet on, and my bet goes with the market.

I have no idea how the markets will react on Monday to the S&P downgrade news, but right now we can only operate on the basis of two known facts: a) without a follow-through day there is absolutely no reason to own stocks as more forced selling places other asset classes at risk of downside (e.g., precious metals), so by default cash is king; and b) with the market down sharply the potential for a snap-back rally grows, hence the short side must wait for a logical rally at some point to short into. Therefore I am waiting to see how some of these big stock names I’ve discussed in this report act over the next few days as I believe further forced selling will bring these names down hard given their status as widely-owned institutional names. Watch them closely, as they will likely be the key barometers on any rally attempt.

Gil Morales

CEO & Principal, Gil Morales & Company, LLC

Principal and Managing Director, MoKa Investors, LLC

At the time of this writing, of the stocks mentioned in this report, Gil Morales, MoKa Investors, LLC, and/or Gil Morales & Company, LLC held no positions, though positions are subject to change at any time and without notice.

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