Subprime: The Gift That Keeps On Giving
Earnings season kicked off this week with two major retailers, Home Depot and Sears Holdings lowering their earnings guidance for the current quarter. Both companies cited the continued housing slowdown as the primary cause of their shortfalls.
Also, the fallout of sliding home prices and the accompanying increase in subprime mortgage defaults prompted Standard & Poor's - one of the world's most prominent credit rating agencies - to set in motion a series of downgrades of these collateralized debt obligations (CDO's). This in turn had the ripple effect of sending the US dollar plunging to an all-time low against the Euro, and decade lows against most other major currencies. The convergence of all these factors was enough to send the market reeling on Tuesday.
The Wall Street spin machine led us to believe that subprime was contained and that the worst was over. As it turns out, the problem is much more pervasive then previously thought. Every time this issue resurfaces it brings with it more questions than answers. Will this turn into an 80's style S&L crisis? Can the economy withstand the possible credit crunch that might ensue? What if the consumers are unable to continue to tap their home's equity? Will this throw the U.S. economy into a recession?
These are very important questions that should definitely be pondered. For traders though, the headline itself should not be that crucial. What is of much more significance is the market's reaction to the data. As professional traders, we are more interested in this because how the market trades after the information is digested can be more telling as to the health or weakness of the market than the actual information itself.
You maybe asking, "Why if we trade based on technical analysis should we care about macroeconomics?" The answer is simple. We should care because the market is in a constant state of flux, always looking for a catalyst, something that will move mass psychology to either feel comfortable in investing or fearful of the consequences if too much money is put at risk.
Traders need to stay abreast of the topical "dominant theme" of the market. The Federal Reserve and their actions are a constant market mover. Other themes could change based on what stage of the business cycle we're currently in, geopolitical concerns, the global economy, inflation worries, homeland security issues, etc.
The takeaway here is to know what the market is keying in on and know when and what economic reports are to be released. This will better prepare you to react to the market in a rational manner rather than an emotional one.
Let's turn to the charts now and see if can make heads or tails of this market. The first chart we'll focus on is the daily ER2 (below). In last week's newsletter I wrote about the trading range we've been in for the last month or so. Note that the ER2 went up to the top the range on Monday, became overbought and sold off on Tuesday. Notice how well the stochastics have been working in the daily time frame. When the ER2 becomes range-bound the stochastics are a very good technical tool to employ.
In the next illustration we'll look at an Hourly chart of the ER2 (below). The focal point here is Tuesday's sell-off. We see this correction has brought us to a 50% retracement of the move initiated on June 27 and also the up-gap created on July 3.
The likelihood that the gap will be filled is very high (I would say almost certain) by the end of the trading session Wednesday. The big question here is: are we going down to the bottom of the range (820) or will we take-out the prior highs? I think the former.
To Summarize: The second quarter reporting season is underway. It got off to a bit of a rocky start with the aforementioned early warnings, but it's much too early to tell if this is the beginning of any trend. There may be more trouble brewing in the subprime mortgage space, which could really upset the applecart for the bulls. My view is that the selling done on Tuesday is the prelude to further corrective action. This correction should take us down to the previously noted 820 area. Beyond that, we'll just have to keep our ears to the ground and see what Mr. Market has to dish out for us.
So until next time, I hope everyone has a profitable week.
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Gabe Velazquez is a professional
trader with 14 years of experience. His focus is intra-day and swing trading the
ER2 (Russell 2000 e-mini) using technical analysis as his primary tool. Gabe has
managed both stocks and futures accounts as well as conducted educational seminars
on technical analysis for the past ten years. He is a frequent guest on Biz radio,
where he shares his market knowledge and utilization of technical indicators.
Gabe also teaches the