Last night as you all know by now, Ireland confirmed they are taking a bailout and the Euro started the week of FX trading with a gap up, this may have been a knee jerk reaction or a lot of other things. However, the reason that the Euro headed back down is despite the bailout, the risks of contagion among other Euro Union countries did not seem to diminish. Portugal may be next as the risk of Portuguese default actually rose in the aftermath of the Irish bailout announcement. The E.U. seems ready and capable of helping Portugal, the real threat is Spain and if borrowing costs through bond yields get to a point in which the Spanish can not repay the debt or the perceived risk of default is high, then they will have to turn to some bailout mechanism and it is not clear that the E.U. can handle a bailout for a country and economy the size of Spain's. Furthermore there are ratifications to the E.U.'s governing documents that must be made to even pull off such a feat and already after two relatively minor bailouts, fractures among EZ countries are emerging. For instance, German and Austrian tax payers are not too happy to foot the bill for a lying Greek government that has not just told little fibs, but has not come clean with regard to the severity of their situation. The risk of Greek default on their bailout has grown exponentially in the last 10 days and the EU does not seem to keen on altering the terms of repayment. Fool me once shame on you, fool me twice.... Greek default on the bailout is on the table.

Remember, it was only a few short months ago that the results of the E.U. Banking system's stress tests came up fairly rosy. Why was that? Probably the same reason that US banks said they had the mortgage risks under control, until they didn't and every earnings season produced bigger and bigger write-down surprises. The fact is the banks depend on deposits and who wants to come out and tell the world that they are in a hole they can't get out of? Or more bluntly put, they lie to prevent bank runs.

Speaking of stress tests, it emerged last week that at least 19 of the largest American banking institutions are about to undergo a second round of stress tests, that number may rise past 35. Meridith Whitney who gained unprecedented international respect for her early and accurate insights in 2007 and 2008 has just come out and said that she believes that somewhere around 5000 banking branches will be shut down over the next 18 months. The reason? A lack of loan growth, which I talked about a little today from my own experience and we know that banks have raised the FICO score standards for lending beyond what is required by the backers of those loans. Not only do we have a real estate market in shambles, but we have banks that are not eager to make loans despite the money Bernanke and the government have poured into these banks so they would do exactly that. Furthermore banks face additional challenges (and I haven't heard this one before) because of earnings pressure and regulations that will leave lower income households without access to banking services, meaning less fees will be collected. Whitney blames the hastily written banking reform laws with the unintended consequences of “de-banking”-her words, not mine. Again, long term I can't see anything really positive for financial sector growth. The trend of “de-banking” she believes will contribute to 5000 branches being closed in the next year and a half and an additional 80,000 jobs lost.

Something else I found interesting (below I have a linear regression chart that may explain part of this) is that the rally that started in September was 3-4 days after Bernanke gave his Jackson Hole speech in which he let the QE2 cat out of the bag. The market previously advanced higher on POMO days, but since the QE2 regime has started, I have seen no evidence that QE2 is anything like the former operations. I'm wondering if that may be the reason we are seeing what we are seeing in the linear regression chart you will see below. At that point of the Jackson Hole announcement, bulls saw a never ending stretch of POMO days that would take the market higher each and everyone. I warned that this operation may be very different then the last setting many bulls up for a possible long fall.

Well lets start tonight with the daily SPY 3C chart.

As you an see, there was no upward r downward progress.

Every so often I check the linear regression channels for the same reason I check my Trend Channel. When a market acts a certain way long enough that it can be characterized (by fitting neatly into a channel) and then it suddenly changes its character, that generally means something is up.

One of the best setups with a linear regression channel is a trend that fits neatly (about 90%) within a channel. The setup is called a "channel buster" and they come in a few varieties that I especially like. The first is a simple breakdown from the channel and almost always we get the “Kiss the channel goodbye” bounce when the market bounces and tries to make it back into the channel and fails, then you usually see volume pick up on the failed test as the market drops. However, there's one I like even more that combines what I just described, but adds a preceding event and that is a move to the upside out of the channel, a breakout of the channel to the upside, which is what we see here. The effect is that longs get excited and sucked into the long play, price falls back into the channel, they are at a loss and then it breaks down as described above. This type of event, even occurring outside of a channel (for instance a false breakout above a resistance level) creates a snowball effect because of the losses sustained by the longs who bought the breakout. As prices move down, the longs start to sell, which creates more supply then demand, which causes prices to find the next level of demand lower, once that is extinguished, prices fall more and more longs sell, and the process repeats. Of course we can't forget the added selling pressure created by shorts who flood the market with more sell-side supply. It's a snowball effect and usually particularly dangerous for longs when combined with the breach of a trading channel.

FX Markets

Although FX markets (as I say repeatedly) can do a lot overnight, especially with the speed and depth of fundamental information that has been accelerating in the last week in both speed and importance, seemingly reaching for a translucent crescendo, I thought I'd update you on the EUR/USD pair, right now the single most important FX pair as far as market correlation goes. If you saw my second to last post, I think it's pretty hard to argue that the correlation is coincidental. However what is important is what the underlying action of that bounce is. We saw negative divergences getting more serious as the day wore on until there was a final push at the end of the day.

As you can see by the green arrows, the up trend was in effect and doing what an uptrend is defined as, making higher highs and higher lows (the green arrows show you this). After the market closed, we saw our first lower high which is an indication that the uptrend is changing. Most people take this to mean that the downtrend will resume, it may very well, but there is a third trend and that is lateral. In any case, the uptrend is running into some shearing.

EMERGING MARKETS?

One of the trades that looks very good to me and I recently mentioned is the Descending Wedge (bullish) in EDZ, the leveraged short emerging markets ETF. In my mind there are both good technical and fundamental reasons to like this trade and mass psychology as well.

Here's EDZ's hourly chart

Today we saw some late afternoon improvement on the pullback. These wedge trades with divergences are quickly becoming some of my favorite, however, they are never as simple as a breakout from the wedge=buy as most technical analysis books have taught for decades, they almost always see a lot of volatility in price after the initial breakout and for that reason I prefer to either phase into them or give them a wide stop, which means fewer shares for my risk management/position sizing rules. Here's EDZ's chart today.

EDZ 1 minute

Note the negative divergence in EDZ today and what time it started to decline and remember this is an inverse ETF or short emerging markets. So as the FX pair traded up at 1 p.m., naturally EDZ traded down. As the afternoon wore on and we saw negative divergences getting worse in the market, EDZ was showing a positive divergence that was getting better into the close.

USO

I like 3C charts like what I see in USO. While a stronger dollar may not be good for oil and controls being put in place by China may have longer term effects on oil, what I'm seeing here and now looks bullish for USO/Oil

USO 60 min showing a negative divergence at the pullback and a positive divergence now

A 30 min chart of USO showing the exact same thing

A 15 min chart showing the same thing in greater detail

 and a 5 min chart that has formed a leading positive divergence today.

USO has seen a pretty deep pullback, but the charts are now lining up and showing that there appears to be accumulation building. I don't know how long this trend will last, but I do think that it is a valid trend worth looking into. Who knows, we may be seeing some inside information leaked regarding Wednesday's Oil Inventories, but because the positive divergences have stretched to the 60 minute chart, it seems more like the pullback is overdone and ready to snap back in the opposite direction. The stock market almost always overreacts like a pendulum, swinging too far one way and then too far the other way.

As I finish this post, the Euro has confirmed my suspicions, take a look at an updated chart:

The red arrows are the definition of a downtrend, lower highs, lower lows, although the trendline drawn in red is an area of support that will have to be broken before this can be definitively called a resumption of the downtrend, until then, it is lateral.

Take a serious look at USO. There is a chance that if the USO gains are dollar related, then commodities across the board may gain in the near term. Otherwise this may just be a deeply oversold move snapping back.