Broad Market View

For the better part of this year, I've posted numerous times market breadth charts which have consistently shown breadth (a measure of the internal health of the market, i.e.- % of stocks participating in the rally through various measures). The breadth readings have been consistently bad, meaning fewer and fewer stocks have been posting new highs as the market was, more stocks were moving to new lows or falling below moving averages they had previously been above, etc. The way in which the market has kept moving higher despite poor market breadth has been similar to an accounting gimmick. The Federal Reserves' POMO operations have given billions of dollars in virtually risk free money to 42 Primary Dealers, the likes of Goldman Sachs and other large investment banks. In return for the virtually risk free money, they've been investing in stocks that are heavily weighted among the averages they belong to. This is one part of the equation. The second part has been revealed in Bank earnings in which their traditional core business models have performed poorly (consumer loans, etc), however their trading desks which have seen (in most cases) perfect trading records for the last quarter, have saved the day. Because of the Fed's loose monetary policy of 0-.25% interest rates, the banks have been able to access and leverage (once again) nearly free money. When the Fed started Quantitative Easing and low loose monetary policy, the idea that was sold to the public was that this would free up the credit markets, it would encourage banks to lend to small business and consumers. Of course the banks had a better idea, one in which they could invest in almost anything that returned more then .25% and they were automatically at a profit. This money didn't go to consumers or small business, I doubt the Fed really ever expected it to. It did however allow Bernanke to claim success in terms of economic recovery by pointing to what he termed "The Wealth Effect" created by higher equity prices. This of course is ridiculous as he even made the claim that inflation and other losses main street suffered (such as the loss of buying power and the loss of the value of savings as the dollar was destroyed) was offset by the "wealth effect" created by higher equity prices. Nearly everyone in the market knows that there are very few retail investors left in the market to benefit from this "wealth effect" and the return of retail investors (as usual) has come near the top of the market. The stock market has long been considered a "Leading Indicator" of economic conditions, so pointing to higher equity prices also allowed Bernanke to make the argument that the economy is showing "green shoots" or that it's on a slow, but steady path to recovery.

Of course one of the well documented side effects of Bernanke's policies has been that of rampant inflation in nearly every commodity. I've observed the gas inflation, but my wife does the grocery shopping. I just went shopping this week for the first time in a long time and was shocked at the prices. Since I haven't been to the store in a long time, the prices were dramatic from my perspective.

Now inflation is causing a problem called stagflation, a stagnant economic environment and jobs market combined with high inflation. Although inflation has been called "transitory" by the Fed, clearly they are now concerned with the effects that are hitting every sector from service to manufacturing.  While in the past Bernanke has vowed to keep all options and tools on the table, his most recent statements regarding further quantitative easing have shown his concern. When asked about the possibility of QE3, for the first time I can recall, his answer was, "the risks are starting to outweigh the benefits", thus the market is unwinding speculative trades everywhere, the dramatic sell off in commodities is one area this can be seen, the unwinding of FX carry trades is another, the sell-off in equities is yet another and perhaps the most obvious and unnoticed can be found in Central Banks across the world investing heavily in gold and silver to a lesser extent. Precious metals are a natural historic hedge to rising inflation and rising rates. Don't forget the Fed's Kocherlakota floating the idea of a 50 basis point hike to the Fed Funds Rate, a move that would put banks in a dangerous bind if they don't start unwinding their speculative and highly leveraged positions. It will also have a dramatic effect on consumers, business and housing, thus stagflation.

I've mentioned many times that I believe we are going to enter the first secular bear market in stocks that this generation has ever seen. There was one in commodities a few decades ago, but not in equities. This is where I believe spectacular profits can be made. Few traders have the disposition to sell the market short and even those who do will have to figure out quickly the new rules of the game. I think we have a big edge in this respect as retail traders still haven't adjusted to Wall Streets raids on traditional technical analysis which can be seen everyday in stops being hit and common  price patterns being broken up.

This is a macro view of the market and will hopefully help you understand more about how the market works.

DIA

 Does this price pattern look familiar?  This is the same triangle that we see in the SPY/S&P-500

 5-day 3C chart of the DIA. I rarely show charts of this length, although they contain the macro-trend, they aren't useful for timing. However, the chart goes from confirmation into early 2011 to a leading negative divergence-the worst kind. What you can learn from this chart is how Wall Street uses demand to sell into or to set up counter trend trades (shorts). It also shows you approximately when the market started growing concerned with the economic and policy environment.

On a shorter chart (15 mins.) you can see the overall negative tone moving into the top. Before the triangle began, Wall Street was already moving out of positions and likely phasing into large short positions. This gives you some idea of how far the market must drop for these short positions to be profitable and that's just the start.

 On a very short term chart (1 min.) you can see where the support line of the triangle was broken today as volume swelled as stops are triggered. This is also an example of how retail trade has not adjusted to Wall Street's propensity to use traditional technical analysis against its practitioners.

 In blue, my trend channel automatically adjusts to a stocks 10-bar volatility, it's more dynamic then traditional price channels, but more useful in determining a trend then Bollinger Bands. When this channel, which held the entire Jackson Hole/QE2 trend, broke below the lower channel on a close on March 16th, something big changed in the market. For that channel to break, the 30-day typical volatility of the market was exceeded by more then 2 standard deviations. That break was the end to the easy money uptrend and introduced the volatility of a topping market. ADX also turned down shortly before, which is another sign of a trend coming to an end. Interestingly, according to the 3 day 3C chart, distribution started between mid-February and early April, which coordinates well with our Trend Channel break in mid-March, signaling the trend had started to change.

IWM

 Once again, does this price pattern look familiar?

Once again on a 3 day chart of the IWM, the heaviest distribution started between mid-February and early April. Since then it's entered a leading negative divergence.

The 60 min IWM chart also shows heavy distribution moving into the price triangle.

 The IWM 3 day trend channel which held the entire QE2 rally also broke in mid March, the 16th to be exact like the other averages. This is a significant break and a definitive change of character in the trend. ADX also turned down shortly before like the other averages.

 QQQ
 The long term 3C chart of the Q's also started showing heavy distribution in mid-February to April 1. Again, since then it has deteriorated much more rapidly into a leading negative divergence. To illustrate the distribution involved in the area of the leading divergence, the QQQ percent change over the period covering Feb. 17 to May 11 was -.17%. During these 3 months, the QQQ literally went nowhere, the 3 month period before this the Q's gained over 14%.

 The Q's on the 3 day trend channel also gave a signal that a change of character in the trend was under way on the exact same date, March 16th.

SPY

 Again the SPY/SP-500 shows the same triangle and negative divergence, at April 1st and a current leading negative divergence.

 Here's the hourly chart falling apart in the triangle.

 Here's the 5 min SPY 3C chart showing several positive divergences along the lower support trendline.

 Here's today's intraday action which again shows a mass of stops being hit exactly at the support line. There would also be short selling at the level as well, but it illustrates the misconception of support and resistance being at exact levels to the penny as we often see multiple shake out moves that trade slightly above and below support.

And once again, March 16th  gave us a signal that the trend was undergoing a change-right in the middle of the bulk of the first major negative divergence.

So it's no surprise that the market looks the way it does. The deleveraging in the market is well underway and although the tops were all broken today, there's more then likely a lot of downside to come in a bear market move down.

Looking forward...

The market has been very predictable in reversal behavior. A straight break of a top like we saw today follow by a downside reversal is very unusual. These obvious triangle price patterns are more often then not, shaken out in several different ways. The first and most common is a false breakout to the upside, drawing longs into the market before dropping the curtain which causes the snowball effect of a rapid sell-off. The second most common shakeout is what I call the "Crazy Ivan" from the movie, "The Hunt For Red October" in which Russian Submarine captains reverse course 180 degrees to try to determine if they are being followed closely in their prop wash where it is difficult to pickup the sound signature of another submarine shadowing it. If we are to see a false breakout to the upside at this point, it would be the Crazy Ivan type, starting with a breakdown of the uptrend, then the 180 degree reversal to a false upside breakout, before returning to the original course of down. This can take place in a matter of hours, but more commonly over a period of days. The more convincing the shakeouts, the more velocity we see in the resumption of what would be a down trend in this case.

There's the possibility that the market has lost control and the ability to effect these shakeouts, but in my experience, it would be pretty rare as Wall Street is usually in full control of accumulation and distribution cycles as can be seen in this chart of our earnings trade of LVS

The white arrow is an accumulation zone, the green arrow is confirmation of stage 2 or mark up, at the red arrows we have distribution sending prices lower, at the yellow arrow we have our false breakout right into bad earnings. In May a leading negative divergence drags prices lower.

So while the downside breakout lessens the probability of a shakeout somewhat, we have to be aware that this is a common occurrence and it would only take a move of about 2.5% to effect a false upside breakout/shakeout from our close today.

I think if you account for  the possibility of a shakeout occurring, this market could be shorted here and now as there's not a long distance to travel (thus not a lot of upside risk) if an upside shakeout or Crazy Ivan were to occur.

Positions that have been established at favorable price points I would personally keep open and deal with any potential drawdown as these positions are already at a decent profit, this would include the May 3rd inverse ETF trades and equity shorts such as LVS, PCLN, BIDU, FXP, EDZ, FAZ. Of course if a move back into the triangle occurs, you can reduce these positions or exit them and re-establish them at better price points.

Just try to keep in mind the bigger picture, whether you chose to short now/maintain current shorts or if you wait a day or so to see if a shakeout will materialize. The fact is, a bear market decline will likely erase much of what has been gained since early 2009. A secular bear market has the potential to take  the averages to unthinkable lows, for instance, the Dow could be trading below 5000 within a year or so. Markets fall a lot faster and further then they climb.