Head and Shoulders Bottom?

The S&P, despite the violent downside moves over the past few weeks, appears to be trading in an inverted head and shoulders pattern.

Indeed, should the market respond favorably to the 10 a.m. Bernanke speech, the neckline of this head and shoulders pattern could be broken to the upside, triggering a strong weekly buy signal.

They say don't fight the Fed and that sentiment seems to be what is going on here over the past two days as buyers have stepped up to the plate. Despite Tuesday's ugly sell off, the market has been marching straight back up the hill, carving out the right shoulder and placing the market in a position to start a fresh leg higher in the secular bull market.

No one knows for sure what Bernanke is going to say today, and no one knows for sure how the market is going to respond. Bulls seem to have a big advantage going into the game today though. Let's see if their advantage remains after today's close.

Things Just Get Silly

Yesterday it was clear from a technical standpoint that the market had rolled over. Major indices had, and still do, strong bearish money flow divergences. Indices had made a series of lower lows and the rollover was one more lower high confirming the downtrend. The only thing missing was volume. But since this is late August it's hard to expect much. Sr. traders are on vacation now after all.

Yesterday's reversal was quite the shocker then. It appears as if this market is entirely random; ran at the whims of the Jr. traders playing with their programs.

It's unclear now who has the upper hand, bulls or bears. Under normal circumstances we would continue to give the nod to the bears, but since the market refuses to play right it's probably next to impossible to guess.

Indices are back up at major overhead resistance. The QQQQ is back kissing its broken trend and the SPY is trading up against its downsloping trend line. Technically the market should turn lower once again. But if the market decides to react positively to the next to sure fact that the Fed is going to lower rates in September, you can throw the technicals out the window because the market is going to do what it's going to do despite what it "should" do.

Market Rolls Over into Intermediate Downtrend

Market technicals spoke loud and clear Monday. Indeed, yesterday the market folded on itself, entering yet another intermediate downtrend. br>
Major indices moved up on light volume last week merely to tag their broken 50-day averages. With yesterday's roll over, a test of August lows is close to a certainty. br>
At this time we will avoid making further predictions about where this market is heading. However, if August lows are penetrated, the broad market will then necessarily be considered to be in a primary downtrend. Whether this will occur or not is hard to say. But right now there is a disconnect in the market as high levels of uncertainty have emerged due to the credit crunch and concern that the Fed is more interested in fighting inflation than keeping the economy out of a recession. br>
When institutional money is uncertain, they sell.

Rally Came on Decreasing Volume

Yesterday we wrote: "Selling short at these levels does not seem offer a great deal of potential."

We need to back track on that statement today.

Yesterday's market breadth was hugely bearish and the number of stocks tagging their 50-day averages from below on rapidly decreasing volume is a strong warning sign that the market's sell off that started late last month is threatening to reassert itself.

We may be second-guessing ourselves here, but the technical conditions of this market are clear. They are signaling a downturn from near current levels.

Shorting this Rally Just Doesn't Feel Right

Last week indices pulled up to resistance areas on light volume. On Friday the S&P, Dow, and NASDAQ all pulled up to their 50-day averages on less than strong volume.

This is a classic short set up.

Even so, something just doesn't quite seem right about shorting here. Firstly, it's the end of the month and typically the end of the month experiences strength due to increased liquidity in the market.

But more than that: Bank stocks continue to see leading money flow divergences, indicating that the sector that leads the market is poised to move higher. Then, if you drill back to the weekly charts, all three averages are exhibiting weekly buy signals.

Finally, and this one is most striking to us, is the fact that none of the ultrashort ETFs (exchange traded funds that move up when the indices move down) look very attractive to buyers here. Sometimes it's easier to see the direction a stock intends to go by flipping the chart over. Looking at the DXD and QID (ultrashorts for the Dow and the NASDAQ 100), it is plain to see that these averages are not good buys at this point and as such, their underlying indices are not good sells.



The bottom line: After last week's run, indices are probably due for some type of pullback or consolidation. We would certainly not buy at these levels. Selling short at these levels does not seem offer a great deal of potential either though. Dips from here are probably buying opportunities.

If we had to make a prediction, we would say that either indices are going to power higher above resistance here, and then pull back and regroup for a buying opportunity. Or, they will suffer a minor pullback, which will then be a buying opportunity.

But let's wait and see.

Mixed Messages with a Technically Bearish Bias

Bearish sentiment readings have now reached lows not achieved since the 2003 bottom. The financials, at least so far this week, have been showing bullish divergences between price and money flow, indicating they are under accumulation.

Even so, technically the market is now at resistance and technical indicators tell us we should look for a pullback or a resumption of the downtrend.

What to make of this?

It’s probably best to pay attention to market technicals here.

Financials Perky

Bearish sentiment continues to rage, though fear levels have come back significantly.

Yesterday we noted that the market could either break higher or pull back into what we argued would be a good, low-risk buying opportunity. Indices may or may not pull back from here, but it looks to us as if shorts are going to continue to be pinned to the wall here, forcing them to cover at higher and higher points.

Significantly, the financial sector is showing a good deal of accumulation at current levels. Stocks with the most exposure to sub prime are still iffy, but other stocks in the sector that were taken down on fears this month are now showing leading bullish divergences with a number of important technical indicators, indicating strong accumulation taking place.

As financials go, so goes the market they say.

Hoping for a Dip

Investor sentiment at Lowrisk.com dropped significantly this week. The number of bulls decreased from 28% last week to only 22% this week. Add to this a continued number of traders buying puts and we have the right combination for a market rally.

Over the past few days the market has come off its lows on decreased volume. This is bearish. So how do we reconcile this bearish technical reading against sentiment levels that indicate we are near a tradable upside rally?

The way we see it, one of two things can occur here. The market can, with a burst of volume, break higher today or tomorrow forcing bears to cover. Or, the market can behave in the way it is technically expected.

Technically, the market should roll over from the resistance levels all major indices are now trading at. We submit that if it does roll over, fear will spike even higher than it already is and the roll over will find a higher low from which to launch a tradable rally.

We hope that the later takes place and that the market pulls back here. Buying at current levels does not offer a good risk:reward. Buying into a fear-inducing dip, on the other hand, offers a very nice risk:reward set up.



Of course we need to mention that there is a third possibility. The market could pull back from current levels and keep on going lower. Given that the Fed has shown itself willing to bail out the banks and considering current levels of fear, probabilities of such are quite low. As such, a dip here should be considered a buying opportunity.

As such, we are symbolically crossing our fingers and hoping for some downside today.

Could Go Either Way Today

Light volume indicates that stocks may be running out of buying interest. Nevertheless, prices remain highly oversold and sentiment remains overtly bearish.

We suspect that even if prices dip back near lows, it will just spark another oversold rally. It is doubtful that the ultimate lows are in, but it is almost equally doubtful that the market is going to be able to take out Thursday's lows before it first rallies and shakes out the bears.

A Bumpy Ride Ahead

We should probably rant about how institutional money and the Fed are in bed together and how the Fed, lender of last resort, is actually babysitter to options sellers, willing to bail them out the first sign they are ready to lose a load of money based on foolish hubris. But what good would that do?

The game is what it is. It is not played fair, nor are all players on an even playing field. Sometimes retail traders get the short end of the stick.

We believe that retail traders have an opportunity to get back at the institutional players here though as this volatility lends to those of us who can switch positions quickly. We can quickly jump back on the long side now that the Fed has shown itself more willing to bail out their friends out of a bad situation. Then, when the market starts to fall under its own weight again, and it will (probably sooner than later) we can jump back on the short side and ride the next wave back down.

Considering the distribution taking place, we are looking for the market to stay bumpy, just like it did in 2000. This gives those of us with flexibility to get in and get out quickly a chance to make some nice profits in coming months.

Support Gives Way

Technical support failed yesterday and the market is likely headed lower. Fear continues to spike and the market is very oversold technically. Nevertheless, these measures are relative.

That is to say, relative to the recent low volatility uptrend experienced over the past few years, fear is extreme and oversold conditions are extreme. This causes traders to look for a bounce. But measured against the 2001-2002 market correction, the numbers aren't quite so extreme. In fact, they are still mild.

Keep in mind that the Fed is going after the credit bubble and in doing so, stock prices are sure to suffer consequences.

In our opinion, this is good healthy behavior. This market was getting to be nearly impossible to trade, but now has a fresh breath of life due to the selling. It takes some adjustments to get used to, but there are some excellent opportunities in this market that just didn't exist over the past few years and certainly not over the past year.

Support or not Support, that is the Question

Yesterday the market tested the very limits of support in the trading range we provided yesterday. The Dow broke through, but it still has uptrend support, which could hem it in for another few days.

Technically the market should bounce here. It's oversold, fear is spiking, and it's at support.

Now, whether or not the market is interested in paying attention to technical support levels or not is another question. We shall see.

Game Plan

Raymond James recently issued a technical report on the market conditions and highlighted an interesting parallel between the current market and 1998. We believe that this has some merit and can provide us with a good road map for where the market might be headed as we move into the fall months.

Friday's liquidity injection was quietly rescinded on Monday, so the bullish case for a short squeeze has pretty much gone up in smoke. This is further evidenced by the fact that bulls ignored their opportunity yesterday and went on a buyers strike letting stocks settle back again on very low volume.

This leads us into the Raymond James report. In this chart they show how in 1998 the S&P 500 broke out of a multi week range, but then failed spectacularly and slid lower on several wide-range sell days. Waves "a" and "b" on the 1998 chart below mirrors the S&P between this May and now.



Following the initial break out failure and slide lower, the market moved into a choppy trading range of what turned out to be the "b" wave of an a-b-c correction. It appears that this "b" wave is where the market is at now.

Given the distribution pressure that persists, we suspect that a move back up to the upper end of the range in the "b" wave (2007 SPY chart below) will produce a high-probability shorting opportunity just like it did in 1998.



Keep in mind that once the c leg of the 1998 correction played out, the market did a double bottom bounce and moved on higher to all time highs. We don't know if this time will be the same or not, but since we have yet to see the enthusiastic euphoria stage of the latest bull market, it may be possible that such a scenario develops again.

Short Squeeze Setting Up?

Friday was a day of whipsaws. The market started out with sellers furiously attacking support levels as the credit crunch affecting the financials produced fears that we were fast approaching a 1987-like crash. By mid morning, however, the Fed stepped in and injected several billion dollars into the economy to calm investor fears and add much-needed liquidity. This caused a quick jump, but sellers were still determined.

Later in the day, however, more money was injected and this time it took hold, pushing index prices and financial stocks higher into the close causing a goal-line stand on the SPY and stemming the outflow on the leading financial sector.

Even so, a huge amount of traders made bets on the bearish side last week shorting Friday's bounce. With expiration this week the short positions are the positions most likely to suffer maximum pain. With money stream figures now diverging bullishly in the financial groups, we see a potential for a strong short squeeze.

Keep in mind that this assumes all things remain equal. If another hedge fund crashes this week, shorts may see a breath of new life in their positions.

Selling Just Getting Started

As we had been warning since last week, the recent market bounce was merely a technical one driven by short covering and oversold conditions. Yesterday the real trend reasserted itself with ferocity.

The VIX, what we like to call the fear indicator, has now surpassed two year highs, but rather than signal a bottom we believe this marks the beginning of a much larger sell off. Distribution has been mighty in recent weeks and the credit crunch banks are faced with looks to be the real deal; not just fear mongering.

A look at the monthly Dow chart tells us that this is a market that is in serious trouble. Whatever it turns out to be though, we are thoroughly enjoying this fresh injection of volatility.

Why This Time May be Different

The rally was able to extend another day yesterday. However, the QQQQ has merely been able to move back up to kiss its broken channel, while the SPY has only managed a return to its 50-day average.

We realize that last March the market was able to rally back up into the broken uptrend channels following February's break down event. We believe this time is different though. Ignoring the fundamentals for a moment, since it is possible that the sub prime issue was overdone (we don't think so, but we could be wrong), technical conditions do not favor the bullish case here.

As we noted last month before this correction really got underway, major indices and a large number of stocks, have been under severe distribution ever since the market was able to rally higher from February's drop. In other words, there is evidence that a great deal of institutional selling was taking place into the weak market rally that took place between March and July.

Add to that the fact that the SPY suffered a long term breakout failure in late July; odds are that the rally this week was just an oversold technical rally fueled by a short squeeze. If so, we should see prices start to struggle in their current area.

Technical Bounce Extends

The response to the Fed's status quo statement was met positively yesterday and program trading took the market into positive territory at the close. Breadth is still poor though and all major indices remain below their 20-day averages.

We won't make any predictions today, but will instead sit out the day and watch to see how the market behaves now that the Fed has spoken.

The intermediate market trend remains down, so we are looking for prices to reverse again once this oversold bounce is played out.

Another Turnaround Tuesday?

The market was technically oversold after last week's hard sell off, so Monday's bounce was not surprising. Breadth on the bounce was lousy, however, as less than 50% of the NASDAQ bounced with the index and just over half the stocks in the other two major exchanges managed a positive day.

Many in the market are hoping for a Fed bail out this week. Such hope is not the best platform to base your bullish bets on. In fact, it's a good contrarian indicator that the market has more downside to go. Wishful thinking is always strongest when players are losing money as their positions continue to erode lower.

Could turnaround Tuesday rear its ugly head again today?

The Worst Storm in 22 Years? Maybe

Friday, the CEO of Bear Sterns, noted that his sector (which is a market leader by the way) was weathering the worst storm in 22 years. That's a bold and significant statement.

Indeed, stocks took a dump on Friday and the intermediate trend of the market is now in a heavy swoon.

We are embracing this downturn. Stocks have been under heavy distribution for months now. In fact, the market has been under steady distribution for the past two years, which explains why it has been progressively harder to make money buying stocks. This sell off, whatever it turns into, is something the market really needed in order to reset the stage for better trading.

As we mentioned last week, we don't believe we are now entering a bear market. We may see bearish conditions for a while, but the long term bull has yet to reach its final stage. This sell off may be just the ticket that kicks off that final euphoric stage. We don't know.

Right now what we know is it's best to position for lower prices and when we start to see capitulation and money flows start to diverge higher as stocks inch lower, then, and only then is it time to start thinking of buying again. Right now sell is the only game in town.

Neutral Set Up in Front of Today's Jobs Report

The market is doing a pretty good impression of a market that wants to quickly recoup last week's losses. The reaction to the jobs report today will be telling. The major indices pulled up to resistance on decreasing volume yesterday, but if the buy programs kick in in response to the jobs report, that won't matter.

Be ready for anything today.

Oversold Condition Likely to Get Some Relief

Yesterday's late day bounce was impressive. The SPY held support at its 200-day average and volume on the intraday reversal was heavy.

The question is, is it enough? V-bottom reversals are rare and it is highly unlikely that prices will now climb right back up the hill from whence they started. A recovery from last week's onslaught is certainly possible, but probabilities favor at least another test of the lows.

Today should be a positive as this oversold market needs a chance to catch back up with its falling 20-day averages. We won't have any real answers about this market until we see how it behaves when it retests the lows after the coming bounce.

End of the Bull?

Monday's rally failed quickly and the dead cat could barely muster a bounce. The 50-day average on the QQQQ provided only a temporary pause on the way down and yesterday the index cut through this level in late day trading like a hot knife through butter.

This correction has legs and it is likely to give us some great short profits.

That out of the way, let's consider the longer term prospects of this market. Is the bull dead? If you pay attention to the news you might think so. Sub prime this, bubble that. The problem is bulls don't die on sour notes. Has it been so long since 2000 that we all forgot the euphoria that the last bull died on?

No, bull markets play out in three phases (click link for source):

• Bull markets commence with reviving confidence as business conditions improve.
• Prices rise as the market responds to improved earnings
• Rampant speculation dominates the market and price advances are based on hopes and expectations rather than actual results.

So far the market has experienced the first two, but has not yet seen the third part play out. In fact, as we have noted here repeatedly, bearish bets have been extreme for months now. What's to happen if this correction doesn't in fact turn into something worse, but instead quickly bottoms and starts to run at the highs?

We'll tell you what will happen. All those hedge funds holding heavy short positions will be in danger of underperforming on the year and they will not only be forced to cover, but buy as well if they expect to keep their jobs when the dust has settled January 01. This is how fall rallies get underway.

Hear this and heed the message: If there is one thing you can be sure about besides death and taxes, it's that the institutions that need buyers at the top and sellers at the bottom will not ring a bell and shout that the sky is falling when the market is topping. Just read the headlines in any financial rag right now and ask yourself what mood the media is attempting to engender in the retail market. It's certainly not one of high expectations now is it?