While Bernanke & Co. have been long defying the laws of currency and other asset values, the bulls learned that not even the Fed can nullify an important law learned long ago -- gravity.

Market Stats

Well, as much as the bulls wanted to believe one of Newton's discoveries was repealed by their main man Bernanke, that wily coyote has proven once again that the market can spin its feet in midair all it wants but sooner or later gravity will take over. The market suffered its worst one-day decline since August 2011.

Gravity Lesson

The good news is that the market looked like a good setup for a bounce on Friday. What the bounce, assuming we'll get it, will lead to is the bigger question in my mind. But a bounce is by no means guaranteed -- some important support levels broke today and the bulls need to step back in right away Friday morning in order to give the bulls a fighting chance here. Oftentimes when a strong move closes the indexes at/near the lows of the day it ends up being a mini-capitulation kind of day and it gets no follow through the next day. So that's the potential for Friday morning. The ISEE data showed a LOT of put buying today so that extreme calls for a reversal as well. But again, the bulls can't waste any time Friday morning. Trading volume was the highest we've seen this year and obviously strong volume on a hard down day is going to be difficult to turn around.

The markets are clearly throwing a little temper tantrum that Bernanke and the Fed would dare to even THINK about tapering their ongoing QE efforts. The markets are so hooked on low interest rates and free money that it has become so skewed from reality and everyone with a brain knows it but as most everyone knows, you have to play until the music stops otherwise you miss the move. With two days of hard selling we all are now wondering if the music stopped or if it is simply a pause in the bigger up move.

One of the concerns of course is liquidity, which is the oil for the market -- remove it and the market starts to squeal and come to a grinding halt. And the problem is that even with all of the Fed's efforts to increase liquidity and the flow of money, the decline in the velocity of money shows they have not been successful. This is a measure of how well money is increasing through bank activity. The fractional reserve system increases the money supply when the banks lend more money but as we know they've been hoarding cash instead (parking it at the Fed for a guaranteed 0.25% return. I've talked about this many times in the past and as the chart below shows, the velocity of money has been declining since 2006 and saw only a brief bounce between 2009 and early 2010. The only thing surprising to me is why the market still has faith in the Fed.

The Fed is full of Keynesian economists and all suffer from group-think. Other economic theories are not accepted and people like Paul Krugman offer an argument that's hard to prove wrong. If all of the money printing by the central banks around the world does not lift the economies out of recession they'll simply state the banks didn't print enough and governments didn't spend enough. How do you argue against that?

Most economists argue that the economic models prove that more government spending increases GDP and helps pull an economy out of recession. Common sense tells us government spending is wasteful in almost all regards. You're taking money from producers who could better invest the money and instead giving it to make-work programs or direct handouts to those who did not earn it. Spending on infrastructure, basic research, defense (not offense) and a few other areas are obviously good public spending initiatives and some of it increases GDP but most is wasteful and detracts from GDP. The broken window theory comes to mind here.

I came across a good story about all this which is humorous and spot on. "Paul Krugman and John Maynard Keynes were out for a walk and they came upon a pile of fresh dog poop. Keynes, feeling mischievous, offered Krugman $25,000 if he would eat it. Krugman, being a trifle low on cash, decided to take him up on the offer and ate the poop. Then they walked on. A little while later, Krugman, feeling rather ill and annoyed at Keynes for the cruel trick, decided to turn the tables on him, and when they passed another pile of dog poop offered Keynes his $25,000 back if he would eat it. Feeling rather foolish at having wasted all that money and anxious to have it back, Keynes complied. As they walked on, Krugman remarked to Keynes, 'You know, neither of us is any richer, and we've both eaten dog poop.' 'Yes' replied Keynes, 'but we've increased the GDP by $50,000.'"

Increased volatility in a market is typically found at major turns and with a -2.5% day today we can add another day to the 31 days that have seen a rise of fall of more than 2%. As the chart below shows, with more than 6 months left in the year we've already seen more volatility than 2011 and 2012 and will soon overtake 2010. We're on pace to beat 2009 as well. It was 2008 that saw a lot of volatility in the strong drop from the 2007 high and it's not a good sign for the bulls.

Number of days that rose or fell more than 2%

When considering all these things, plus the strong volume on a strong down day, it's not hard to feel especially bearish about the market right now. It's hard to imagine the market simply dusting itself off and rallying back up from here. But that remains a possibility that must be considered, even if only to keep from getting complacent about the downside.

Starting off with the DOW tonight, the weekly chart shows last week's break of its uptrend line from December-April, a back test this week and the kiss goodbye that led to a new low for the month. Following the achievement of the 15405.70 projection in May, for two equal legs up from October 2011, it was a good setup for THE top to the rally. There are a couple of wave count ideas that support another rally leg but from a weekly chart perspective it's easy to argue for much lower prices from here.

Dow Industrials, INDU, Weekly chart

One of the challenges, from an EW (Elliott Wave) perspective, is trying to figure out what the first leg of the decline (May 22 - June 6) is. It doesn't look impulsive and that keeps the door open for just an a-b-c pullback from the May high that will lead to another push higher (green path). The decline from May right now is a 3-wave move and we don't know if it's an a-b-c or a 1-2-3. Two equal legs down points to 14642 so a decline below that level would improve the bearish potential but for now it could go either way. The leg down from Monday looks like it might have completed a 5-wave move and that sets up the potential for a bounce on Friday. If the bounce leads to another leg down then the bearish wave count would look strong. But if the bounce leads to something more bullish (impulsive move back up) then we'll still need to look for the bullish possibility of a new high in July.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 15,340> - bearish below 14,640

SPX broke below price-level support at 1597-1598, which comes from its April high and June low. Not shown on the daily chart below is the longer-term trend line along the highs from 2000-2007, currently near 1594, so a drop below 1594 points to a decline to at least 1565 where it would achieve two equal legs down from May. The next downside projection is to 1510 where the 2nd leg down would be 162% of the 1st, which would also be a test of the 200-dma. But, as with the DOW, the 3-wave pullback from May could be just an a-b-c correction to the larger rally and be followed by another leg up into July. Mid-July is when a few different cycles converge and has been pointing to the potential for a major high for the market at that time.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1655
- bearish below 1597

The SPX 60-min chart shows a closer view of why I'm struggling with what the 1st leg down from May is. It looks more like a 3-wave move for wave-A, which is the reason I continue to wonder if we're getting just an a-b-c pullback before heading higher again. If the decline from Monday has completed a 5-wave move down, which it looks like it has, we'll get at least a bounce to retrace some portion of this week's decline. A corrective bounce up to the 1620 area would set up a shorting opportunity while a stronger bounce above 1620 would have me leaning a little more bullishly. Obviously it would be more bearish if it simply continues to head lower from here but in that case watch for possible support near 1565 (two equal legs down from May).

S&P 500, SPX, 60-min chart

NDX looked bullish on Monday as it broke out of its bull flag pattern for its pullback from May, which also looks very choppy and supportive of just a pullback correction before heading higher. And Monday's rally looked like the start of the next leg up. Wrong! Head-fake break followed by a strong reversal -- a failed pattern tends to fail hard and that's what it did. As soon as it dropped back inside the flag pattern it was a failed pattern and a sell signal. It briefly broke the bottom of the flag but found support at it. It's a setup for a bounce back up but obviously the bulls need to get started right away.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 3000
- bearish below 2900

The RUT was holding up better than the others when it comes to its 50-dma, currently at 964.99, holding above it until this afternoon's leg down. Once that support level broke I was looking for a decline to 957.14, where it would have two equal legs down from May and crosses its uptrend line from November-April on Friday. Today's low at 957.51 might very well have completed a 3-wave pullback from May, setting us up for another rally leg. It closed near the bottom of a parallel down-channel for the 3-wave pullback. Of all the indexes, the RUT is still the one that has the most bullish pattern with its choppy pullback from May and I think is our canary for now. But that doesn't prevent a drop down to the 930 area where the 2nd leg of the pullback would be 162% of the 1st leg down.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1000
- bearish below 957

The bank index is a little stronger than the broader indexes since it hasn't broken below its June 6th low. It might be forming a sideways triangle if it bounces back up on Friday, which would fit as a continuation pattern that would likely lead to the final leg of the rally. With the EW labeling I show the rally complete at its May 30th high and the drop back below the trend line along the highs from September 2012 - March 2013, currently near 60.55, is a little bearish at the moment. Continued selling from here could turn into very strong selling, but watch for possible support at its 50-dma at 58.95, its March high at 57.60 and then its uptrend line from November-April, near 57.

KBW Bank index, BKX, Daily chart

With bonds selling off the past two days we're on the verge of finding out if it's going to be a more bearish breakdown (rally in yields) or a setup for a reversal. Looking at the 10-year yield (TNX), it pushed slightly above price-level resistance near 2.41%, which comes from August 2010, October 2011 and March 2012. It will be an important break to the upside if TNX can hold above this level, in which case we would likely see the 200-week MA at 2.579% tested and possibly up to its long-term downtrend line from 1981-2007, currently near 2.85%. A break of that downtrend line would clearly be bullish for yields (bearish for bond prices).

10-year Yield, TNX, Weekly chart

The daily chart of TNX shows another reason for possible resistance right here -- it tagged the top of a parallel up-channel for the rally from May 1st. It has also reached a Fib projection at 2.42%, which is where it might have completed an a-b-c bounce pattern off the July 2012 low (wave-c = 162% of wave-a). Today's candle is a dragonfly doji at potential resistance, which is a reversal candlestick if the next day confirms it with a red candle.

10-year Yield, TNX, Daily chart

The Transportation index is currently showing some bullish non-confirmation with the DOW because it has not broken below its June 6th low (like the banks). It will obviously be more bearish below 6115, especially since it would likely mean the rest of the market is also dropping lower. But interestingly, it's easier to look at its first leg down from May as more of an impulsive move, which in turn supports the idea that it's a 1st wave down instead of an a-wave. Back above 6400 would be bullish while below 6100 would be bearish. Let price lead the way.

Transportation Index, TRAN, Daily chart

The U.S. dollar has had a decent rally the past two days and today's high tested a broken downtrend line from June 2010 through the July 2012 high as well as its broken 20-dma. The dollar had rallied above the downtrend line in March, April and May but then dropped back below it with the strong decline this month. The downtrend line and 20-dma are both near 82.17 today (today's high was 82.32 but it closed at 81.96) and both of those might hold as resistance. If the dollar were to drop below the June 13th low at 80.50 it would turn the pattern more bearish for at least this year. The bullish path, which I continue to believe is the higher-odds scenario, is depicted on the weekly chart below. It calls for higher prices this year inside what I think is a very large sideways triangle pattern playing out from 2009, the top of which will be near 87.30 by the end of the year.

U.S. Dollar contract, DX, Weekly chart

The dollar's decline in May did nothing to save the commodity index from dropping lower and with the dollar's rally the past two days it puts more downside pressure on commodities. The index broke a short-term support shelf near 130, which it had been holding above since mid-April and now it looks like it could drop to its June 2012 low near 127. SPX has at least started down to start closing the gap between the two (from here or maybe after one more high for the stock market). Just for comparison here, the June 2012 low for SPX was 1266.

UBS Commodity index vs. SPX, Daily chart

The metals got clobbered today and gold gave up almost $100 (-7.1%). Silver was hurt even more. Gold continues to stair-step lower and as depicted on its chart, the downside objective at 1155 by September is the expectation (while recognizing the fact that the large spread between commercials, who hold a very small short position, and small speculators, who hold a very large short position, is actually bullish for gold).

Gold continuous contract, GC, Daily chart

Oil was looking bullish with last Friday's break of the downtrend line from September 2012, near 95.6, as well as Monday's break of previous highs since January. But that was all reversed between yesterday's and today's selling, putting it back inside the sideways triangle pattern that has formed since the September 2012 high. If it rallies back above Monday's high at 98.67 we should see it head up to the downtrend line from May 2011 (the top of a larger sideways triangle). But a continued drop from here would likely take oil down to the bottom of the smaller triangle, near 86.70. Oil is likely to remain volatile this year.

Oil continuous contract, CL, Weekly chart

Today's economic reports, which were generally good, were completely ignored by the market. There are no major reports on Friday.

Economic reports and Summary

Following the 1-1/2-day selloff the market is oversold and due a bounce. Just keep in mind the series of Hindenburg Omen signals that the market experienced in the recent weeks and that stock market crashes come out of oversold conditions. The setup is good for either a crash (to join the Nikkei) or at least a bounce but the bullish scenario calls for something more than a choppy upward correction before gaining confidence about the upside.

For the bears, if we do get a bounce on Friday it might be a very good setup to get short. The bearish pattern calls for a bounce to retrace a portion of this week's decline and then an even stronger decline to follow. Figuring out whether a bounce will develop into something stronger will be the hard part. I'll be evaluating the pattern and will first try shorting a 3-wave bounce to a Fib retracement and then manage it carefully in case the bounce just keeps going. If you're instead feeling bullish about the possibility for a new high, start looking to get long (while trying not to get cut by the falling knives).

Good luck and I'll be back with you next Wednesday.

Keene H. Little, CMT

In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying