For many days now we've seen gaps to the upside followed by selling, which is a sign of distribution. It's one sign of several now that we should be looking for a top.

Market Stats

This morning's gap up was followed by an immediate selloff, a pattern that has been repeating for many days now. It's a distribution pattern employed by many of the big hedge funds -- they help lift the futures market in the overnight/pre-market session, create a gap up for the start of the day, which then sparks a flurry of buying that the fund managers sell into. The extra liquidity with the gap up and buying creates a good opportunity to sell at better prices. It's a way for the fund managers to hand off their inventory to the retail crowd, which means you don't want to be one of the buyers in the morning.

Following yesterday's disappointing showing in existing home sales, this morning's report of new home sales was better than expected, coming in at +497K vs. 483K expected and better than May's upwardly revised +476K. But it didn't prevent the home builders from getting whacked today -- down -4% today. The home builder's index continues to chop up and down inside the potential diamond top pattern I've been showing for weeks so there's no clear direction yet other than that it's in a topping pattern.

There were no other important economic reports, the Fed is in its quiet period and we're getting mixed reviews on earnings. AAPL squeezed a lot of juice out of its stock today and jumped +5.1% while CAT had some dirt shoveled over it as it have up support near 85 and dropped -2.4% to about 83, closing its gap up on July 9th. That was its 2nd gap of 3 in the move up from July 5th. There's an uptrend line from October 2011 near 81.50 and strong price-level support near 80 if it drops further from here.

Other than more stories about the weakness in China there's very little happening in the global markets to shake things up so it's been a quiet week. For those who read updates from Stratfor (George Friedman) you might have seen the analysis on China. For a long time they've been pointing to fundamental weaknesses in the country that were being masked by government reports that were, um, less than honest. Now many people, even Paul Krugman, are beginning to realize China is a house of cards waiting for a wind storm.

All the easy credit and massive spending on projects designed to keep workers busy has built an economy on weak supports -- they do not have the domestic demand to absorb all that's been built and their exports are dropping because their customers' economies are slowing. Commodity prices have been in decline since they peaked in April 2011 (while stock markets ignored the warning signs) and they've probably got much further to fall. This will have a particularly negative effect on countries like Australia and Canada, which are primarily resource economies.

Will something happen in China that creates a black swan event? The markets are perched on the edge and we could be close to something kicking it off cliff. The rally from June looks like a blow-off top following a rally pattern that looks very similar to the 2003-2007 rally. We've even had the momentum high in May, similar to July 2007, and now a new high on lower momentum (bearish divergence for a double top) in July. As the saying goes, the market doesn't necessarily repeat but it often rhymes.

Since it's been relatively quiet in the market there's not much to discuss so I'll just jump right into the charts. But speaking of quiet, trading volume in the climb up from June continued to slow and we had volume on Monday and Tuesday that was near the lowest of the year. Today's volume saw a jump higher, which for a selloff is not a good sign for the bulls. The price patterns for the indexes support the idea that we've seen major highs and now I'm looking for confirmation of that (still early in that regard).

The SPX weekly chart shows price has stalled at the price projection at 1688.73, which is where the 5th wave in the move up from June 2012 is equal to 62% of the 1st wave. If the bulls stay in control there is further upside potential to 1768 where the 5th wave would equal the 1st wave. That projection crosses the trend line across the highs from September 2012 - May 2013 in August. I consider that a lower-odds potential from here and the bearish divergence is supporting the idea that we should be looking for the final 5th wave high at any time now, which might already be in place as of Tuesday's high.

S&P 500, SPX, Weekly chart

The daily chart below shows a tight up-channel for the leg up from June 24th and today's decline confirmed the breakdown from the channel. Confirmation of a high would be a drop below the July 16th low near 1671. If this week's pullback is followed by another push higher we could see an upside target near 1705 achieved. Anything higher than that would be potentially bullish for a run up to at least 1750, if not the 1768 projection shown on the weekly chart.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1705
- bearish below 1671

The 30-min chart zooms in on the rally from July 16th and you can see the break of the up-channel as well as a drop back below the May high. The rally from June 24th is a 5-wave move, with the 5th wave being the rally from July 16th, which is why a drop below that low, near 1671, would indicate the high for the move is in place. Considering the fact that it's the completion of a larger 5-wave move up from June 2012 it's a reason to be thinking bearishly about the market now (especially once SPX drops below 1671).

S&P 500, SPX, 30-min chart

One measure of market breadth is the number of advancing issues minus declining issues. When looking at the cumulative value of this measure you can get a good sense for how well supported the market's rally is. If the a-d line is keeping up with the climb in the indexes it's a good sign because more stocks are supporting the rise. When the indexes continue to rise on fewer and fewer stocks it begins to warn you that the rally is running out of support.

So far we have the a-d line starting to lag the price climb in the NYSE. The July high was slightly below the May high and you can see MACD showing a significant bearish divergence and starting to curl over. At the moment this is looking like a double top in the making.

NYSE Cumulative Advance-Decline issues, NYAD, Daily chart

Today the DOW dropped down to its uptrend line from June 24th, which will be near 15525 Thursday morning, and not surprisingly it bounced off that support line. But the bounce looks corrective and more like consolidation on top of support. If it breaks down then the next level of support is near 15400 if 15500 doesn't hold and then each century level following that. A drop below the July 16th low at 15415 would confirm THE high is in place and a sign to short bounces from there.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 15,600
- bearish below 15,415

The DOW's 10-min chart shows a nice setup from this morning, one which can be used on any time frame that you see this pattern. There was a rising wedge building since last Friday's low, along with the bearish divergence seen on MACD. This morning is broke below the bottom of th wedge, bounced back up to it for a back test and then a bearish kiss goodbye. That was the signal for the bears to pounce. But the uptrend line from June 24th held so it's potentially bullish, although so far the bounce is to another lower high in a series of lower highs since Tuesday morning's high (potentially THE high). The bearish pattern here is a series of 1st and 2nd waves to the downside, setting it up for a strong decline on Thursday (to unwind 3 degrees of 3rd waves). It would mean a fast drop to the 15400 area and then stair step lower from there before it will be ready for a larger bounce.

Dow Industrials, INDU, 15-min chart

The tech indexes topped out earlier than the other indexes and the COMPQ hit its high near 3625 last Thursday morning. The decline from there does not yet look impulsive and therefore supports the idea that we could see the market make another run higher. The alternative interpretation of the choppy pullback so far is that it's building up a bearish wave count that is going to suddenly let go. I think a break below the top of its July 11th gap up, near 3550, would be a strong indication that it's breaking down instead of correctively pulling back. But if the rally from June has not completed yet, which would be confirmed with a push above 3625, the next upside projection that I have is at 3687-3695. I'm using the tech indexes as my bullish canaries -- if they head higher they're not going to do it alone.

Nasdaq Composite index, COMPQ, Daily chart

Key Levels for COMPQ:
- bullish above 3625
- bearish below 3550

Last week the RUT pushed slightly above the top of its parallel up-channel from October 2011, currently near 1044, and pulled back to the top of the channel today, closing slight below it. This should hold as support if there's more rally to come. But the leg up from June 24th, shown holding inside a very tight and steep up-channel, looks complete now. At a minimum I would expect a larger pullback to correct the rally before heading higher again. More bearishly, the rally from June is the final leg of the rally from 2009 and we should now be at the very beginning of the next major bear market leg down.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1053
- bearish below 1036

The VIX has seen a collapse in fear since its June high, which fits the sudden bullishness in the stock market following the rally to a new high above the May highs for the indexes. It dropped below its uptrend line from March and below its May low at 12.26, hitting a low of 12.07 yesterday before rebounding. Following the stock market's gaps up yesterday and today, and then the selloff each day, the VIX has been climbing back up. But it tagged its broken uptrend line from March and could drop to lower lows from here, which would obviously be bullish for the stock market. Downside potential is to just below its March low at 11.05. On the flip side of the coin, a rally back above its broken uptrend line would signal it might have an important low.

Volatility index, VIX, Daily chart

An interesting perspective with VIX is to look at it as a ratio between SPX and VIX, which shows when SPX is getting higher relative to a low VIX than "normal" times. As the chart below shows, previous peaks in this ratio have been at important market highs in the past. This is a monthly chart and shows the previous peaks in 2000 and 2007, with the currently peak approaching the one in 2007. Note too that the peaks identifying important stock market highs occurred after peaks in the rate-of-change (ROC) indicator, which is what we currently have. This is not a timing tool but it's a clear warning to the bulls -- this is not a time to be complacent about buying the dips anymore. The next "dip" should be like the one following the 2007 high.

SPX/VIX ratio, Monthly chart

The banking index took the higher ground that I had been pointing out the past couple weeks by pressing up near the top of its parallel up-channel from October 2011, currently near 67.60 (this morning's high was at 66.99). It has reached the top of a parallel up-channel for price action since the April low and its rally can be considered complete at any time from an EW (Elliott Wave) perspective. If it presses marginally higher into the end of the month, the tops of both up-channels cross near 67.80 on July 30th. Two equal legs up from April points to 67.95 (in case it's an a-b-c up from April rather than the 5-wave move up from November 2012 as currently labeled).

KBW Bank index, BKX, Weekly chart

The TRAN has been hit harder than the broader indexes this week, dropping another 1% after yesterday's -1%. This follows the back test of its broken November-April uptrend line last week and the bearish kiss goodbye is not a good sign for the bulls. I decline in the TRAN will b another indicator of economic weakness and with China's weakness I don't think the stock market will be able to ignore it much longer. The 5-wave rally from June did a nice job completing its rally and the bearish divergences with overbought indicators on the daily and weekly charts suggests we could see more than just a pullback to correct the June-July rally.

Transportation Index, TRAN, Daily chart

The dollar's volatility makes guessing its next direction a bit challenging. I haven't given up on thinking it's going to head higher still but I'll admit it's been a lot whippier than I thought it would be. There is support at its broken downtrend line from 2010-2012, tagged yesterday and today, and then slightly lower is the bottom of its up-channel from the end of 2012, near 81.70, and its 200-dma at 79.75. It should not break below its June 13th low at 80.50 if the bullish pattern is to hold.

U.S. Dollar contract, DX, Daily chart

Gold bugs are excited about gold's bounce off the low on June 28th, from a low of 1179.40 to last night's high at 1348.70 (+69), and they might have good reason to be excited. The rally from June looks impulsive (5-wave move), which suggests a pullback from here and then higher again. As depicted on the chart, we could see a pullback to its broken downtrend line from April and then another leg up to the 1400 area. Higher than that would be a bullish sign for gold. But with the expectation for this bounce to be a 4th wave correction, we could see a minor push higher from here (to create a corrective rather than impulsive wave count for the bounce) and then the resumption of the decline. The uptrend line from April-May, which was broken with the snap to the downside on June 20th, is currently near 1365 so a quick move up to that level could be followed by another leg down.

Gold continuous contract, GC, Daily chart

One reason why I remain bearish gold is because of what I see for silver. Its bounce off the June 28th low is forming a small rising wedge with overlapping highs and lows in the bounce pattern (it's not impulsive like gold's bounce). It looks more like a 4th wave correction before heading lower. As indicated on its chart, I see the potential for one more bounce higher to about 21 by the end of the month and then lower again next month. It could drop down to the 15.50 area before setting up another bounce in its stair-step lower pattern.

Silver continuous contract, SI, Daily chart

Following last week's update, showing oil reaching an upside target at 108.75 (for two equal legs up from June 2012) as well as the top of its parallel up-channel from June 2012), it reacted with a strong pullback, including today's $2 decline. Its broken downtrend line from 2011-2012, near 103, should hold as support (if tested) if the bulls are to remain in control of the pattern. Below 103 would further support the idea that we're going to see oil drop down to at least the low 80's.

Oil continuous contract, CL, Weekly chart

Tomorrow's economic reports include the durable goods orders, which are expected to be weaker than May's numbers. It might move the market if it's significantly different than expected.

Economic reports and Summary

We have early signs that a major market high might be in place. We don't yet have the evidence, with an impulsive decline, to confirm the top is in place and by this time next week we'll know for sure. But the decline started from expected levels and there is the potential for the market to drop hard on Thursday. If it does we'll have more proof that the rally leg from June has completed. In the larger price pattern that leg completes the rally from 2009, which is the reason I'm suggesting bulls be very cautious here.

Once a top is confirmed, instead of buying the dips you'll want to sell the bounces. Instead of riding a pullback, with the expectation that the market will come back (after all, it always does, right?), I think we're at the point where longer-term positions need to be protected. Set your maximum loss, place your stops and let the market decide for you when to sell (it takes the emotion out of placing the actual sell order).

Betting on the long side is now very risky. We can see that each morning when the buyers are getting hammered. Today was a classic bull trap. Fading rally attempts is currently working and might work for a long time. Trade carefully in the transition here.

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