There had been hope for a relatively quick resolution to the government shutdown, and even an expectation that both sides would be forced to compromise and that nothing bad would happen. Some are now starting to worry about those assumptions and that's putting pressure on the stock market.

Market Stats

Jim and I are switching wraps this week. He will be back with you tomorrow.

As we headed for this morning's opening bell it was looking like we'd start the day on the right foot following an overnight bounce attempt. But then a couple of sell programs hit right at the open and other than a relatively brief attempt to get the market to rally it then proceeded to sell off for the rest of the day. A small bounce attempt for an hour late in the trading day failed to attract any buyers and the market sold off into the close. It was not a good day to be a bull.

The market is of course not happy with what's (not)happening with our government. Hopes for a quick resolution, and the reason for last week's rally attempts, had traders front-running the market in hopes of enjoying a powerful (even if short-lived) rally following a settlement between the parties. The longer this inability to settle the difference the more worried people are becoming. The market hates uncertainty and we've got a lot more of that this week than we did last week. The selling since Friday's hope-filled rally attempt is reflecting this worry.

As is true for so many of us, I'm sick and tired of our inept government. Most Americans classify themselves as in the middle between the hard left and hard right but it seems the two extremes are the ones trying to run the show and they're entrenched in their positions without any settlement in sight. I read a very good analysis by George Friedman from Stratfor.com that has very little to do with the stock market but in effect it has everything to do with the market because of the uncertainty over what's going to happen this month before the debt limit ceiling is hit in early November. It's a very good read (The Roots of Government Shutdown) and it will help you understand a little more how we got into this mess and what's needed to get out of it.

If neither side in government is able to compromise (and from the above article you'll understand better why they can't compromise) we will spend the rest of this month hearing the bickering and threats from both sides. We will hit the limit in spending and then there are all kinds of speculation about what might happen. A president's hands are effectively tied by the Constitution that requires him to spend only on what Congress authorizes and only as much as Congress authorizes. Congress rightfully does not want to give up this responsibility (it's part of the balance of power that our Founding Fathers created with our Constitution). The president rightfully does not want to see the country default on its obligations and suffer the domestic and global ramifications resulting from that.

And here's where we find another argument -- that which is considered a government obligation when it comes to the discussion of default. Most believe it is the payments on our debt (Treasuries) that must happen otherwise we default. This has countries like Japan and China (our two largest debt holders) demanding the U.S. fix the problem and not default. But we have enough income on a monthly basis to easily pay our debt obligations. So why the fuss and scare tactics?

It turns out the bigger argument is what is considered "government obligation." There's a lot of speculation now that Obama will use the 14th Amendment, which came out of the post-Civil War reconstruction era, to get around Congress. This Amendment has been one of the most litigated sections of the Constitution and while it's known primarily as the Amendment that addresses citizen rights and equal protection of the laws, the 4th section of the Amendment deals with the government's obligation to meet its public debt. As quoted from the Amendment, "The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned." [Emphasis on part of the quote is mine.]

The speculation here is that Obama will try an end-run around Congress and invoke the 14th Amendment to ignore the debt ceiling and continue to spend that which is required to meet the government's obligations. He figures he's going to be forced to break the law one way or the other -- either not meet the government's obligations (as he interprets them) or spend more than Congress authorized -- so he might as well choose which law to break. The problem of course is in the definition of "government obligation" and that could get tied up in court for years before a Supreme Court decision is finally made.

I didn't intend to give a civics lesson here but I think it's important to understand why the "uncertainty" factor is climbing. Tying this back to our market, if the President decides to ignore the debt limit, using the 14th Amendment as justification, he will make Congress impotent in controlling the budget. The President will get to spend as much as he has to on whatever obligations the government incurs. We know Obamacare is going to cost a lot more than originally forecast. All of the entitlement programs will continue to get funded. By Executive Order he could simply declare any expense item a "government obligation" that "shall not be questioned." The Fed has already decided QE will become a structural part of the government (do you suppose they saw all this coming?) and the vehicle for additional money required to fund the government's obligations is already in place.

As more of this potential starts to become more real we could see a significant impact on the value of the dollar and precious metals. We could see a stock market rally once the dust clears and traders realize that more Fed "stimulus" (otherwise known as monetization money) will stoke the fires again. But in the short term there is so much that we don't know and the big unknown of course is how this will all play out with the public and overseas partners. Sentiment is key here and even if the mechanics of how the bills are paid gets resolved we can expect sentiment to sour and that's what affects the stock market. Hang onto your hats for what could be a wild and wooly ride.

Today was another bad day for the market, especially for the techs and small caps. They were leading the parade to the upside and now that fund managers are becoming more concerned about the near future they're starting to lighten up on their exposure to riskier stocks. But money did not rotate into bonds, which finished flat for the day, and while the blue chips were a little stronger than the techs and small caps, there wasn't a rush into the blue chips for safety. The metals were also flat-to-down today and what we had was a no-where-to-hide kind of day.

I'll start off tonight's chart review with the small caps since the RUT is at an important inflection level and is a very good sentiment indicator. We should know shortly if another new high this year is coming or if instead the year's high was on October 2nd. The weekly chart shows a rising wedge pattern for the rally from October 2011 and then a tighter one from the November 2012 low. The top of the wedge is the trend line along the highs from February 2012 - July 2013. From that high it has now dropped down to the bottom of the rising wedge from November 2012.

Russell-2000, RUT, Weekly chart

The uptrend line, from November 2012 - June 2013, is where today's low found support when the line is viewed with the log price scale. The uptrend line is lower when viewed with the arithmetic price scale, currently near 1033, but at the moment price is respecting the higher line (it traded relatively flat all afternoon near the low). These wedge patterns have a habit of morphing into larger ones so another rally to the top of the wedge into November can't be ruled out. A projection for two equal legs up from the March 2009 low is near 1120, which crosses the top of the wedge in November. While I don't believe the market will take the RUT up to that level (I think the highs are now in place), it can't be ruled out yet and bears need to stay aware of the higher potential.

The daily chart below shows more clearly how it's holding at its uptrend line, with only a small break of its 50-dma at 1050. Between the 50-dma and the uptrend line there's plenty of support to entice the dipsters back in. If support here doesn't hold we'll probably see a drop down to 1030-1040 area in the next day or two. It stays bearish below price-level S/R at 1063 and would be bullish above 1081.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1081
- bearish below 1063

Getting in closer, the 60-min chart shows the 3-wave move down from the October 2nd high, which could be an a-b-c pullback correction or the start of an impulsive 5-wave decline. The short-term pattern suggests we'll see the RUT stair-step a little lower on Wednesday and find support in the 1040-1044 area (1044 is where the 3rd wave down would be equal to 162% of the 1st wave down). Following that we should see another bounce/consolidation through the rest of the week before dropping lower next week. That would give us a 5-wave move down and confirm the trend has changed to the downside. But if we start to get a stronger bounce (dashed line) we'll have to start more seriously entertaining the thought of new market highs in November, especially if it gets back above 1063.

Russell-2000, RUT, 60-min chart

After hammering on support at its 50-dma, near 1680, for the past week SPX broke it with gusto today. Each test of the 50-dma ate through more supply and once it became clear price was only consolidating on top of it it was just a matter of time before it broke. There were a lot of stops parked below that average and then more stops just below its uptrend line from November-June, near 1668 today. Once that trend line broke there were a lot of sellers looking to get out of their long positions. Was it just a flush today, to be recovered on Wednesday, or was this the kickoff to much lower lows? If it bounces back up to its broken uptrend line and turns back down from there (back test and kiss goodbye) we'll know there are lower prices ahead. But a rally back above 1670 on Wednesday would tell bears to be cautious.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1697
- bearish below 1670

The decline for SPX from its September 19th high has been somewhat orderly as it marches down a parallel down-channel. A little selloff into the close had it breaking the bottom of the channel but it's hard to say whether that was the start to a more significant decline on Wednesday or just a little throw-under that will be reversed Wednesday morning (oftentimes a finish at the high/low of the day following a big move leaves the market primed for a reversal the following day). If the bearish wave count is correct (same as the RUT's discussed above) we'll eventually see price break down from the down-channel, which is the indication that the move is a 3rd wave of an impulsive move down rather than just an a-b-c corrective pullback. And once the channel breaks you can watch for the bottom of it to be resistance when back tested (a shorting opportunity). But a rally back above 1670 would be the first signal for bears to back off.

S&P 500, SPX, 60-min chart

The DOW has been very weak since its September 19th high and it's been a little surprising. During a period of market weakness it's common to see money run into the relative safety of the bluest of the blue chips and their huge float (making it easier to sell later). Each time I think it's ready for a bigger bounce it declines instead and today's decline was a firm break below the uptrend line from June-August. The next support level (maybe) will be its 200-dma at 14720. That could launch a bigger bounce and back above 14875 would be reason enough to get bears to back off. A small bounce off the 20-dma could lead to a drop lower to its uptrend line from October 2011, currently down near 14400 (log price scale, whereas it's lower, near 14100 with the arithmetic price scale).

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 15,200
- bearish below 14,875

NDX led the way down today, reversing its relative strength in the run up to its high on October 2nd. Today's decline was a strong break of support at its 20-dma and uptrend line from June-August, both coinciding near 3212 (log price scale for the uptrend line). Multiple stops below that level were obviously hit today. The next level of support is its 50-dma at 3151.57 and its August 13th high at 3149. For the move down from October 2nd there is a price projection at 3150 where the 2nd leg of the decline is 162% of the 1st leg down. For this reason I suggested during the day that 3150 should be strong support and to look for at least a small bounce into tomorrow. We didn't get much of a one before selling off into the close and if there's no bounce on Wednesday it could be a signal that there's serious trouble ahead. I show a bounce/consolidation near support and then lower to about 3100 by early next week before a larger bounce. A bounce and lower low would give us a 5-wave move down and confirmation an important high is in place. At the moment another rally into the end of the month cannot be ruled out.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 3257
- bearish below 3150

The VIX shot higher today, following yesterday's spike higher as well. That had it reaching its downtrend line from the end of December and could result in a pullback in VIX, which would mean a stronger bounce in the stock market. Whenever the VIX spikes up it's a warning sign that things are turning too bearish too quickly. The flip side of this is that a kickoff to a stronger decline could see the VIX spike much higher (30 to 40+) so this is not a signal to take by itself but it is another reason for bears to be a little careful here.

Volatility index, VIX, Daily chart

Treasury yields look like they'll be heading lower. Following the decline into the end of September we've seen yields consolidation sideways. This looks like a bearish continuation pattern and should lead to another leg down. That would mean a rally in bonds, which could result from money rotating out of stocks into the relative safety of bonds.

10-year Yield, TNX, Daily chart

There are a couple of reasons to think bonds are ready for a stronger rally -- the two charts below show sentiment is very bearish bonds right now and that sets it up for a bullish turn (lower yields). The top chart shows the COT (Commitment of Traders) and the net short position that matches previous lows for bond prices (TLT, the Treasury ETF is referenced here). The bottom chart shows SentimentTrader.com's Bond Indicator Score, which is a measure of bullish vs. bearish sentiment in bonds. Again, it's currently deeply bearish and that sets it up for a reversal. The chart pattern supports it and the sentiment picture supports it -- look for a continuation of the rally in bonds.

TLT and bond investor sentiment, 2007-September 2013

If we're to follow the money, and if the bearish wave count on the BKX chart below is correct, we should be thinking only short right now. The wave count for the move down from August 1st can be considered a 1-2, 1-2 setup, which calls for a very strong decline in the 3rd of a 3rd. This calls for a continuation of the selloff from here with barely a pause for the next few days. If that happens, you will want to sell bounces and not consider buying the dips. BKX could drop quickly through its 200-dma and down to its uptrend line from October 2011, currently near 58, maybe even down to its H&S price objective at 56.50. But right now there are hints of bullish divergence so any larger bounce, such as once that gets it back above its broken uptrend line from November-April, near 62.32, should have traders backing away from the short side. Follow the money, whichever way it goes.

KBW Bank index, BKX, Daily chart

The U.S dollar had been relatively quiet the past few days and while one would expect the dollar to show weakness as the government debate continues, it's quietly showing some strength since last Thursday's low. On Friday it broke its downtrend line from September 6th and then pulled back to test it on Monday and again today. If it holds as support, which it's doing so far, it could lead a stronger rally as depicted. But there is still the potential for a drop down to its H&S neckline from February 2012 where it intersects the trend lines for September's decline, all crossing near 79.50 on Friday. A break below that level would likely see the dollar dropping down to 78.58 for two equal legs down from July.

U.S. Dollar contract, DX, Daily chart

There's an eye-opening chart put together by Doug Short (dshort.com) that shows the declining value of the dollar since 1870. As he noted on the chart, the real decline didn't start until the Federal Reserve was established in 1913 (he notes it was in 1914), which is strange because one of their charters was the stabilization of the dollar. I guess that means a stable descent. If they were established to destroy the value of the dollar through steady inflation (as many conspiracy theorists surmise) they get an outstanding achievement award. Taking the dollar valued at about 1.25 in 1913 and driving it down to about 5 cents (probably lower since the CPI calculations were changed in 1982) in 100 years is quite an achievement.

Price Inflation, chart courtesy dshort.com

Gold is back up to resistance after bouncing off its October 2nd low. Its downtrend line from February-April (log price scale) and the bottom of its resistance band at 1336-1345 is once again being tested. A rally above 1345, which includes its 50-dma, would be bullish and it would point to another rally leg to equal the June-August rally (giving us an upside target at 1531.50 and a test of its previous important support level near 1525, which it broke in April). But at the moment the little bounce from October 2nd looks corrective and points lower.

Gold continuous contract, GC, Daily chart

Oil broke its uptrend line from April at the end of September and has been trying to get back above it since spiking back up on October 2nd. But between the broken uptrend line and its declining 20-dma, now at 104.38, it could be tough resistance for the bulls to push through. A rally above its 50-dma, at 105.90 would be a bullish move but at the moment I think the bears remain in control. We could see some volatile price action, as depicted on the chart, but lower prices into November.

Oil continuous contract, CL, Daily chart

Economic reports have of course been hit or miss, depending on which government agency produces the report and whether or not they're working or off on paid vacation (sorry, that slipped). The only report tomorrow that will likely get at least some reaction is Wednesday afternoon's FOMC report where we get to read what the Fed wants us to read about how they decided not to taper.

Economic reports and Summary

The worries about the impasse in government are growing as both sides further and more deeply entrench themselves in hard positions; neither side is willing to cooperate (I won't even use the evil word "compromise") lest they lose support from their political base (read the link provided to George Friedman's analysis that was provided near the top of my report to get a better understanding why compromise isn't working). The traders are beginning to doubt a solution is in the works and because of the uncertainty about what it will mean for the market we have fund managers taking risk off the table.

We were getting rally attempts last week in anticipation of a market rally following a settlement. That front-running has turned into selling this week as more traders are starting to question the idea that we'll get a bounce and the idea that the bounce might come from much lower levels. The reduction of risk is seen most in the stocks that led the rally -- the techs and small caps. As long as these "sentiment" stocks are in decline it's not a good time to be thinking long. The dipsters are now fueling the decline and while we could see a bounce on Wednesday we have to assume that lower prices are ahead for as long as Congress and the President continue to act in defiance of the common good of the country.

Good luck during this mess and I'll be back with you next Wednesday and opex week. This one could be interesting.

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