Heading into Tuesday's highs we had a good setup for a reversal of the rally. Following Tuesday morning's highs we now have some confirmation that the rally has probably finished and the 3-wave bounce correction off the August low has probably completed. We now wait for further confirmation.

Today's Market Stats

Tuesday morning gapped down but there was a big buying spike at the open, which was then followed by strong selling as big money used the buying and increased liquidity to sell into. The same thing happened this morning with the buy programs hitting at the open and then before 10:00 AM the sellers hit the tape, again using the liquidity surge in the buying as a way to cover their selling. But then the selling overwhelmed the buying and the indexes dropped back into the red. An afternoon bounce attempt was again used to sell inventory and it's looking like a distribution pattern this week, which is at odds with a normally bullish opex week. Was last week's rally the usual head-fake move in front of opex, but this time opposite to what has been normal?

Not helping the market's mood this morning were the economic reports that showed a continued slowing in inflation (not deflation since that's a bad word so we'll go along with the Fed's "disinflation") and a continued slowing in the economy.

The PPI numbers before the bell showed a decline of -0.5%, which was a more significant drop than the expected -0.3% and a drop from 0.0% in August. This continues the slowing in inflation since peaking around +2% last year. Taking out those items near and dear to most of us, that being food and energy-related goods, the core PPI was -0.3%, which was also lower than expected. The expectations were for a drop from +0.3% in August to +0.1% for September. The economy appears to be dissing the Fed with its disinflation.

Retail sales are also in decline and have been this year, coming in at +0.1% (but -0.3% when removing automobiles). August was revised lower as well, from +0.2% to 0.0% and it was less than the +0.2% expected. Ex-auto saw the August number revised lower from +0.1% to -0.1% and it too came in less than the expected -0.1%. A drop in energy prices was expected to boost retail spending but it appears the consumer failed to get the memo and instead pocketed the savings. Not even back-to-school shopping could get the consumer spending more than usual. And if the mighty consumer cuts back on his and her spending it's going to cause further slowing in the economy.

But the Fed continues to see "moderate" growth according the Fed Beige Book report for September, which was released this afternoon. Wage growth was mostly flat and consumer spending grew moderately (not apparent in this morning's retail sales report). The energy sector continues to slow as active rigs and drilling activity continue to decline. The stronger dollar gets the blame for the slowdown in manufacturing (never mind that the dollar hasn't moved much since March and is in fact lower since then). Overall, the report supports those who say the Fed will not be raising rates this year.

Jumping into a review of the charts, I'll start tonight's review with a look at the NYSE Composite index since it gave one of the cleaner setups for this week's reversal. Following the low in August, which was a test of the 200-week MA, we've had a 3-wave bounce correction (I'm calling it a correction to the May-August decline until proven otherwise). The b-wave, which was the pullback into the end of September, was another test of support and a retest of the August low. The c-wave, which is the rally from September 29th, came close to achieving a price projection near 10418 (with a high at 10400 on October 9th), which is where the bounce off the August low has two equal legs up. When I see a reversal from near that kind of price projection it helps confirm the likelihood that it's an a-b-c bounce correction and not something more bullish.

NYSE Composite index, NYA, Weekly chart

The bearish setup on NYA was triggered with the decline below the October 7th high at 10284 and now we wait for further confirmation that we have something more than just a pullback before pressing higher. Note also that the rally into the October high was also rejected from price-level S/R at 10387 (the October 2007 high). The bulls need to get the NYA above 10418 before I'd starting thinking that perhaps we have something more bullish going on. In the meantime, shorting the bounce for another leg down is the higher-probability play and the downside target is the May 2011 high near 8700 (-16% from the October high). That level is also close to where the decline from May would have two equal legs down. A more bearish interpretation of the pattern calls for much lower prices than 8700 but one leg at a time until the bigger picture becomes clearer.

The daily chart below shows the price projection near 10418 for two equal legs up from August and how close it is to the October 2007 high at 10387. Last Friday's small doji at resistance was a good setup to short resistance. Now all the bears need to do is break support at the 50-dma, near 10211, which was almost tagged with today's low near 10215. It could be good for at least a little bounce on Thursday but watch the series of lower highs since last Friday -- a break of a downtrend line along those highs would be fair warning to those in short positions.

NYSE Composite index, NYA, Daily chart

Like the NYA, SPX nearly achieved its price projection at 2025.76 (with Tuesday's high at 2022.34) where its 3-wave bounce off the August low would have two equal legs up. Tuesday's high was short of price-level resistance at 2040-2045 that most had been expecting to see and the spike rallies out of the gate yesterday and today likely caught many traders in bull traps. While the setup for a reversal followed by the decline from Tuesday morning looks good for the bears, another leg up can't be ruled out yet. SPX hasn't yet tested/broken its 50-dma, currently near 1988 (today's low was near 1991) and there's a bullish setup for a back-test that could be followed by a bullish kiss goodbye. Back above Tuesday's high near 2023 would be bullish but then there's that 2040-2045 resistance to worry about.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 2023
- bearish below 1960

The rally from September 29th (the c-wave of the a-b-c bounce off the August low) completed as a 5-wave move, which it needs to be. There's a way to look at the current pullback as just a correction that will lead to another new high, probably up to the 2040-2045 resistance zone. A rally back above today's midday bounce high at 2005.74 would be a warning sign for bears to heed since that would suggest another new high is coming. In the meantime, especially with the downside potential, I think shorting bounces is the way to go.

S&P 500, SPX, 60-min chart

Considering what looks like a reversal back down in the stock market, the VIX is confirming it with what looks like a reversal to the upside. On Monday I thought it was setting up a reversal after it dropped down near 16 where it was about to test price-level S/R and back-test its broken downtrend line from October 2014 - July 2015. The bounce off Tuesday's low leaves a reversal signal so VIX is bullish until proven otherwise (with a drop below 15.70).

Volatility index, VIX, Daily chart

Into Tuesday's high the DOW had been able to push marginally above price-level resistance at 17037-17067, which are the February 2015 and December 2014 lows, resp. But yesterday's little doji and close at this S/R line has now been followed by a big red candle and that gives us a sell signal. If the bulls negate the sell signal with a rally above Tuesday's high at 17173 I'd look for a rally to 17242, for two equal legs up from August, and perhaps up to the top of its parallel up-channel for the bounce off the August low, near 17450. If this is the start to the next decline, one which should at least match the May-August decline (nearly 3000 points), the first downside target would be a test of the August low at 15370 before getting another large bounce before heading lower again.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 17,173
- bearish below 16,740

NDX held onto a potentially bullish setup today. Last Friday it climbed above price-level S/R near 4345 and its downtrend line from July and then tagged its broken 200-dma on Monday and again on Tuesday. Tuesday's pullback was close to back-testing both the S/R line and its broken downtrend line, which it did again today but continues to hold above both. Today's pullback found support at its 50-dma, near 4329, and all of this keeps the NDX looking bullish and a rally back above today's midday high near 4374 would keep the bulls in control. The bears need to see a continuation lower Thursday morning and a firm break below the 50-dma near 4329. It should be noted that the Nasdaq has not been able to break its downtrend line from July and has only been able to back-test its broken 50-dma, near 4816, including another failed test today (twice).

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 4403
- bearish below 4273

The RUT's rally off the September 29th low, which was a test of price-level support near 1080, made it up to its downtrend line from June, poking slightly above it and its 50-dma, both near 1160. It then rolled over from resistance and has dropped back below price-level S/R near 1152. It tagged its 20-dma, near 1137, and held it so there's the potential for another attempt at a new high for the bounce and maybe up to its broken uptrend line from October 2011 - October 2014, near 1187 (and a test of its September high at 1194). The bears would be in better shape with the RUT below the October 6th low, near 1127, which would also be a break of an uptrend line that is parallel to the one for the August-September bounce.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1170
- bearish below 1127

The RUT continues to be a good sentiment index for us -- when investors are feeling bullish they want to be exposed to the higher-beta names to get more punch out of their investments. When they're worried about the stock market they know the small caps are higher risk. The big fund managers know it's harder to get out of the small caps and therefore start lightening up their inventory of small caps if they're worried about the market. So when we look at a relative strength (RS) chart of SPX vs. the RUT we can identify those times when the players are feeling bullish vs. bearish and take our cues from that overall sentiment.

The chart below shows the RS of the RUT as compared to SPX and it's been warning us since it peaked in March 2014. That's a long time that the RUT has been underperforming and the bounce from the October 2014 low led to a RS high in June 2015 was followed by a break of the uptrend line from October 2014 in July. That was of course during the time the entire stock market started to decline and the RUT was one of the leaders to the downside. Another bounce off the August low has been followed by a new low, once which is breaking a H&S neckline along the lows since May. This is all supportive of the idea that we've entered a larger decline and that the RUT will likely lead the way down.

RUT vs. SPX Relative Strength, Daily chart

I think another sign of trouble for the stock market comes from what we see happening in the emerging market, using EEM, which better reflects the weaknesses underlying the markets. The removal of the threat of a rate increase by the Fed helped the emerging market recover off their August lows (along with the bounce in the markets in developed countries), as can be seen on the EEM weekly chart below. A stronger dollar from a rate increase would further devastate developing economies as they struggle to pay down their debts (all thanks to the lower-than-normal borrowing rates that prompted over-leveraging in the past decade) with a lower-value currency. The bounce off the August low was good enough for a back-test of the shelf of support near 36.15 and a rollover from here creates another sell signal.

Emerging Market ETF, EEM, Weekly chart

Another interesting RS chart is between the banks and the broader market. BKX had peaked in RS compared to SPX back in early 2003, started to taper off into September 2005 and then peaked at a lower high in July 2006. It started to drop steeply from there into the 2009 low. I remember in July and October 2007 thinking the banks' weakness was another confirming sign that the broader market was peaking. Following the March 2009 low we've seen the RS chart go sideways and it has formed a sideways triangle, retracing less than 38% of its former glory. As the stock market made new highs along the way, the RS chart made lower highs, once again showing us the banks were never full onboard with the Fed-induced rally (the unnatural low rates hurt the banks). The wave count for the sideways triangle looks complete (a-b-c-d-e) with a throw-over for wave-e into the August high. This pattern suggests another big leg down in what will be a large A-B-C pullback from the 2003 peak. In other words, along with the RUT, I see the banks leading the way lower. As leveraged as they are (far more than in 2006-2007) we're looking at either massive bank bailouts in the near future or massive failures.

BKX vs. SPX Relative Strength, Weekly chart

Need a little more proof that the thrill is probably gone for bulls? A comparison (not RS) between SPX and the difference between junk bond prices and 10-year Treasury prices (HYG-ZN, the blue line on the weekly chart below) shows the significant drop in HYG prices relative to Treasury prices (less demand for the riskier junk bonds) compared to the much smaller drop (so far) for SPX. This is just another chart showing how much money is leaving the riskier assets and why it's important to think defensively about the broader market. It's time to be picking out shorting candidates or if you don't like playing the short side then at least get into cash, which includes short-term Treasuries.

Comparison between SPX and difference between HYG and 10-year prices, Weekly chart

The U.S. dollar has pulled back a little further than I expected but still well inside its descending wedge pattern and holding above support at the top of its parallel up-channel from 2008-2011, currently near 93.70. It's also currently holding its 50-week MA, near 94.77, which held on the last two tests in August and September. I continue to look for a slightly higher bounce before turning back down inside its descending wedge pattern before starting another rally at the end of this year.

U.S. Dollar contract, DX, Weekly chart

Gold has attracted strong buying over the past two weeks, rallying $86 from a low near 1104 on October 2nd to a high near 1190 today. And the rally might not be finished since there's a price projection near 1195 for two equal legs up from its July 24th low at 1072. But it has reached a level that could be a challenge for gold bulls to push through. It climbed above its 200-dma, near 1176, and its 50-week MA, near 1181, but it's only one day so far. The downtrend line from October 2012 - January 2015 is also near 1181 and it has almost made it up to the top of a parallel up-channel for its 3-wave bounce off its July low. So there's a little more upside potential but if you're long gold here you should be asking yourself if this is a place you'd enter a new long trade. If not then you should either take profits and/or trail your stop up closer. I think gold will head lower into next year (1000 or lower) as the deflationary cycle continues.

Gold continuous contract, GC, Weekly chart

Supporting gold's bullish run is silver, which is lagging but it has climbed above resistance near 16 (with today's high at 16.19), which includes its 200-dma, at 15.97, and 50-week MA at 16.04. But its daily RSI is showing bearish divergence against last week's lower price high and its weekly RSI is in overbought territory and back up to previous highs made in January and May. Again, there's more upside potential but I would not want to enter a new long trade here. If anything I'd be looking to short the bounce into resistance (on a rollover) since silver should drop down toward 12 (if not lower) by the end of the year.

Silver continuous contract, SI, Weekly chart

Last week I had mentioned I expected oil to pull back to retrace a portion of the rally off its October 2nd low before continuing higher. We have the pullback and now I'm looking for the rally to continue up to the price projection at 55.55 for two equal legs up from August 24th. Assuming we'll get the rally, I continue to believe it's all part of a larger sideways consolidation that will continue into early next year before heading lower (as the dollar heads higher).

Oil continuous contract, CL, Daily chart

Tomorrow morning will be busy with economic reports, which will include CPI data, the Empire Manufacturing index and the Philly Fed index. We'll get to find out more data about what's happening with inflation as well as the economy. With each passing report it seems the bond market is pricing in a lower and lower probability of a rate increase this year. I continue to believe the Fed will be implementing its next QE program (probably a massive one) long before they'll raise rates.

Economic reports and Summary

Conclusion

Last week I was watching for the completion of the leg up from September 29th (with a 5-wave move) to then complete the 3-wave bounce off the August low. That was a setup for at least a pullback, if not the start to the next big decline, one which should at least match the leg down in the August lows. If the market is going to instead head higher, we should see a choppy pullback that retraces a portion of the rally from September 29th and then continue higher. If that happens I'll turn bullish since it should indicate new highs are coming. But for now, I think the 3-wave bounce correction off the August low is a very good setup to get short and ride the next leg down, possibly into the end of the year. By this time next week we should have a much better idea whether or not the market has turned down and then whether or not we should expect lower lows or instead just a pullback before heading higher. In the meantime, trade safe until we get further confirmation of what the next big move should be.

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