The stock market had a nice rally going this morning but once Janet Yellen began her Congressional testimony the market started to pull back. The techs held up while the others sunk back into the red.

Today's Market Stats

The stock market got a lift out of the gate this morning, thanks to an overnight rally in the futures, but after the first hour of trading the rally was given back and it happened after Janet Yellen started talking. The market appears to be losing faith in what the Fed can accomplish for the market, I mean economy. Also negatively affecting the stock market is what's happening in the political arena.

The stock market is not happy with the prospects of having either Bernie Sanders or Donald Trump as president (although Wall Street would prefer Trump over Sanders), both of whom are doing well in the polls. The frustration and anger of the electorate is showing up in the rejection of the status quo in the political system and they're voting for the two that have a different message (it's that hope and change thing all over again). The same level of frustration is showing up in the stock market, one of the best reflectors of social sentiment. When social mood turns sour it is always accompanied by a bear market in stocks. It really is as simple as that.

The problem for the market is that Yellen is not showing signs, yet, of helping the market recover from its January decline. In her prepared remarks to the House Financial Services panel, she said financial conditions "have become less supportive to growth." Like so many are now doing, she pointed the finger at China and effectively said "they did it!" She warned that "downside risks" tied to the health of the Chinese economy could weigh on our economy.

Yellen shared with the committee that the Fed had considered negative interest rates back in 2010 but decided it was not the right way to go. Besides, according to Yellen, there are some legal and regulatory issues that haven't been fully researched yet (after all, it's only been 5 years since then and these things take time, wink). As she told the committee, "We got only to the point of thinking it wasn't a perfect tool...we were concerned about the impact it would have on money markets, we were worried it wouldn't work in our institutional environment." My guess is that when they do implement NIRP, all those concerns will be swept under the rug as they continue to experiment on us. It will be a Hail Mary pass and according to Yellen she doesn't believe the Fed will have to resort to it unless the stock market drops by 50%, real estate loses 25% and the labor market significantly softens.

One of the problems with negative interest rates, which is essentially a tax on the banking system, is that banks start to underperform. We can see that already in the relative poor performance by banks this year compared to the S&P 500 index. It's not likely the banks will absorb the higher costs all by themselves out of the goodness of their hearts. I doubt Jamie Dimon will give up his $27M bonus (on top of his multi-million salary) to help his JPMorgan Chase company cover some of those costs. Instead, the banks will pass along those costs to its customers, which will include lower rates of returns on savings (can't get much lower) and charging more for services, such as for holding your money.

The problem with negative rates charged to banks is that it could actually do the opposite of what the Fed hopes to achieve. As some European countries are finding out, negative rates result in less lending by banks, thus negatively affecting the credit cycle. Money tends to leave the banking system of countries with negative rates and flows to countries providing better returns. Or Mom and Pop simply withdraw their money and put it in a safe deposit box or under their mattress. They put their money into U.S. Treasuries (one of the better places to park your money if you want to be in cash) and the result is the same -- money leaves the banking system. Banks with less money to lend then results in a contraction in credit, which then slows the economy further.

Emerging markets tend to offer higher yields to compensate for the higher risk and that's where much of the money from Europe has been flowing. The risk to the emerging markets is when the money flow reverses, which tanks their economies and stock markets. Their companies then start defaulting on loans and that starts to ripple through the global financial system -- a butterfly flapping its wings in Africa causes a hurricane to hit the U.S. (chaos theory).

So why are central banks resorting to NIRP policies? As explained in an article in the The Economist:

The best hope for success, however, lies in foreign-exchange markets. Negative rates might send investors in search of better returns abroad, leading to depreciation of the currency. That would raise the price of imports, helping to combat deflation and giving a growth-enhancing boost to exporters. Since the ECB introduced negative deposit rates the euro has fallen against the dollar by nearly 20%.

The Fed is deathly afraid of deflation, as are all Keynesian-trained economists (and practically all central bankers think the same way as they've been trained the same way). Fighting deflation is their first priority and that makes the NIRP decision easier to understand. The problem is when other countries match each other, effectively negating the effects. The only thing it accomplishes is a race to the bottom in currency devaluation. We have been and continue to be in a currency war and unfortunately they tend not to end well for anyone.

The rally in the stock market from 2009 has been built primarily on a booming credit cycle and nearly 100% of the corporate borrowing has been to buy back stock. This of course improves the earnings per share and drives stock prices higher. But it hasn't resulted in any productive use of the money and now many of those companies are finding it more difficult, with lower earnings, to service their debt. Lower earnings, higher debt and the inability to "massage" their earnings per share will result in lower stock valuations (prices). This is just one example of the QE efforts have simply distorted money flow and as with all distortions, the corrections tend to move faster and more violently than the distortion itself.

Yellen mentioned several times that she does not see evidence of slowing in the global economy or the U.S. economy. I'm not sure what numbers she's looking at but it sure seems obvious to me. One are that's been slowing is retail sales, starting with the disappointing holiday sales between Thanksgiving and Christmas. It appears many shoppers are tightening their belts and keeping their wallets closed. Paying down debt would be a good thing for most people but we also know that doing so will hurt our consumer-dependent economy. If it's not a necessary item we tend to buy less of them when things get tighter, such as electronic goodies, vacations, eating out, etc. What doesn't tend to slow down as much are those items we use most every day, such as toothpaste, toilet paper and other consumables, which are placed into the consumer staples category. Johnson & Johnson is a consumer staples company and it has done better than others this year.

It's often said when we're entering a recession, when it comes to which stocks to own, "if you can smoke it, drink it or eat it, buy it." But companies involved with discretionary items will suffer more in an economic downturn. The spending between consumer staples and consumer discretionary items will determine the profitability of those companies associated with each and therefore comparing these two groups is a way to provide a clue about how consumers are feeling about the economy and their financial position. These two groups are represented by the Consumer Discretionary ETF, XLY, and the Consumer Staples ETF, XLP.

I'll start tonight's chart review with a weekly chart of SPX and on the chart I also show the ratio of XLY to XLP, which I'll discuss further, below the chart. This chart is using the arithmetic price scale and the first thing to notice is the parallel up-channel for the rally off the March 2009 low. The January decline broke below the bottom of the up-channel, which is a very important signal that says the leg up from 2009 has now completed. The bounce off the January low into the February 1st high resulted in a back-test of the bottom of the broken up-channel and the selloff from the February 1st high leaves a bearish kiss goodbye.

S&P 500, SPX, Weekly chart

Back to the discussion above about the XLY/XLP ratio, which is shown in blue on the chart above, you can see this week's break of support at the lows since 2014 and I think that's a big deal. The consumer is moving more into hibernation mode and not willing to spend money on discretionary items. Just as we've seen the utility sector outperform other sectors in the market lately (people still need to buy electricity and water), now we're seeing people focus their spending more on staples than discretionary items. Being a consumer-driven economy, this is another sign of a coming slowdown in the economy, otherwise known as a recession. Stock markets don't do well in recessions.

The SPX daily chart below shows today's rally attempt above price-level S/R at 1867 (the August 2015 low) but the failure to hold above that level is at least short-term negative for the market (today's shooting star candlestick is bearish since it reflects the day's inability to hold onto the rally attempt). But it remains possible we'll get a larger rally up to the price projection shown at 1963.37, which is where the bounce off the January 20th low would achieve two equal legs up for an a-b-c correction to the January decline before heading lower. SPX would also likely test its broken 50-dma at the same time. A rally above the February 4th high near 1927 would confirm a break of its downtrend line from December 29th and that would be good confirmation that a rally to at least 1963 is likely. But a failure to rally above this morning's high near 1882 points to lower prices and those are at 20-point increments, starting with 1820 and down to 1760.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1927
- bearish below 1767

When I look at the short-term pattern for the decline from February 1st I see the possibility for a sharp decline this week and into next, which would mean a decline could quickly break below 1760.. From an EW perspective, the decline from February 1st could be a 1-2, 1-2 to the downside (because of the overlap between the current bounce and the February 3rd low), which suggests the selling is about to pick up speed if it can't rally above 1885-1892. Today it struggled at the top of a parallel down-channel for the decline from February 1st, as well as price-level S/R at 1867 (the August 2015 low), and the bearish wave count suggests the next leg down will be a strong one that will drop price below the bottom of the down-channel and likely below 1760 (the February 2014 low near 1738 would become a downside target). This bearish interpretation is not supported by the techs and the RUT, whose patterns suggest only one more minor new low, and therefore I show this only as a warning of what could happen. Be careful about trying to catch a bottom in the next selloff, if it starts down from here and drops quickly.

S&P 500, SPX, 60-min chart

The Dow held price-level support at 16K on a closing basis on Monday and Tuesday but it lost the battle today, closing at 15914. I see the possibility for only a minor new low below Monday's, at 15803, but if price-level support at 15666 doesn't hold then there's a good chance we'll see price-level support at 15340-15370 tested. Those are the lows in February 2014 and August 2015, resp., and following the completion of the leg down from February 1st I'll be looking for another multi-week choppy bounce correction. There is additional downside risk in a stronger breakdown but I'd want to see a strong decline below 15300 before thinking more bearishly.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 16,486
- bearish below 15,803

The Nasdaq has been fighting to hold onto support near 4300 and today's bounce has the potential to build something more bullish. But it needs to get above its broken uptrend line from October 2014 - August 2015, near 4395, about 25 points above today's high, and then break out of its down-channel for the decline from December, currently near 4425. The sellers drove the Naz back below the August 2015 low at 4292 on a closing basis today, after holding above that level all day. This has it looking more bearish and I think we're looking for another leg down, in which case the downside target would be the October 2014 low at 4099. A drop below that level would suggest a decline to the bottom of its down-channel could be next, which will be near 3890 next Monday.

Nasdaq Composite index, COMPQ, Daily chart

Key Levels for NDX:
- bullish above 4546
- bearish below 4099

Over the weekend I had mentioned the biotech index, BTK, and said it looked like it could be ready for a bounce. It's been hammered this year and actually since its high in July 2015. I had mentioned we might see it find support slightly lower than Friday's low and then we got the move down into Tuesday's low at 2575. This is good for two equal legs down from July 2015, at 2642, a test of its uptrend line from November 2008 - October 2011, near 2600, and a test of its 200-week MA at 2655. This is a dangerous sector to play but it looks like a good setup for at least a bounce. If you're a disciplined trader (be honest with yourself), this is an opportunity to try the long side (pick an ETF, such as BBH). Just don't let it go below Tuesday's low without you pulling the ejection handle. The next support level is not until 2260-2270.

Biotech index, BTK, Weekly chart

Like the other indexes, the RUT remains inside its down-channel for the decline from December and nearly tested the top of the channel with today's high at 983. A rally above today's high would be more bullish but short against that high looks like the right place to be at the moment. If we get another leg down watch to see how it does at the price projection shown on its chart at 941.15. This is where the 5th wave in the decline from December would equal the 1st wave down. At the moment the RUT is fighting to hold support at its trend line along the lows from February - October 2014, near 959 and it would show significant bullish divergence if it turns back up from here (a reason not to be short if it rallies above this morning's high). If the RUT drops below 940 we could be looking at a more significant decline and potentially down to the next price projection at 881.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1040
- bearish below 940

Treasuries have rallied strong while the stock market has sold off as a flight to relative safety continues. As mentioned at the beginning, in the discussion of NIRP and the flight of money, buying in Treasuries could be coming from Europe and Japan as well. This has resulted in Treasury yields dropping and the 10-year yield (TNX) has now dropped back down near its January 2015 low at 1.65%, with Tuesday's low at 1.70%. The small bounce pattern off yesterday's low looks like a correction and should be followed by another leg down, which means the January 2015 low will likely be tested, if not broken. This week's decline has TNX breaking its uptrend line from July 2012 - January 2015, near 1.76%, but there's still the potential for another bounce back up to the downtrend line from June 2007 - December 2013, which was last tested in November-December 2015. Another leg up inside a descending triangle would be a setup for a stronger decline but at the moment, if support at 1.65% doesn't hold then we'll likely see the decline continue to at least the July 2012 low at 1.39%. What it does from here will help clarify the next likely move for the stock market as well.

10-year Yield, TNX, Weekly chart

The banking index has outperformed the broader market but unfortunately that means it has outperformed on the downside. BKX has already broken well below its 2014-2015 lows and is now testing its April 2013 high at 58.83 (Tuesday's quick low was 58.42 and then it traded around 58.83 for most of the day). Today's low at 58.93 looks like it's going to be followed by lower lows and that should have BKX testing its uptrend line from March 2009 - October 2011, which this week crosses its 50% retracement of the 2007-2009 rally, at 57.25. That should set up a multi-week bounce correction into April before continuing lower. Below 57 would suggest the next support level near 52.50 would be next.

KBW Bank index, BKX, Weekly chart

More talk about negative interest rates further depressed the US$ this week but so far it's just continuing to trade inside a 94-100 trading range, which is not expected to change until later this year when I'm expecting another rally leg out of the consolidation. I'll change that opinion, which I've held since its high in March 2015, when price tells me to.

U.S. Dollar contract, DX, Weekly chart

Who lit a fire under gold bugs' butts? Last week gold broke above its downtrend line from October 2012 - January 2015 and then price-level S/R at 1142 and then blasted higher from there. I had mentioned it would be bullish above 1142 and that turns out to be no lie. The strength of the rally has it looking like a c-wave of an expanded flat correction, which is when the b-wave pullback (the October-November 2015 decline) drops below the previous low (July 2015). When that happens and it's followed by a strong spike up, as we see here, the c-wave generally achieves 162% of the a-wave, which is the 3-wave move up from July 2015 to the October 2015 high. That projection is shown on the weekly chart below at 1238.59, which closely aligns with previous price-level S/R at 1235. Once the leg up from December 3rd completes, assuming for now up near 1235-1238, it should get completely retraced as gold heads to a new low. That would obviously be extremely depressing for gold bugs and might finally dissuade them from trying to buy a low, which is what we need to see before a longer-term bottom will be in place. But a rally above 1240 would have me thinking a longer-term bottom might already be in place so we'll see what happens if and when it reaches that area.

Gold continuous contract, GC, Weekly chart

The pattern for oil's decline from June 2015 would look best with one more new low and that could be coming sooner rather than later. A downside projection for a new low is near 23 if it happens by the end of the month. Following a new low, if we get it, we should see a stronger bounce/rally in the coming months. The commodity index also supports this idea.

Oil continuous contract, CL, Weekly chart

There are no significant economic reports on Thursday but we'll export and import prices on Friday (to check how the inflation/deflation battle is going) and retail sales. Michigan Sentiment will be out after the open on Friday but none of the reports are likely to be market moving. If retail sales come in much different than expected (relatively flat for January) we could see a pre-market move so watch for that possibility.

Economic reports

Conclusion

The stock market looks like it has another leg down before we can look for a larger bounce (in time if not price). It could be just a minor new low or a significant drop and unfortunately it's not clear at this point which we should expect (assuming we'll get a new low). If we get a minor new low and a reversal with bullish divergence against the January 20th low I'd be more inclined to try the long side, especially if a minor new low is followed by a rally above today's high. But a sharp decline that breaks through the close-by support levels would have me sticking with the short side until we see some kind of ending pattern to the downside, with bullish divergence. We have a vulnerable market and that means downside surprises. Long trades should be considered counter-trend trades but the short side could be short-lived if we're nearing a tradeable bottom, which I think we are. That means small base hits for sides while we watch to see how the larger pattern is setting up.

Good luck and I'll be back with you for the weekend wrap (filling in for Jim).

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