The bulls have taken no prisoners since the stock market bottomed last Thursday. It's been a straight-up rally, the strongest we've seen since the August 2015 low, and now the bulls are hoping to make it an even stronger one to finish opex week on a high note.

Today's Market Stats

The day started with another big gap up and that makes it three in a row for the 3-day rally off last Thursday's low. Will it turn into an exhaustion gap or is it a breakaway gap? Only time will tell but the rally now has the short-term charts deeply overbought and looking for some relief. It's been a strong short-covering rally but it could easily draw in real buying and this being opex week we could see the market hold up for at least another day or two. What kind of pullback pattern follows will then provide clues for what to expect next.

This morning's economic reports showed some improving data, which theoretically could help the Fed stay on track with their desire to raise rates this year. The PPI numbers came in stronger than expected, up +0.1% and +0.4% for PPI and Core PPI, resp., which were better than the -0.2% and 0.0% expectations. The Fed desperately wants to see inflation so they were probably heartened by this morning's numbers.

Housing numbers were in line if not a little disappointing, which depressed housing stocks (they finished flat for the day). Industrial production for January improved +0.9% which was better than expectations for +0.3% and a big improvement over December's -0.7%. Capacity utilization ticked up marginally as well so overall, the numbers go into the "rate increase" column as the Fed debates whether or not to continue raising rates this year.

The FOMC minutes that were released this afternoon highlighted the fact that the committee members agreed they would need to see more supporting data before raising rates further. That gave the market a little extra pop higher just after 2:00pm so the market was pleased that the Fed showed it's at least acting cautiously. Apparently the committee members were a little surprised by the negative reaction to the rate increase and they wish to tread carefully from here. The stock market was relieved by the better economic reports this morning and the Fed's willingness to back off on their rate-increase desires.

Regardless of what the Fed thinks about the market it's important what the market thinks is going on. The junk bond sector has been crushed in the past year and it's a sign of stress in the weaker sectors that have borrowed a lot of Fed-created cheap money. We know the energy sector is starting to default at a higher rate on their loans, which amount to much more than we had in the sub-prime slime days before the 2007 top. But now there are more sectors joining energy in struggling with their debt loads and that's being reflected in the stock market plunge.

Moody's uses their Liquidity Stress Index to measure how many firms are in trouble and the index jumped up to 7.9% in January from 6.8% in December. This is the highest level since December 2009 and the biggest one-month jump since March 2009. The stock market has barely begun a descent and already we're seeing major cracks in the debt-burdened industries. As credit markets tighten there are many companies finding it more difficult to service their debts (lower earnings) and roll it over into new debt. Moody's has already warned of a spike in defaults in the energy sector and now it's starting to spread to other sectors.

As reported my Hoisington in their Quarterly Review and Outlook for the 4th quarter, public and private debt currently stands at 375% of GDP, far above the historical average of about 190% (1870-2014). In their opinion, the extremely high level of debt suggests it's been used for unproductive and counterproductive purposes, such as stock buybacks, Debt is good if it generates a return such that the debt payments are covered by the investment of the money (in capital improvements for example). One specific bad use of debt was to generate higher stock prices without a commensurate rise in corporate profits, which is where we are now.

The end result of all this bad debt and an increasing number of companies unable to service their debt has been an increasing number of defaults on loans. This in turn had been reflected in the decline of the junk bond funds. The bond prices drop, boosting the yield, as a way to entice investors to take the risk. Clearly investors have been shying away from this risk and this risk-off attitude is finally being reflected in the stock market as well. Using HYG as a measure of junk bond performance we can see how relatively poorly it has done compared to the stock market, but the stock market could be at the beginning of "catching up" to the falling junk bond index.

SPX has rallied +6.7% from Thursday's low to today's high but HYG has rallied half that. The short covering in the stock market is not being matched by the buying/short covering in junk bonds and while that doesn't prevent the continuation of the stock market rally (look at how it continued to hold up after HYG started to nose dive in 2015) but as long as there's a lack of interest in junk bonds it will continue to warn us that risk-off trades should be preferred by investors.

The weekly chart of SPX vs. HYG, shown below, highlights the huge difference between the two. These two mimicked each other since the 2007 top (although HYG made a lower high in October 2007 while SPX made a new high, showing early weakness) and they only started to diverge after HYG peaked in May 2013. It tried to make a new high with the stock market in June 2014 but then started to sell off strongly from there. It's been a long-term bearish divergence since then but I think the stock market is going to play serious catch-up (catch-down?).

As I'll show with the daily chart further below, I'm expecting a higher bounce correction into March but there's something on the weekly chart below that has me feeling very cautious about upside expectations. There's a parallel up-channel for the rally from 2009, the bottom of which was tested in August/September 2015 and broken in January. The bounce up to the February 1st high was a back-test and kiss goodbye at the bottom of the broken up-channel. A second up-channel can be created by attaching another parallel line to the October 2011 low and that line was broken intraweek into the January 20th low. That line was broken again into last week's low and the bounce is now back-testing the line, near today's high at 1930. Is it a setup for another bearish kiss goodbye?

S&P 500, SPX, vs. High Yield Corporate bond fund, HYG, Weekly chart

As you can see on the daily chart below, SPX has run back up to its previously broken uptrend line from January 20 - February 3 and while I consider this to be a weak line of resistance it appeared to be respected this afternoon. Just another resistance level for the index to gap up over tomorrow morning (wink). I think the best fit for the decline from December 2nd is a completed 5-wave move down into last Thursday's low (this fits very well across the other indexes) to complete either the 1st wave down (techs) or the 3rd wave down from November (the RUT fits this interpretation particularly well for its decline from June 2015). To keep the indexes in synch, except for the RUT, I'm looking at the December high as the completion of the THE bull market rally (with truncated highs for the Dow and SPX. This sets us up for a strong bounce into March for a 2nd wave correction (bold red depiction). But the bulls need to keep this going since the weekly chart above is scary for the bulls.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1957
- bearish below 1195

One reason I like the idea of a stronger bounce correction into March is that it would help relieve the significant oversold conditions and it would turn the most traders bullish just before the 3rd wave down gets started. The 2nd wave is called the sucker wave for a reason, as is the name for the 3rd wave – the recognition wave. As I'll point out later for the RUT, it looks like it needs a 4th wave correction in the decline from June 2015 but it might get another 2nd wave to set it up for a 3rd of a 3rd down, to lead the market lower in a powerful 3rd wave decline into the summer. That's only speculation at this point but it's a theory I'll test along the way as the price pattern develops.

The previously broken uptrend line from January 20th is shown more clearly on the 60-min chart below and you can see how SPX tagged it to the penny today and then pulled back marginally. If it continues higher Thursday I'd look for a test of the February 1st high near 1947 and watch for possible resistance there. The 60-min chart is more overbought than it's been since last year's high and clearly due at least a pullback. The straight-up rally looks like a typical bear market rally and the risk for those chasing it higher is that we could see a deep pullback before heading higher (assuming we'll get a larger 3-wave bounce correction into March but that's certainly not a guarantee).

S&P 500, SPX, 60-min chart

On the Dow's chart I'm tracking the idea that we're only going to get a relatively short-lived bounce, which could be complete at any time now, and then one more drop down to test recent lows (to create a triple bottom). That would then be followed by a larger consolidation pattern into April before continuing lower. This idea suggests lots of choppy whipsaw moves in a multi-week consolidation. It wouldn't be a fun trading environment unless you're a good day trader and catch the tops and bottoms of the moves. I'm hoping for the sharper bounce pattern into March so we have some clearer trade setups.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 16,510
- bearish below 15,300

The tech indexes show the clearest reason why we should be looking for high bounce corrections. Looking at its bull market rally has having finished at its December 2nd high, the 5-wave move down gives us a larger-degree 1st wave. That calls for a sharp 2nd wave correction and the leg up from last Thursday is likely just wave-a of what should become a larger a-b-c bounce pattern. The big question at the moment is what kind of pullback we can expect for the b-wave before heading higher again.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 4225
- bearish below 3902

Like the techs, the RUT made a higher high in December than it did in November (unlike the blue chips with their truncated (lower) highs in December). The 5-wave move down into last Thursday's low also sets it up for a larger bounce but it could trade in more of big sideways choppy consolidation instead of a high bounce. How high a bounce we ultimately get will then provide clues for what to expect for the next leg down (either a 5th wave in the decline from June 2015 or a 3rd of a 3rd wave down following another 2nd wave bounce correction. For now we should simply expect some whippy price action so trade carefully.

Russell-2000, RUT, Daily chart

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

Banks were a little weaker than the broader averages today and that's always a bit of a warning sign for the bulls to heed. The morning high stopped a little shy of the bottom of its previously broken parallel down-channel from July 2015, currently near 62.60 (today's high was 62.40), and then sold off for the rest of the day, giving back the bulk of its morning rally. The pattern is not clear enough to offer a high-probability setup here but as depicted on its chart below, there is the potential for one more new low, or a test of last week's low at 55.99, to complete the leg down from November 2015. If this happens it would likely drag the other indexes back down as well, even if it will be for just a deep pullback in a larger bounce/consolidation pattern.

KBW Bank index, BKX, Daily chart

Along with the broader market the TRAN has had an even stronger rally in the past 3 days and has now retraced 50% of its decline from its November 20th high. Today's high at 7383 is close to its previous low on August 24th, near 7453, and that's likely to be strong resistance if and when reached. The longer-term pattern suggests we should see only a pullback and then another leg up for a larger bounce pattern but from here it's looking vulnerable to at least a pullback as the next move.

Transportation Index, TRAN, Daily chart

The US$ has bounced with the stock market in the past few days, after both dropped together from their February 1st highs, and the bounce could make it higher but at the moment it's testing its 200-dma at 96.90 (it broke above it this morning but then closed 2 cents below it) and is nearing its 50-week MA at 97.10. With the dollar and stock market trading in synch, if the stock market is looking at a bigger bounce in the coming weeks we could see the dollar do the same, especially if it's able to get above 97.10 and hold above. It's even possible the dollar will rally to one more new high following the 3-wave pullback from December, up to 103-104 (light-green dashed line), to finish its longer-term rally but at the moment I'm sticking with the higher-probability pattern that calls for a continuation of its sideways consolidation for several more months before continuing higher (bold green line).

U.S. Dollar contract, DX, Weekly chart

In the weekend wrap I showed the monthly chart of gold with its down-channel for the choppy decline since August 2013. The top of the channel is near 1262 and last Thursday's high was 1263.90. Thursday's big spike up (+66.50 to the day's high) was quickly retraced with the decline into yesterday's low and now we wait to see if the bulls can break through the top of the channel or if instead it was a blowoff ending to the a-b-c bounce correction off the July 2015 low. Bullish above 1264 but gold remains bearish below that level since it's still in an established down trend.

Gold continuous contract, GC, Weekly chart

Silver has the same down-channel from 2013 as gold, the top of which is near 16.10. And there is a downtrend line from April 2011 - October 2012, which was tagged with last Thursday's high at 15.99. A broken uptrend line from last August is also near 16.10. So there was more than one reason why last week's rally ran into trouble where it did and like gold, the decline into yesterday's low completely retraced last Thursday's exuberant rally. So what's next? Was the parabolic spike just another bear market rally that completed with a blowoff top or are we in the middle of a powerful wave up? Last Thursday's highs are now important for the bulls to get above.

One pattern that has been common in silver's decline from 2011 is the consolidation patterns -- they've each been a descending triangle, starting with the one that ran from September 2011 to October 2012 (the a-b-c-d-e triangle on the top left side of the weekly chart below) and then the next one from June 2013 to July 2014. The last one, I think, is the one at the bottom right side of the chart that just completed, running from December 2014 to February 2015. The first two triangles ran 53 weeks and 54 weeks and the latest was a little long in the tooth at 62 weeks. The e-wave of a triangle is often a head-fake move that gets traders caught in the end of a move instead of the beginning a reversal and that could be the case again. The bulls need to rally silver above 16.37 (the October 2015 high) to prove it's a real breakout, otherwise look out below.

Silver continuous contract, SI, Weekly chart

It's looking like oil's bounce could make it up to at least the 32.20-33.20 area before turning back down. At least the larger pattern calls for another turn back down for one more new low to complete the wave count to the downside. A downside target is currently near 23 in March and then we should have a good setup to get long oil. If oil gets above 35 there would then be upside potential to about 38-39 and above 40, with a break of its downtrend line from June 2015, it would be much more bullish. But at the moment I don't think we've seen a tradeable low for oil yet.

Oil continuous contract, CL, Daily chart

Thursday's economic reports include the Philly Fed index, which is expected to improve somewhat from January's -3.5 to -1.8 but Monday's Empire Manufacturing index was also expected to improve from January's -19.4 to -6.5 and instead came in at a marginal improvement to -16.6. We'll have to see if that data point falls in the "raise rates" or "hold rates" column of the Fed's spreadsheet. She loves me, she loves me not, she loves me ... not

Economic reports

Conclusion

The big question following the strong 3-day rally off last Thursday's low is whether or not it's sustainable. We don't know yet if this is the start of a stronger bull run into the spring or if instead it's just another bear market rally in what will be a continuation lower (the slope of hope is a decline punctuated by brief but strong hope-filled rallies and then a continuation lower).

One sign of a bear market rally is how strong it is. That sounds perverse but it's a fact that the strongest rallies occur in a bear market, albeit relatively short-lived thanks to short covering. In fact today Bespoke Investment Group tweeted the chart below, which highlights the fact that the strongest stocks in the Russell 3000 the past three days have been the ones most heavily shorted. Today's advance-decline line actually started back down after this morning's open while the advance-decline volume continued to climb. Money was pouring into fewer stocks (sending the a-d line lower) but still powering the select few (the most heavily shorted) higher. If it's hard to read the note on the chart it says "Stocks with the most short interest have significantly outperformed stocks with the lowest short interest over the last two days."

Stocks with highest short interest rally the strongest, chart courtesy Bespoke

As I mentioned earlier, the setup is good for a higher bounce correction into March but it could be whippy with a deep pullback before heading higher. The weekly chart of SPX highlighted a concern for the rally if the bulls can't keep it going here so a higher bounce is by no mean guaranteed. We are in a bear market and all rallies are suspect. It's only a question (in my mind) of how high the bounce will get before stronger selling kicks in.

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