Following Tuesday's strong rally it was looking like we'd have a good week. Instead, the selloff from Tuesday's high gave us the worst week of the year. Now we look for evidence to see if it's just a pullback correction or the start of something more to the downside.

Weekly Market Stats

Friday's Market Stats

I'm filling in for Jim this weekend. He'll be back with us for his Tuesday wrap.

The weekly numbers in the first chart above show the damage (lots of red), with most of the damage coming on Friday. That's the bad news. The good news is that most of the indexes (except oil and commodities in general) are up for the year. In fact you can see the techs are up strong and the financials and housing stocks are up very strong (but dwarfed by the performance of the biotechs). This week's pullback is the pause that refreshes, or so goes the bullish perspective.

The big question is whether last week, especially Friday, was simply a knee-jerk response to worries about the European elections, specifically France. If Sarkozy is booted and Hollande wins the election there could be very significant changes made to how France deals with the decisions around austerity vs. borrowing more. A break between France and Germany would have obvious consequences as well, knowing the history of Europe. As with so many things affecting the stock market, sometimes worries about an event are far worse than the actual event so it will be interesting to see how the markets react on Monday.

There was a small reaction to Friday's Payroll numbers but I don't think that was the primary motivator behind the selling. The numbers where not good but in general they were mixed. It was of course disappointing to see that only 115K jobs were created vs. expectations for 162K nonfarm jobs. The number for March was revised higher from 120K to 154K (February was also revised higher). The good news (cough) is that the unemployment rate dropped from 8.2% to 8.1%. We know this is an accurate accounting of the unemployed because the number comes from the government (cough).

The unemployment rate dropped primarily because of a drop of 169K in the labor force (I've seen numbers as high as 495K dropping out). It really is a shame we can't trust the numbers given to us. The Administration of course focused on the rate instead of the dismal jobs numbers. When you lower the numerator of a fraction (for those who have forgotten more than they learned in math class, that's the top number) it lowers the value of the fraction. So by lowering the top number, the participation rate, you get a lower unemployment rate. Voila! Problem solved -- we have an improving employment picture if you believe the politicians. Here's a chart of the labor participation rate since the 1950's, chart courtesy Scott Barber, data source Thomson Reuters Datastream:

Needless to say, there's been a steep drop in the labor participation rate since peaking in 2000 and the decline has been steepening since the 2007-2008 recession. The April number was 63.6%, down from 63.8% in March, and it is the lowest rate since 1981. The last secular bull market started in 1982 so we've retraced the entire bull market period and we've got perhaps the worst part of the secular bear market still ahead of us.

So where's the recovery (where's the beef)? Wage growth (year-over-year percentage change) is below the 2004 low and below the 1987 low so again, the previous bull market growth phase has been completely retraced already. There's a good chance the "Great Recession" will turn into the "Greater Recession". It's in fact a Depression but no one wants to use that scary word. While Bernanke is a self-described Great Depression expert and has made it his life mission to never let it happen again, like Greenspan before him (wanting to be known as the man who stopped the Kondratieff cycle), he will be proven by history to have been a miserable failure. And worse, inflation is a bigger problem than the Fed will admit (more smoke and mirrors hiding the real number).

The government wants inflation and uses Fed policies to insure we have it. It helps the government pay down its long-term debts with cheaper money over time. But inflation kills consumers and combined with very low wage growth the average consumer is getting hammered. That's not a good recipe for increasing consumer spending, something our economy is so dependent on. A depression, which all periods of contraction were called prior to the 1930s, is actually a healthy correction in the economy. By attempting to prevent them, with all the money printing, the Fed has in fact made the problem worse.

All the bubbles in the past 12 years have been self-inflicted wounds from the Fed's monetary policies. It started with the tech bubble (Y2K concerns had Greenspan flooding the market with money which made it into speculative tech stocks) and continued through the housing bubble, the commodity bubble, the bond bubble and back to the stock market bubble. The bursting of these bubbles is far and away more disruptive to the economy and people's lives than an economic contraction.

If instead of preventing the contractions with money printing and artificially lower rates, which only worsens the over-indebtedness that needs correcting in the first place, we need the cleansing step that contractions are good for. An economy needs to inhale and exhale but the Fed wants us to just keep inhaling. When our lungs pop it's not a pretty sight for anyone. As with Greenspan I predict history will not be kind to Bernanke who I think is even worse than Greenspan. Long-time readers know I have not been a fan of the Federal Reserve system and would love to see it demolished, which very well could be the outcome following the economic contraction that is coming, despite what Bernanke tries.

The good news is that once we get through the correction, which would happen faster if Bernanke would just get out of the way, we will have a strong period (decades) of recovery. While it might take a few more years to get through this I think it will be important to remember it will get better. It will be easy to get sucked into the morass and feel the world is coming to an end and that the U.S. (or wherever you live) will be forever in a decline. Some of the greatest companies were born during the Great Depression and it will happen again. We can't know what technologies or companies will rise from the ashes but continue to keep your ears and eyes open for opportunities.

But the short term is going to be difficult and our job as traders is to go with the flow. Most investors are clueless and unless they're dollar cost averaging and have 20 years before they'll need the money back, this market is going to be very difficult for most people. As traders we can make money in a down market or at least get out of the way of a bear market and get into cash. Close your ears to the negativity around you and look for money making opportunities (turn lemons into lemonade). Just one piece of advice though -- never brag to your non-trader friends that you made money in a down market.

Part of last week's concerns had to do with mounting evidence of a slowing economy, something that challenges the reasons for expecting the stock market to continue rallying. While there is concern about the global economy slowing down, which is a very legitimate concern I might add, one of the other factors hanging over the market like a big anvil is the health of the financial system. There's a reason why central banks keep trying to jawbone the market higher with promises of more easing -- their jobs literally depend on the banksters getting all the money they need to stay afloat. But like water flowing down a hole into the ground and heading for the sea, creating more money doesn't seem to be enough to fill the hole. As hard as they try and the more money they spend on the banks the more they seem to need.

The Spanish banks are the most recent ones in trouble but it's a global banking problem. First Greece, which was merely a symptom of the problem (just as the subprime loans were a symptom of a much bigger housing bubble), and now other European countries are following right behind. The chart below shows why the Spanish banks are in trouble. Their borrowing has skyrocketed from early 2011 while deposits have been declining quickly. At some point they will no longer have the assets, even crappy ones, to cover their loans and at that point they have to declare bankruptcy to prevent further withdrawals.

Another challenge for the Spanish banks is the growing number of bad loans on their books. As their economy worsens and unemployment rises it's not at all surprising to see the number of non-performing loans rising as well. Makes me glad our unemployment rate is improving (cough). Bottom line is that Spain is in a world of hurt right now and everyone knows it but not sure what to do about it. And now with France looking like it will head deeper into debt (especially if Hollande wins the election) we could be looking at a similar but much bigger problem soon. Remember, France currently has a AAA rating. This chart, by Scott Barber, Thomson Reuters, is current as of April and shows the climbing number of bad loans:

The concerns about a country's debt are of course reflected in the bond market. Purchasers of sovereign debt will accept a lower return on investment if they have assurance that their capital is safe. Once the safety of their investment becomes an overriding concern they demand a higher rate of return to compensate for the higher risk. Back in November, before the ECB started their massive "investment" program, the yield on Spanish debt was climbing quickly and made it up over 6%, a yield that is considered unsustainable (soon the country's debt payments overwhelm their ability to pay other bills and they have to start borrowing just to make the debt payments).

Spanish 10-year Government Bond Yield and Spanish-German Bond Spread(br>

There's been a little relief lately since hitting 6% again in mid-April but as with any chart pattern, it's looking like a little bull flag pullback and I strongly suspect we'll soon see yields heading above 6% again. Once it becomes clear that the ECB will not be able to buy enough of the Spanish debt (through loans to Spanish banks) and auctions go unfilled we'll see the problem become worse and likely very quickly (the reactions are often like flipping a light switch). That's also when the spread between Spanish and German bond yields will climb above 5% and will be a clear indication of trouble. That's when depositors will start withdrawing money at an alarming rate and the banks will institute all kinds of rules about how and when depositors can withdraw their money. By the way, don't believe for a minute that the same problem can't or won't happen in the U.S.

A large bank declaring bankruptcy tends to become nationalized by the country. We've already seen this occurring over the years. What appears to be happening in Europe, with the ECB extending more and more credit to banks, is an effort to eventually get the individual countries to ultimately be forced to nationalize their banks. In that way the banking crisis becomes less an EU problem and more of an individual country problem with each having to deal with their own financial crisis. It's a delicate act the ECB is trying to play and they need time to get it done. The big question is whether they'll have the time or if instead the whole financial system collapses together and as one.

There's been a lot of hope (4-letter word when talking about the stock market) that the U.S. will avoid the contagion spreading in Europe. A lot of money has been flooding into the U.S. stock and bond markets in a flight to safety and when you look at the U.S. indexes relative to just about any other index you will see the U.S. has held up strong. This is true even against countries like Canada and Australia which are resource rich and have relatively strong economies. In one respect that's actually dangerous for the U.S. stock market because a rally built on hope can quickly collapse.

Following a bad week like last week, one which saw indexes breaking important support levels (moving averages, trend lines, price-level), we have to wonder if we're starting something more serious to the downside or if last week was just some fear and caution heading into this weekend. From a chart perspective it's too early to tell so we'll look at what we need to watch in the coming week. I'll start with NDX this weekend since it's a good "sentiment" indicator and has been suffering lately because of some of the high-profile "sentiment" stocks like AAPL.

The NDX weekly chart below is squished so that I can fit in the price action since the March 2009 low, which shows a large rising wedge pattern. The top of the wedge is actually a broken uptrend line from 1990 through the 2002 low. The vertical lines I've shown before -- they show the Fibonacci time relationship between the current rally from 2009 and the 2002-2007 rally. The 2002-2007 rally was wave A of a large A-B-C bounce off the 2002 low and wave B was the 2007-2009 decline. Wave C is the rally from 2009 and the Fibonacci time ratios are often good guides to watch for turning points, which you can see at the previous 38% and 50% lines. It fits for an important high here but price form is more important than time (although Gann would argue that point).

Nasdaq-100, NDX, Weekly chart

The daily chart below zooms in on the leg up from November, which is the 5th wave of the move up from March 2009 (wave C needs to be a 5-wave move). The 5th wave also needs to be a 5-wave move and that's why I've been showing an expectation for a new high into mid- or late May. But now last week's decline has raised some questions about that expectation. The 5th wave may have finished as a truncated high (lower high than its April 3rd high) as you can see that it achieved the 62% projection of the 1st wave (the minimum expected for the 5th wave). The other possibility is that the pullback from the May 1st high is going to complete an a-b-c pullback from the April 3rd high and that we still have one more new high coming (light red dashed line. A drop below a price projection near 2600 would more strongly favor the bears but in the meantime stay aware of the bullish potential for a rally into the end of the month following the current pullback.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 2757
- bearish below 2590

Now we zoom in on the move down from April's high and specifically the pattern for the decline from May 1st. Ideally the pattern calls for a 5-wave move down from last Tuesday and so far it's a 3-wave pullback. Friday's decline closed its April 25th gap and is set up for a bounce on Monday. If last week's 3-wave pullback is part of a larger corrective pattern we'll see the market rally back up, starting from here. If we're to get the 5-wave move down we should see a choppy sideways/up bounce on Monday that then leads to another leg lower (bold red). At that point the move down from April 3rd could be the completion of an A-B-C correction to the larger rally and we'll see another rally leg get started. If the May 1st high was THE high (truncated finish as opposed to the DOW's new high) then we'll only get a bounce later this week that corrects the decline from May 1st and then continue lower. The answer to this question will only come with further price action in the coming week.

Nasdaq-100, NDX, 60-min chart

The big bearish thing I see on the chart above is the island reversal between the April 25th gap up and Friday's gap down. Note that the island reversal reverses the previous island reversal on April 25th. A reversal of a reversal often leads to a strong move, which supports the bearish wave count. The other thing that had me wondering about the further upside potential for NDX was what I was seeing in many of the component stocks. AAPL, AMZN, PCLN, CMG and many other high-flying stocks were all showing topping patterns. On Wednesday I showed the chart of INTC and noted how it had run into trendline resistance (important trend lines) and suggested it was a very good reversal setup. And reverse it did. This looks like an important high for INTC and a break of its 50-dma would be the nail in the bull's coffin.

Intel Corp, INTC, Daily chart

The SPX chart below reflects the wave count that calls the April 2nd high as THE high and the 1st wave down to the April 10th low was followed by a 2nd wave correction into the May 1st high and now we're seeing the start of the 3rd wave down. The 1st wave of the 3rd wave is what started last week and as shown on the NDX 60-min chart we should see a bounce/correction and then another leg down this week to complete the small 5-wave move down. Then back up again into the end of the week before heading lower in a stronger decline. That's the bearish wave count and it calls for a volatile week in the coming week. The short-term bullish wave count calls for another leg up to a new high this month before finishing its rally.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1394
- bearish below 1357

Friday's decline broke the uptrend line from November through the April 23rd low but that was an untested trend line (only two points) and therefore might not be important. So far, as you can see on the chart above, SPX is holding at the mid line of its up-channel from November and a rally back above its 20- and 50-dma's (1383-1386) would be at least a bullish heads up that the bears are losing control (again).

For the coming days I'm showing what I'll be watching on the chart below. Price broke below a parallel down-channel from May 1st, the first indication of trouble for the bulls. If the bottom of the channel remains resistance on Monday and price heads lower it's going to be potentially very bearish. Other than meeting its H&S price objective near 1372 it also found support at the Fib projection at 1368.44 (where the 2nd leg down is 162% of the 1st leg down from May 1st), which is why it's a good setup for at least a bounce.

S&P 500, SPX, 60-min chart

I'm hoping we'll see a bounce on Monday back up to the 1382 area for a 4th wave correction and then another leg down into mid-week to finish a 5-wave move down (that would keep the wave pattern clean). A break above 1382 would be a bullish heads up here and above 1394 would leave a 3-wave pullback and suggest the move higher had already begun. If we get the 5-wave move down we can then expect a bounce into the end of the week and by Wednesday wrap I will hopefully have a better idea what's playing out.

Similar to NDX, the leg up from April 10th for the DOW achieved a minimum projection based on it being 62% of the 1st wave up from November (it was actually about 6 points shy) and might have finished its rally there with a truncated finish, especially since it made a new high above its April 2nd high. But the 3-wave look to it is what's keeping me bullish for now. As I continue to show on its chart, we could see the resumption of the rally from here and complete a 5th wave for the move up from April 10th (as some kind of expanding triangle). Note that the DOW is at/near support at its uptrend line from November and its 20- and 50-dma's, near 13040 and 13061, respectively. For this reason a break below 13K would be more bearish and below 12845 would negate the 5-wave count idea on the chart. Then we'd be looking for a deeper retracement at a minimum before thinking about another leg up (light red dashed line)

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- stay bullish above 13,000
- bearish below 12,845

The March and April lows for the RUT have formed a neckline near 785 and if that doesn't provide a bounce it will obviously be a bearish statement. If it holds as support it should be good for a bounce for day traders to try a long (maybe even for a ride back up to the top of the descending triangle pattern). The bullish pattern calls for another rally leg to a new high into the end of the month. But if the bears are in control of this market then the better play will be to short the bounce (mid-week perhaps if we get a small bounce on Monday and then another leg down on Tuesday before the bigger bounce sets up).

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 830
- bearish below 785

With the decline in the stock market on Friday we saw money flee into the bond market and that dropped yields. TNX is now very close to its uptrend line from last September, near 1.87%. That sets up the potential for a bounce in yields, which of course means selling in bonds. If that's true then it remains possible for the stock market to also start a bigger bounce, perhaps even to a new high as TNX makes its way back up to the top of an ascending triangle pattern (2.4%). The more bearish pattern for TNX says we should expect a bounce but then start heading lower into the summer (light red dashed line).

10-year Yield, TNX, Daily chart

In Wednesday's wrap I showed a weekly chart of the DJ US Home Builders index and the A-B-C bounce off the November 2008 low. Wave C is the leg up from October and it would be equal to wave A (the November 2008 - April 2010 rally) at 368.77. The top of a parallel up-channel (bear flag) for the A-B-C is near 360. The top of a parallel up-channel for the rally from October crosses 360 in the coming week and as shown on the daily chart below, one more leg up following this week's pullback would do a very nice job completing the 5th of the 5th wave to complete wave C to complete the A-B-C correction of the 2005-2008 decline. That would be a very good setup to trade the home builders from the short side. The eventual move will be another leg down to break the November 2008 low, probably in 2013.

DJ U.S. Home Construction index, DJUSHB, Weekly chart

The dollar continued higher last week and broke its downtrend line from March 15th through the April 6th high and closed above its 20- and 50-dma's, near 79.50. As noted on Wednesday it should be on track for a move up to at least its downtrend line from January, currently near 80.40. That would likely keep pressuring the commodities markets and perhaps the stock market as well.

Gold broke below its 20-dma again and bounced off the bottom of its sideways triangle pattern. I see the potential for a bounce up to its 20-dma, near 1652, before breaking down from the triangle. Back above its May 1st high at 1672.30 would be bullish otherwise I'd look at bounces as shorting opportunities.

Gold continuous contract, GC, Daily chart

Oil bulls got spanked last week. The big drop in oil, down near 5%, was blamed on the government suggesting it would allow fracking on federal lands. There were also reports that oil production in Iraq is expected to increase. Sounds more like an effort to pluck reasons out of thin air to help explain the big price move. I've got another idea -- an a-b-c bounce off April 10th low completed where it achieved two equal legs up and therefore was ready for a continuation of its decline from March 1st. On second thought I guess it would be easier for the masses to understand the first reason (smile).

I had mentioned on Wednesday that the a-b-c bounce off the April 10th low achieved two equal legs up at 106.06 on Tuesday (the day's high was 106.43) and the down day on Wednesday was an indication that we'd see selling into Friday. It was stronger selling than I had expected but it's clear the setup for it was a good one. It's also a good example of a failed pattern for the bulls. A breakout of the bull flag and the close back above the 50-dma had many traders long oil. Once it broke down instead, especially with the drop back below the downtrend line from March 1st, all those long traders started bailing in a hurry. Thursday's and Friday's declines were longs bailing more than short sellers selling. When you see this kind of pattern that fails it's generally a good trade to jump in on the reversal (down in this case).

Oil continuous contract, CL, Daily chart

Monday is a very light day for economic reports. We'll get the Consumer Credit report and expectations are for an increase of $11B. Recent reports have shown there's also been a major increase in government revolving credit so the problem of too much debt continues to get worse. It will be driven down eventually and when the numbers start back down we will have already seen the stock market lower. The rest of the week is fairly benign as far as economic reports go with Friday's PPI and Sentiment numbers the key data for the week.

Economic reports, summary and Key Trading Levels

On Sunday, the French people will cast their votes for either the Socialist presidential candidate Francois Hollande or the incumbent Nicolas Sarkozy. Heading into the weekend Hollande was leading Sarkozy 52% to 48%. A win by Hollande will not be good for the EU. It might be good for France for a short period of time (less austerity, more spending with higher tax rates on the wealthier) but that won't last and I predict if Hollande wins the election it won't be long before he wishes he hadn't. The same will likely be true for whoever wins the U.S. election in the fall -- you should vote for whoever you want to see go down in flames in the history books.

Greece will also hold parliamentary elections and on Friday Greece's Finance Minister, Evangelos Venizelos, stated that these elections would determine whether or not Greece would remain in the euro. And we wonder why there was nervousness in the stock market on Friday?

The chart pattern would look best with a bounce/correction on Monday, another leg down on Tuesday for at least a minor new low, and then start a bigger bounce into the end of the week. Whether the bounce develops into a rally to a new high into the end of the month or just a bounce to correct the decline from May 1st can't be known yet. We're still in the mode of playing this one leg at a time until the bigger pattern identifies itself. So stay loose, trade short term, make hit and run trades and soon, hopefully within a week's time, we'll know whether or not we can expect "one more high" or if instead THE high is already in place.

Many believe that sell in May and go away is still the way to go in the market. Even though we have two very good examples of that, in 2008 and 2011, it's generally true that selling in June is the better way to go. The saying should be "sell in June before the swoon." I saw data from Tom McClellan where he identified a pattern of Democratic election years and it suggests a strong rally into June. So that's a warning to bears -- don't get complacent in this market since it might not be finished having some bear for lunch.

But keep in mind that the market is throwing off all kinds of warning signs. The chart below shows the DOW with a line behind it showing the number of NYSE stocks above their 50-dma. Note that while the DOW made a new high on May 1st (with the other indexes not far behind) the number of stocks participating in the rally (as measured by how many are above their 50-dma) continues to dwindle. In other words, it's not just volume that is shrinking but it's also the number of stocks participating. The rally in the indexes is happening on the backs of fewer and fewer stocks, which is typically a good indication the rally is coming to an end. It's not a good timing signal but it's a good warning to keep those stops tight on long positions -- it's better to protect profits and miss one more leg up here than to give back too much.

DOW price highs diverging with number of NYSE stocks above their 50-dma

Good luck and I'll be back with you on Wednesday to see how the week is looking.

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