We're starting to get some cracks in the foundation of this bull market. Most will see a healthy pullback but the risk is for something more significant.

Market Stats

Tuesday morning started off with a bang to the upside and only a slow pullback the rest of the day, making it look like the market might head higher on Wednesday. Following a quiet overnight session it was looking like we were going to start the day's trading with another gap up, even if it was a smaller one. But as soon as the cash market opened it got hit with some big sell orders, especially in the banking sector. It was all downhill from there. Even the mighty DOW couldn't stop the onslaught of sellers, which latched onto the hull of the USS Bullship and bore holes into its hull, allowing the invaders inside.

Before the market opened we had only two economic reports worth considering and neither one affected the futures much. The ADP report came in with a disappointing number, showing a 158K increase in private employment in March, which was weaker than the 205K expected. But isn't that supposed to be good news? Doesn't that mean less risk of the Fed backing off its QE efforts? This market has been focused on how much money the Fed will continue to print and not about the multiple signs of a slowing economy, all of which continues to defy logic of expectations about how the market is going to react to any report.

The ADP report showed private employment was revised upward for February from 198K to 237K (+39K, good news) but downward for January from 215K to 177K (-38K, bad news). The net result for changes to January and February were a wash but March was lower than expected so the employment picture worsened. It should also be noted that there were no new construction jobs and that's not a good sign for the housing market (I'll cover the charts for the home builders later). It was the lowest reading since October 2012 when ADP first started reporting construction jobs. Now we wait for Friday's payrolls numbers.

The ISM Service index for March came in at 54.4, which was a little lower than the 55.5 that was expected and a drop from February's 56. ISM's chairman, Anthony Nieves, mentioned in his monthly conference call that order growth was disturbingly slow and in his opinion not related to sequestration. New orders, prices paid and the employment sub-indexes all declined, which is of course not a good sign about the economy.

All sectors on my watch list were in the red today, with the weakest being the semiconductors (which have been weak all week), banks, home builders and gold/silver indexes (also weak all week). Commodities in general have been weak this week, in spite of weakness in the U.S. dollar. The strongest of the weak today were the utilities and drug/healthcare (defensive sectors). This week has produced some potentially significant cracks in the foundation for the stock market so let's get started reviewing what we've got.

There's nothing bearish on the SPX weekly chart as this week's pullback looks like nothing more than a minor correction within a well-established uptrend. The long-term uptrend line 1991-1994-2002 has held all pullbacks for the past 4 weeks and currently near 1553, it is still holding. The uptrend line from October 2011-June 2012 has been holding since it was recovered last December. Based on the short-term pattern I think a high is now in place but from this weekly perspective I need to continue to respect the potential for a move up to 1590-1600. It takes a break below 1485 to confirm a weekly sell signal.

S&P 500, SPX, Weekly chart

The daily chart below shows the price projection near 1590 where the 5th wave of the move up from November would equal the 1st wave. I believe the final 5th wave completed on Tuesday but a break below its uptrend line from December, near 1546, would be better confirmation. The completion of a 5-wave move up from November calls for at least a pullback correction of that rally. The longer-term pattern calls the completion of the rally from November as the completion of the correction off the 2009 low, which makes this top extremely important to longer-term investors. Don't be a buy-and-hold here; it's simply not worth the risk of what you're likely to experience over the next few years.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1571
- bearish below 1546

The big reason why I believe the top is now in place is due to the rising wedge pattern from the March 19th low that completed yesterday. The rising wedge fits as the ending diagonal 5th wave in the move up from February 26th. That 5-wave move completes the 5th wave of the move up from November, which in turn completes the A-B-C move up from June 2012 and in turn the larger 3-wave moves up from October 2011 and from March 2009. In other words today's break down is potentially a very big deal. The decline from yesterday might have completed a small-degree 1st wave down and we'll get a 2nd wave bounce correction on Thursday. Look to short it, especially if it bounces back up to about 1565 to back test the broken uptrend line from March 19th (the bottom of the rising wedge pattern).

S&P 500, SPX, 60-min chart

Keep in mind that rising wedges tend to get retraced very quickly and we have one from March 19th, a larger one from February 25th and an even larger one from November. And then going back to the 2009 low we've got a very large rising wedge. All these point to the vulnerability of the market -- I don't like predicting market crashes and even if we're going to get one it's probably too early in the pattern to expect one. But even a quick retracement of the rally from February (perhaps in a week's time) would be a painful jolt to the bulls who are simply waiting for a pullback to get long.

The moon phases are still largely correlated with important highs and lows for the market, with important reversals coming within 3 trading days of a new or full moon. Not every new or full moon marks an important reversal but almost all important reversals occur within 3 days of the moon phase, including yesterday's high for SPX. Many still poo-poo this relationship but I don't know why -- the chart speaks for itself. The 2009 low was near the full moon, as was the April 2010 high and June 2010 low. The May 2011 high was at a new moon and the August 2011 low was near a full moon. As you can on the chart below, the April 2012 high and June 2012 low were both near full moons and the September 2012 high and November 2012 low were on new moons. If we have an important reversal from yesterday it will be on a full moon.

SPX MPTS, Daily chart

Whereas SPX has a little more upside potential to 1590, where the 5th wave of the move up from November would be equal to the 1st wave, the DOW did achieve its target at 14678 with yesterday's high at 14684 and today's retest at 14683. Today's decline dropped it back to price-level support near 14550 (previous highs of recent consolidation). It should be good for a bounce but if the high is in place we should be looking at the bounce as a shorting opportunity. A bounce back up to its broken uptrend line from February, near 14620 Thursday afternoon, followed by a failure would be the time to short it. Between the 14550 level, its 20-dma near the same level tomorrow, and its uptrend line from December, near 14420, the bears have some work to do but clearly below 14400 would likely mean a quick test of support near 14200 (October 2007 high and its 50-dma).

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 14,680
- bearish below 14,550

The Nasdaq finally lost its battle with the trend lines. For the past 3 weeks (15 trading days) the COMPQ managed to add 15 points (one a day) and was getting pinched between support at its uptrend line from 2009-2011 and resistance at its trend line along the highs from March-September 2012. The choppy slowly rising pattern, like the ending diagonal shown on the SPX 60-min chart, was an ending pattern and I was simply waiting for the breakdown (nibbling short along the way). Today's breakdown confirms the top is in place with Monday's high. It has broken support at its uptrend line from November (although it held it today when viewed with the arithmetic price scale) and it might find support at its 50-dma but each bounce off support will now be a shorting opportunity.

Nasdaq Composite index, COMPQ, Daily chart

Key Levels for COMPQ:
- bullish above 3280
- bearish below 3230

Hurting the tech indexes is the weakness in the semiconductor index (SOX). As the chart below shows, the drop from March 14th was followed by a choppy bounce back up that was only able to ride up underneath the bottom of its broken up-channel from November and following the back test of its 2007-2011 downtrend line on March 28th it has sold off hard. The decline from March 28th fits well as the 3rd wave of what I expect will become a 5-wave move down but that is yet to be proven. A 5-wave decline this month to its 200-dma, currently near 393, would be a good setup for a bigger bounce but it would also tell us the trend is down. For now stay short this index below 423.

Semiconductor Index, SOX, Daily chart

The RUT has been one of our early-warning indexes, the canary in the coal mine. This week's decline has it giving off some important sell signals that should not be ignored. The first was the break of its 20-dma on Monday, although that also happened in February and it recovered nicely. Will the second break be the second mouse (bear) getting the cheese? Tuesday's decline found support at the bottom of its up-channel from December and just above its February 19th high at 932. But today's decline broke below the channel and 932 and that puts the bulls on the defensive. The next support level was at 923-924, which is the top of its parallel up-channel from March 2012 (the top of a broken up-channel is typically support when back tested if the pattern is to remain bullish) and its 50-dma at 923.35. But support was meant to be broken today so now we watch to see if 932 becomes resistance if back tested. A higher bounce to about 938 would be a back test of its broken uptrend line from December.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 950
- bearish below 932

The RUT is the first to solidly break its series of higher highs by breaking below its February 19th high (the COMPQ made a minor break today but recovered and NYSE has also broken below its February 19th high). As discussed last week, this is the level on the Gann Square of Nine chart that is 6 squares up from its 2009 low at 343 (similar to the relationship between the SPX 2002 low (768) and 2007 high (1576). This is a very important number on the chart. The fact that it's the February high makes it doubly important. Ever since the 2009 low each time a prior swing high has been broken it has led to a decline of at least -8%. The RUT just gave us a sell signal based on that pattern.

The RUT's 60-min chart below shows what I'm watching for to help confirm whether or not we've seen a trend change. A 5-wave move down from March 28th is depicted on the chart (today's low looks like the completion of the 3rd wave down). A relatively small bounce followed by a new low would create the 5-wave move, which would then be followed by a bigger bounce early next week before heading strongly lower. So we'll see how it plays out from here and react accordingly.

Russell-2000, RUT, 60-min chart

The transportation index and the RUT continue to mirror each other and the relative weakness in both, compared to the broader indexes, is a clear warning sign. The generals are out front calling for the troops to follow but the troops are starting to retreat back over the hill. It shouldn't be long before the generals realize they're vulnerable.

The TRAN is of course a good reflection of how traders are feeling about the economy and right now it's showing worry. Its high near 6292 on March 19th stopped only 17 points shy of the projection at 6309 where the 5th wave of its rally from November equaled its 1st wave. It has a very clean EW count for the rally and following a 5-wave move we'll see at least a pullback correction of the move and that appears to have started. The choppy bounce off its 20-dma from March 21st to March 28th was followed by a breakdown on Monday. The decline has now broken the uptrend line from December and today it tested its uptrend line from November, which is also where its 50-dma is located (6009). A break below 6000 would be a big deal for the bears.

Transportation Index, TRAN, Daily chart

The weekly chart of the TRAN shows why the setup here is particularly bearish. Two equal legs up for the 3-wave move up from 2009 projects to 6109 -- check. Two equal legs up from October 2011 projects to 6271 -- check. The rally into the March high tagged the top of its parallel up-channel from October at the same time the 5-wave move up from November completed (and only 17 points shy of the projection for the 5th wave in the move up from November). All the pieces are in place to call the bounce off the 2009 low as complete, calling for the start of the next bear market leg down (to match or exceed the 2007-2009 decline).

Transportation Index, TRAN, Weekly chart

The home builders got slammed today and the home construction index finished down -3.2% after bouncing off its early-afternoon low and down -5.1%. Following its March 20th high, which was a back test of its broken uptrend line from November-December (following the break of it in February) the index has now broken its uptrend line from June-November 2012 and November-February. I've basically run out of uptrend lines for the index to break and following the completion of a 5-wave move up from October 2011 it's a setup for at least a decline to correct a portion of that rally leg. This index remains bearish beneath 488.

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

I've shown the weekly chart of the home builders in the past and it's an important reminder that I don't think we'll be looking for just a pullback correction of the rally from October 2011. The bigger pattern is an A-B-C bounce correction from November 2008 that corrected only 38% of the 2005-2008 decline. The confluence of Fibs near the 500 level is the reason why I thought we'd find a high near that level (the March 20th high was near 529). The longer-term pattern calls for a drop to new lows (below 130) before the bear is done with this index (and the housing market in general).

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

The banks got hit hard today. JPM, MS and GS were all down more than -2% today and BAC and C were down more than -3%. The banking index (BKX) was one of the weaker sectors, finishing down -2%. BKX had been declining in a choppy pattern that was forming a bullish descending wedge since its March 15th high. But today's decline dropped it out of the bottom of the wedge and that created a failed pattern (and failed patterns tend to fail hard). The break below its 50-dma, at 55.27, and its uptrend line from November, near 550.05, is just icing on the cake for bears. Look for a drop down to potential support near 54 before a bigger bounce next week (for a shorting opportunity).

KBW Bank index, BKX, Daily chart

The U.S. dollar has been hanging tough even though it should be ready for a pullback, which might be just a choppy sideways/down kind of consolidation for a few weeks before heading higher again. In last Wednesday's update I pointed out the dollar reaching its price projections at 83.43 and 83.50 and should be ready for a pullback correction. So far it's holding above its broken downtrend line from 2010-2012, which was tested yesterday at its low of 82.64 and remains bullish above that line.

U.S. Dollar contract, DX, Daily chart

I hear more and more from pundits how the dollar is going to crash and gold skyrocket because of the Federal Reserve's efforts to monetize our debt. All that money creation is inflationary and will cause the dollar's value to tank and gold to shoot for the moon (I'm hearing $5000 before the end of 2013). At least that's the argument based on fundamentals of too many dollars and not enough goods, which is correct. The problem continues to be deflation, not inflation. What's happening in Europe is clearly deflationary (those who thought they had 200,000 euros in their Cypress bank account could be lucky to walk away with half that -- that's deflationary). Whether it's people losing the value of their savings or people/businesses/governments writing off debt, or companies hoarding cash, it's all deflationary.

The Fed would be more successful in fighting deflation if they could get the banks to lend more and people/businesses to borrow more. Our fractional reserve banking system requires the lending so as to increase the velocity of money expansion. But as you can see in the chart below, we're seeing exactly the opposite -- the velocity of money has been in a steep decline since the late 1990s. The Fed has been fighting deflation with their easy-money policies without effect (except for the stock market, primarily due to bullish sentiment that they've spawned). And the Fed will continue to lose this battle until the hyper-credit period of the two decades prior to 2000 is corrected. And once the Fed hits the wall with their money creation (when the bond market starts demanding higher rates) we should see an acceleration of the deflationary effects.

Velocity of M2 Money Stock, chart courtesy Fed Reserve Bank of St. Louis

The negative psychology (disbelief in the rally) has created an increased demand for liquidity, as evidenced by decades-low money velocity. Businesses would rather hoard their cash (or buy back stock and/or pay dividends) rather than invest. It's further evidence of the negative mood. Try as he might, Bernanke can't do anything about this -- the Fed and other central banks might have the will and a way to create more money, but the negative social mood trumps their efforts. It's the market's way of thumbing its nose at the great and powerful man behind the curtain.

The Fed and governments hate deflation because it makes the situation for debtors even worse. The Fed has been trying to stoke inflation as a way to help reduce the value of the debt. But if inflation goes higher it will cause bond yields to increase as well (bond holders will demand higher yields to compensate for inflation) and the debt payments will skyrocket, thereby only increasing the debt load. It's why the policy of increasing inflation, through monetary easing policies, does not work. Governments cannot inflate their way out of debt. And as the chart above shows, it's been a losing battle for the Fed anyway.

Deflation is actually a very healthy cycle to go through since it cleans out the debris of an expansionary period and corrects faults covered up by the previous expansionary periods. It's governments that don't like deflation. And with deflation being a bigger worry than inflation, there is less of a need for gold, which has been selling off for the past seven months and sold off hard the last two days (fund managers dumping their gold ETF holdings once they got through end of quarter?). Gold bugs have a hard time grasping this and most want to believe in the hype that gold is heading for $5000. It's not. Gold is more likely heading for sub-$1400 this year.

But there's a possibility we're going to see the shelf of support for gold, near 1525, hold and get a multi-week bounce before heading lower. It might even find support near today's close, which was a test of the bottom of its down-channel from September as well as its February low.

Gold continuous contract, GC, Daily chart

Silver is the one that has me thinking lower prices for the metals. The bearish wave count calls for a sharp decline from here, one that will take silver well below support at 26.15 (today's low was 26.67). The break below its trend line along the lows from November is bearish and unless it does a quick recovery back above 27.15 we should see a quick test of support at 26.15. A large descending triangle pattern on its weekly chart (the purple lines on the daily chart below) suggest 26.15 will hold and silver will make its way back up to the top of the triangle by the end of the summer before starting a more serious decline. So we'll see if it can hold above 26.

Silver continuous contract, SI, Daily chart

Oil dropped hard today, down -2.5% and broke its 50-dma at 94.66 but is trying to recover in after hours. I show the possibility for another attempt to break its downtrend line from September 2012 but at this point I think the higher probability is for oil and the stock market to decline together, which should see oil drop below its March 4th low at 89.33 and then down to its November low near 84 in the next few months.

Oil continuous contract, CL, Daily chart

It will be a quiet day for economic reports on Thursday but then Friday will be the big day with the Payrolls numbers before the bell. How the market will react to the numbers, regardless what they are, is anyone's guess. If we get a day of consolidation on Thursday I suspect we'll see a downside reaction on Friday.

Economic reports and Summary

Most market participants are looking for a pullback that will lead to another rally leg. In other words, a dip to buy. If my interpretation of the longer-term pattern is correct we're moving into a period where you'll instead want to sell the blips instead of buying the dips. When most are anticipating the same thing from the market we'll rarely see the market accommodate those hopes and dreams.

The real risk from here is from the multiple degrees of rising wedge patterns. I see them on the weekly, daily and intraday charts and that's a setup for a market crash. I don't like predicting a market crash but will point out when I see a setup for one. It requires extreme caution from here since a 1987-like event is possible (dwarfing the May 2010 flash crash). It's the reason I've been recommending for the past week that you should consider nibbling on a short position now, before we have proof of a top in place. That proof will be in hindsight and it could be from much lower levels before we wonder what hit us. And as for being long the market I'll simply ask you why -- do you think there's a lot more upside potential?

I'll leave you with a recent quote from Robert Prechter:

"...In 40 years of watching markets closely, I have never seen more dangerous conditions than exist in the stock market today. It is natural yet amazing that so many analysts are saying the current juncture is the start of a major bull market and that conditions are historically bullish. It is natural because increasing optimism propels markets upward; that's why optimism is high at tops. It is amazing because even some technicians are calling for Dow 20,000, while some economists are saying they have never been more bullish in their entire lives. Our technical analysis leads to the opposite conclusion."

Keep in mind that traders have maxed out their margin accounts so it won't take much of a decline to start the margin calls. We could see some violent moves in the coming week so trade carefully and good luck. 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