Following the break of green Tuesdays we have now broken the string of short pullbacks with today's negative day making it three in a row.

Market Stats

Not since 1900, so I'm told, has the DOW rallied for so long without a 3-day pullback. The last one was in December and now with today's decline we have had three negative days in a row. First we lost the string of green Tuesdays and now the 3-day pullback record has ended.

Yesterday was a red Tuesday, the second one in a row. Are our green Tuesday's going to turn into a string of red Tuesdays? I ask that question with tongue-in-cheek since it's of course a silly question after only two negative Tuesdays. But the typically bullish Tuesday has been notably absent once the market started becoming weaker after the May 22nd high. We had three other periods of pulling back in the up-channel from November -- in December, February and April -- and the green-Tuesday run held through those. There was no pullback that lasted for more than two straight days. Both have now come to an end during this pullback, which begs the question --is this pullback different from the others?

Today's decline is also the 2nd test of its uptrend line from November and 50-dma for SPX. All previous tests were one day and then new rally so this pullback is different (and weaker). It's not yet apparent that support will break, and we could still get one more rally into July, but the bulls need to step back in quickly to save this. Perhaps the rubber band is being pulled back to suck in some shorts and provide some short-covering fuel for a run back up into opex week next week. We've seen that happen a time or two, especially after a head-fake low into Thursday morning prior to opex week. Stay aware of that potential here.

The global stock markets are showing worry that the central banks are not going to keep up with a slowing economy and markets. Japan frightened traders when the BOJ would not add more stimulation to an already hyper-stimulated economy. The -20% decline in the Nikkei 225 index apparently didn't qualify for more stimulation and traders had a little hissy fit. Added to the "taper talk" by Federal Reserve members and the market is starting to act a little spooked. It's a sad commentary when you have to acknowledge that the only reason the stock market is up is because of free money from the Fed but it is what it is and what we have to trade.

But in reality there's probably very little the market needs to worry about from the Fed since the Fed is trapped. The stock market will likely come back down regardless of what the Fed does or doesn't do primarily because sentiment will change and free Fed money will not be enough to stop a market slide.

One of the things that will likely prevent the Fed from backing away from their QE program will be Congress. The Fed has been paying interest on the "excess reserves" that its member banks keep at the Fed. This is the free money that the banks receive from the Fed and then returned to the Fed for safe keeping. The money made on this free money is then deposited into the banks' coffers and the executives pat themselves on the back and take home huge bonuses for being so smart. But I digress. If the Fed were to try to reduce their QE we would very likely see an increase in interest rates and the money on deposit with the Fed would likely stay there. They would be paying higher interest to the banks but getting smaller payments on their holdings of Treasuries and mortgage paper purchased over the past few years.

Since the profits on the Fed's balance sheet flow to the U.S. Treasury guess who would not be happy if those flows decline -- Congress. While the TBTF banks would be receiving massive amounts of money from the Fed there would be significantly reduced flows to the government. Congress would have a fit dealing with less income and more debt while the banks were reaping a windfall and would likely press for a change to who gets to mint more money, taking back their constitutional power to coin money. This would pressure the Fed to back away from any plans to reduce their QE efforts. They're trapped. They have successfully painted themselves into a corner.

But this is not a win for the market since there's an end game to all this money printing. We'll find out from Japan how successful it is since they're well ahead of everyone else and doing massive QE right now. If the Nikkei does not recover, and I don't think it will, and their economy does not show signs of life from all the monetization effort, sentiment will sink like a stone. Rising rates will kill Japan's ability to pay their debt (a rise to only 2.2% would take 80% of their budget just to pay their debt load) and the shock waves would be heard around the world. Central banks are trapped in what they're doing but there's simply no good outcome for this grand experiment of the central banks. All are bad and it's only a matter of which bad option is chosen. The central banks will hang on to the very end, which is the worst option.

And on that cheery note, let's take a look at what we're facing this week. One reason for the market's current weakness, as compared to previous pullbacks, can be blamed on the hedge funds, which are clearly one of the largest drivers of this market. Unlike normal mutual funds, which are always long (or flat but then they have to justify why they're not invested), hedge funds can more easily bail out of the market and even short it. The chart below, from Bank of America shows the net buys by type of client and the largest net buys were from private clients (the retail investors) over the past month and especially the last week whereas the largest net sellers were the hedge funds. We know retail investors tend to be the last one to the party to pick up the tab (or at the bottom to be the last ones to puke their holdings).

Net stock market buys by client type through June 7, chart courtesy Bank of America

BAC's equity strategist, Savita Subramanian's report last week detailed the weekly flows and noted that the hedge funds have heretofore been the primary driver of the rally. But seven straight weeks of buying has been followed by the "largest net sales last week." He noted there was stronger selling in small and mid caps while money flowed into large caps, which is clearly a defensive move. He also noted that outflows from U.S. stocks total $10.8B so far this year, nearly matching the $10.9B for all of 2012. This says big money is not too sure about the expectations for another new high within the current up-channel and a strong indication we should listen to them.

From a pattern perspective I can still argue for one more new high into the end of June/early July, one which would very likely show all kinds of negative divergences. In other words, the May high might have been the momentum high and one more high could essentially be a test of it (with at least a minor new high). We've seen this occur at multiple important highs in the past, most notably at the 2007 high where the minor new high in October showed lots of bearish divergence against the July high.

If the bulls are going to drive the market higher they need to start right now. As can be seen on the SPX weekly chart below, it has pulled back, again, to the bottom of its up-channel from November and the mid line of its larger up-channel based off the trend line from September 2012 to the recent May high (parallel attached to the November 2012 low). The bottom of the wider up-channel is currently near 1530 and is a possible downside target if the bulls can't hold it here.

S&P 500, SPX, Weekly chart

One statement that can be made today about the indexes is that the 50-dma's are holding. Prices closed on them so the bulls need to hold the line here but at least they held into today's close. I suspect there are more than a few bulls nervous about tomorrow and keep in mind that intraday breaks don't count; it's the closing price that counts.

Because the price pattern since the May 22nd high looks more corrective than impulsive I continue to lean into the bullish camp. As long as the up-channel from November and the 50-dma hold we clearly still have an intact up trend. The uptrend line from November-April is currently near 1615 and was tested today. That line is climbing nearly a point a day. The 50-dma, near 1611, was also tested today and is a must hold for the bulls. Everyone has their eye on that moving average and if it breaks it could create a flood of sell orders. So the bulls need to hold the line here otherwise we would likely see a quick drop to at least 1560 (two equal legs down from May), if not down to the 200-dma near 1500.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1649
- bearish below 1598

At the moment the pullback from Monday morning's high is more of an a-b-c and holding at support. That's why an immediate rally on Thursday could put the bulls back in charge. The bears have the bulls on the ropes so the bulls will have to come out fighting. Otherwise a drop below a support zone at 1607-1609 is going to be trouble. From a short-term bearish perspective I see two possibilities: one, a hard drop right from here, which would create the waterfall decline appearance from Monday's high and help confirm it's into a 3rd of a 3rd wave down from the May high; or two, lower prices but then a bounce on Friday and into Monday before the bottom falls out. It's opex week next week, which is typically bullish but very bearish when it's not bullish.

S&P 500, SPX, 60-min chart

Monday's doji at resistance, which was its broken uptrend line from December-April (using log price scale) as well as its broken 20-dma, was followed by a red candle on Tuesday. From a daily candle perspective that put the bulls on the defensive and they didn't play too well in that position today. The good news is they prevented the bulls from scoring with a drop below the 50-dma. They'll need to do better than just preventing a score tomorrow.

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 15,300
- bearish below 14,840

The choppy pullback for NDX fits within a little parallel down-channel from May 22nd, which looks like a bull flag consolidation. The choppy overlapping price structure supports the view that this will be followed by another leg up and that's the way a lot of people are betting. But a break below its 50-dma at 2914 and the bottom of its flag pattern, near 2900, would be failure of a bullish pattern and that would likely be followed by a strong selloff to potential support at its uptrend line from November-April, currently 100 points lower near 2826.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 3005
- bearish below 2900

The RUT has pulled back to an uptrend line from April through last week's low so it's a good setup for the bulls following the 3-wave pullback from May. I've been using the RUT since that high to point out how we could see more rally into early July when several important time cycle studies coincide for a major market turn. As long as the RUT stays above last week's low near 963 I'm looking for the rally. But below 963 and especially below its uptrend line from November-April and its 50-dma (near 955 and 958, resp.) would have me looking for much lower. The RUT would likely jump out in the lead to the downside if the market starts to break down.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1000
- bearish below 963

Recently I've shown the collapse in lumber prices from the March high and have said that it points to a slowdown coming in home building (less demand for lumber) and that we would likely see a decline in the stocks of the home builders this year. The weekly chart below shows the decline in the home construction index from May, which has now broken its uptrend line from October 2011 through the April low, near 480 (today's low was 463.71 and it closed near 465). It's nearing its 50-week MA at 455 and still has a way to go before reaching the bottom of a possible diamond top pattern (the trend line along the lows from February-April), near 425. The diamond top is still speculation but something I'll be watching for. It calls for a whippy period into next year in its topping pattern before heading much lower.

DJ Home Construction index, DJUSHB, Weekly chart

All of this begs the question -- if lumber is so weak and the home construction index has dropped sharply from its May high, why are housing prices climbing so quickly? One reason could be explained by a delay between lumber prices, home construction and housing prices. There's often a delay between lumber prices and the housing index as well, as Tom McClellan explained today in a CNBC interview (McClellan interview).

McClellan talked about the predictive value of lumber prices for home values and it's interesting how the move in lumber prices shifted forward a year shows good correlation with the housing index. Based on lumber prices peaking in March 2013 we could see a final high for the home builders inside their diamond top pattern in March 2014. That's obviously pure speculation but it makes for an interesting scenario based on McClellan's work.

What's interesting about all this is what I see on the home price index chart below. I took the chart and added the a-b-c and note about possible hedge fund activity, which I'll get to in a minute. The a-b-c bounce off the 2009 low would have two equal legs up if the year-over-year change reached about +15%, which I've indicated with the red horizontal lines. That would be back up into bubble territory reached in 2004-2005. The 2nd leg of the bounce, which is the move up from 2011, is the result of strong demand from buyers, including hedge funds, as they rush in to snatch up good deals with low mortgage rates. The data on the chart is through April and I wonder if it will reach +15% before the summer is finished. The a-b-c pattern, following the decline from 2005, will likely lead to another leg down (back into negative year-over-year change).

Home Price index, 2002-April 2013, chart courtesy CoreLogic

There have been several stories recently about the demand for houses and that much of it is coming from hedge funds offering cash and often buying houses sight unseen. This would explain why housing prices continue to climb while mortgage applications fall. These hedge funds, many of which belong to the TBTF banks, are picking up blocks of houses at perceived good values as rental properties and/or to flip them back to the public at a profit (hopefully).

Blackstone has raised over $8B to buy up medium- and low-priced homes. JP Morgan has started a fund to buy up to 5000 homes and Morgan Stanley raised $1B to buy up 10,000 homes. As one analyst commented, it's somewhat ironic that TBTF banks were bailed out by tax payers for getting in too deep with bad mortgages and are now reaping the benefits of the housing collapse, including foreclosed homes that are the result of their actions.

Many of these stories warn about the danger of excessive demand from these hedge funds placing unnatural pressure on the market and preventing "normal" buyers from getting in. There are two potential problems here: one, hedge funds, as the largest demand component, could disappear in a hurry once the perceived good values are far and few between; and two, those hedge funds could quickly flip the houses back to the market if home prices turn back down (once the c-wave on the chart above completes). A sudden increase in the for-sale inventory would obviously negatively affect prices.

Back to the chart above, the Fed's make-believe money has created an unusual demand for houses (another bubble in the making?) and the money has enabled these banks to price home buyers out of the market, or worse, it's forcing new buyers to chase prices higher into another bubble and guess who will be left holding the bag again. Many of the new buyers are using fog-a-mirror FHA qualified mortgages that might be foreclosed when the housing prices turn back down and the buyers abandon ship again. This time the tax payer will be on the hook again to pay off the abandoned FHA mortgages. Will we ever learn?

OK, back to the market indexes. The bond market is at an important level and we'll soon know if yields are going to get away from the Fed (by running higher) or if a bond market rally can start and reverse the sharp decline in bond prices since their May 1st highs. The weekly chart of the 30-year yield (TYX) shows it has rallied up to resistance at the trend line along the highs from September 2012 (same for TNX). So far it's done a little throw-over a drop back below the trend line would create a reversal signal. A decline in yields could drop straight down to new lows later this year or we could see a down-up sequence as shown and then new lows into next year. The bounce pattern off the July 2012 low is what has me strongly leaning toward new lows for yields (new highs for prices) before we'll see a generational reversal in bonds.

30-year Yield, TYX, Daily chart

The transportation index looks like the DOW -- it pushed up to its broken uptrend line from November-April last Friday and Monday and then sold off from there. The back test and bearish kiss goodbye does not look promising for the bulls. But it remains possible that we'll see it, and the DOW, keep pushing up underneath its broken uptrend line to at least test its May high. We've seen the DOW do this repeatedly at important highs.

Transportation Index, TRAN, Daily chart

The U.S. dollar's sharp decline from its May 23rd high has been surprising and at the moment it's certainly looking bearish. I drew in a parallel up-channel based off the trend line along the two highs in November 2012 and April and attached the parallel line to the low between them, in February. Today the dollar closed slightly below the bottom of this channel as well as its 200-dma at 81.11, which had supported the dollar since last week. The only thing holding it so far is the trend line along the lows from March and a price-level support near 80.75. There's not much support between here and its uptrend line from February 2012 (potential H&S neckline), near 79.25. It's a good place to start a bounce so we'll have to see if there will be enough dollar bulls out there.

U.S. Dollar contract, DX, Daily chart

Gold's bounce off its May 20th low was choppy and corrective and continues to support lower prices ahead. The drop from the bounce high on June 6th looks impulsive and the bounce off yesterday's low looks corrective. This all continues to point to lower prices and as the weekly chart shows, a drop to Fib support near 1300 is the more probable move from here before bouncing again and then lower into the summer. I'll continue to show an ultimate low for an A-B-C pullback from September 2011 near 1150 until the price pattern tells me otherwise, which I remain very alert to because of the large skew between commercial traders being much more bullish than speculators.

Gold continuous contract, GC, Weekly chart

Oil remains inside a sideways triangle within a larger sideways triangle. All the choppy and whippy price action since its May 2011 high is explained by these consolidation patterns. Even the weekly MACD has practically stopped oscillating near the zero line, as if to say "wake me when you're ready to leave."

Oil continuous contract, CL, Weekly chart

Today was a quiet day for economic reports but Thursday will be a little busier. But there's not likely to be anything that will be market moving. Overseas events are having a bigger impact at the moment.

Economic reports and Summary

The overall feel of the pullback from May has me leaning toward a bullish resolution. But that resolution needs to start with an immediate rally on Thursday or else important support lines and 50-dma's will be broken. Intraday breaks are expected but closing prices are the important ones and the bulls do not want another red day for Thursday. That would open the door to another leg down at least equal to the first leg down from May. And there is a much more bearish potential than that so it's important to play defense and/or the short side if the market proves it's going lower.

It's been a somewhat typical pattern to see the market pulled lower into the Thursday prior to opex week, pull in the shorts and then use short-covering fuel to launch the market back up into opex week. Remain watchful for that possibility as well. Trade carefully into next week.

Good luck and I'll be back with you next Thursday (Thomas and I will be switching next week).

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