The day started with another large gap down and it was once again a dip-buying opportunity. But the buying wasn't quite strong enough to reverse the gap down for all but the techs. The new-month money was put to work to hold the market up but what follows will be more important.

Market Stats

Like Monday, the market gapped down (not quite as much but still significant) and looked like trouble following this week's bounce attempt. But the dip-buyers saw another opportunity and swooped in to find some bargains. The trouble is that buyers are buying the high flyers rather than looking for bargains (they're willing to pay top dollar for the higher-beta stocks). The techs managed to make new highs again but they couldn't hold and the highs are showing bearish divergence. So now that the new-month money has been put to work we are left to wonder if there will be any follow through.

The current worry is what the government shutdown will mean for the economy. Some will argue that it will hurt growth. Stated somewhat tongue-in-cheek, I could argue it will help. Get the government out of the way and perhaps companies will do better. But it's the uncertainty that the market dislikes and right now there's a lot of uncertainty. The last time the government shut down it was in 1995 for 21 days. Congressional approval actually climbed after that and the stock market rallied. Considering the approval rate for Congress is currently in the mud it wouldn't take much for sentiment to improve. But in this case most believe we have a more-dysfunctional Congress and sentiment is not likely to improve. Both camps appear to be fully entrenched and this battle could end up looking more like WWI than anything else.

The last shutdown has Clinton and Gingrich, both open to compromise and the two talked constantly before and after the shutdown. This time we have Obama and Boehner, neither of whom are willing to compromise for fear of alienating their base and if they've talked with each other for more than 10 minutes in the past few months that would be a lot. Partisan politics is much stronger today than it was in 1995 and the economy is not doing nearly as well today as in 1995. These are significant differences and today's shutdown has the potential to be a lot more difficult to solve. Add in the debt limit debate coming up and we're facing a real showdown. This shutdown could last for quite a while and when the market senses resolution is not coming we could see a lot more selling.

Part of the problem is that most people now feel Congress is not representing the people but instead putting themselves well above the people. Perhaps I'm not alone in feeling that the government shutdown should only be ended when the President, Congress, Supreme Court and the rest of government workers stop exempting themselves from the same healthcare plan that they've foisted onto the public they supposedly serve. Exempting themselves from the limitation for government subsidies gives them 72% of the cost of the new healthcare plans ( As Peter Brandt says, "I have a solution: Demand that the President and his family, members of Congress and their families and all government employees become subject to the exact same health insurance the rest of us "trash West of the Beltway" must receive. So I say this -- call your elected officials and tell them that government can re-open and Obamacare can be put into effect the minute the rest of us chumps get the same deal they give themselves." And with that I'll get off my soapbox.

The markets are not sure what to make of the shenanigans going on in Washington, DC but if anything it's not going to help sentiment. The debate over the debt limit is just ahead and that's going to be the bigger problem to solve. The charts of the indexes point to a nearby top if it's not already in place (in place for the blue chips but maybe slightly higher for the techs and small caps) and the government "shutdown" might be the catalyst that provokes more selling. We can never be sure what that catalyst will be which is why I prefer to stick with the charts and see what might be setting up and then wait to see what catalyst triggers it.

Countering the problems with our government and the out-of-control spending problem is the Fed and their out-of-control monetization (one could say their spending problem). Last week I had discussed the Fed's policies and the market risks that are accumulating because of their policies. Fighting each financial crisis (or perceived crisis) with the same accommodative policies has only fueled the next crisis.

For you pilots out there you can probably relate the Fed's actions to "pilot induced oscillation" or PIO. It's a common problem that new pilots have to learn to control -- you put in a correction and wait to see what happens. As the plane starts to exceed the desired altitude the pilot puts in a correction by pushing the nose down (taking away monetary accommodation). The correction is often too much and the airplane overshoots the desired altitude to the downside. The pilot then tries to correct the move with again too much input (pulling the stick back and adding power) and the plane climbs too fast and overshoots even more (the Fed adds too much monetary stimulus). These over-correcting inputs causes an increasing amplitude in oscillation that typically will dampen out all by itself if the pilot would just let go of the controls (assuming the plane is trimmed for stable flight). These increasing oscillations in altitude control might look something like this:

Pilot Induced Oscillation

The thing about an increasing amplitude sine wave is that it requires increasing input to cause it to expand. It's not a natural state. The chart of the DOW below is the one shown last week -- does it look similar? This is called FIO -- Fed Induced Oscillation, which will soon lead to FIT -- Fed Induced Terror. The market needs the Fed to let go of the stick and let the market dampen out its oscillations but the Fed is incapable of doing that, which is one reason why I believe the Fed will be abolished before this is over.

Dow Industrials, INDU, Monthly chart

Back in 1998, following the failure of LTCM (Long Term Capital Management) and the fear of contagion in the financial sector the Fed engineered a bailout as a way to "save the system." Following the bust into the 2002 low there was another massive Fed accommodation which then led to low interest rates and credit speculation and the housing boom into the 2007 market high. Following the bust there's been an even larger Fed accommodation strategy that has led to massive credit speculation (most acknowledge that we are in a credit bubble, the likes of which has never been seen before) where it's risk-on and don't worry about the downside.

The pattern above is known as a megaphone pattern or broadening top and it's generally a reliable topping pattern. The question of course is what kind of top it is and what will follow. Is it a top to the rally from the 1930s? Some say yes and the correction that will follow will lead to a very long-term market decline (back to the 1970s level). While I certainly see the potential for that, considering how messed up our government and fiscal policies are, I think it is instead a large correction within the larger rally and the next leg down should complete the bear market and lead to the next bull market.

Regardless of the longer-term pattern I think the expanding megaphone pattern is correct and it calls for one more leg down to complete an a-b-c-d-e 4th wave correction within the larger rally. The next leg down is the one that will scare the cr** out of everyone and they'll be yelling "PULL UP! PULL UP!" The Fed will be pulling as hard as it can and pouring the coals to the fire (oh, that's right, the Obama administration intends to bankrupt the coal industry so we'll have to use a different metaphor) and when the financial sector goes splat there will be a lot more people asking why we have a Fed.

The techs and small caps have been leading the charge back up the hill as fund managers chase performance. I think it also has a lot to do with HFT -- they're essentially momentum traders and the momentum is clearly in the techs and small caps. But when that momentum dries up, which would likely happen when fund managers start looking for the relative safety of the blue chips, those same HFTs will then force the techs and small caps back down as they again chase momentum but this time to the downside. In effect this makes the techs and small caps the higher-volatility indexes and even more so with the program trading constituting the majority of today's trading volume.

Since the techs were the strongest sector today (NDX closed marginally in the green), I'll start tonight's review with the Nasdaq. The September rally popped the Naz out the top of its parallel up-channel from August 2011 and is now up near the top of a shorter-term up-channel from the November 2012 low. It's overbought on a weekly basis (and monthly and daily) and I think it would be a risky bet to believe it will rally above the top of its shorter-term up-channel, near 3830 (about 11 points above today's high).

Nasdaq Composite index, COMPQ, Weekly chart

The daily chart below shows the top of the up-channel from October 2011 (blue), a rising wedge pattern from May-June and a small up-channel from the August 27th low. The top of the rising wedge (trend line along the highs from May-August) crosses the top of the up-channel from October 2011 tomorrow at 3830. That's also where the broken uptrend line from August is located for what could be a final back test if the bulls can push it a little higher on Thursday. I've had this as an upside target since last week and so far it's coming together nicely. Look to short it if tested and fails from there.

Nasdaq Composite index, COMPQ, Daily chart

Key Levels for COMPQ:
- bullish above 3830
- bearish below 3695

The other strong index has been the RUT but it too has now made it up to potentially strong resistance. Yesterday and today it banged its head on the trend line along the highs from February 2012-July 2013, which stopped the August rally and again the high on September 18th. Yesterday it also came close to back testing its broken uptrend line from September 3rd. That broken trend line is near 1096 on Thursday and that's the upside potential if the bulls keep this going. But the daily oscillators are overbought and showing bearish divergence against the July high and now a shorter-term divergence on top of that against the mid-September high. Up against resistance like this is not a good time to be thinking long; instead, look for a rollover to short.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1100
- bearish below 1063

SPX has been working hard to hold support at its 50-dma, which has held since Monday's quick spike below and then recovery. Currently at 1680, the bulls don't want to see that broken again. But if it does break we should see some support at its uptrend line from November-June, currently near 1664. A break below 1660 would be more bearish. I show a bounce up to price-level resistance near 1710 before heading back down but I'm beginning to wonder if 1710 is a little too ambitious. It's not that far away and it would be only a little more than a 62% retracement of the September decline (in the land of 78.6% retracements that should be a walk in the park). But the buying will need to be stronger on Thursday before I'd look for that high of a bounce.

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1730
- bearish below 1660

The 30-min chart below shows an idea for what kind of bounce we might get for SPX -- an a-b-c bounce off Monday's low with two equal legs up at 1702, which would also be a 50% retracement. The bounce idea is just a guess but a rising wedge (ending diagonal) for the c-wave (the leg up from this morning) would make an excellent setup for a reversal back down.

S&P 500, SPX, 60-min chart

There is also a Gann Square of Nine reason why we should be looking for a top for SPX this week. The chart below is too hard to read but it provides a snapshot of the vectors that are important. A larger version of the chart can be seen at this link: Gann Square of Nine chart. You can click on the chart in the link to make it larger and scroll around.

Gann Square of Nine chart (small version)

When using this chart it's important to look for strong relationships between price levels and dates, especially when they correlate to other prices and dates. The price levels along a vector "vibrate" off one another and are therefore important to watch when the market is reaching the number. A rally into it could result in a turn back down and vice versa.

The red vector, at about the 11:30 position, goes through some important levels -- the October 2002 low at 768, the April 2012 high at 1422 and the October 2007 high at 1576. From a time perspective it's important to note dates that are 90 degrees to this vector, which is the red line drawn from about the 8:30 position to the 2:30 position. The one that is 90 degrees to the right, at the 2:30 position, points to April 2nd, which is when that April 2012 high occurred at 1422. The vector at the 8:30 position points to the multiple October highs and lows in 2002, 2007, 2011 and 2012 (and 2013?). It points to October 5th and crosses through 1697 (Tuesday' high was 1696.55). Also note the price that is one level below 1697 -- 1536. This was the double bottom in March-April 2013 from which the rally shot higher into the May high.

The blue vector, in the 12:30 position, goes through the March 2009 low at 666/667. The blue vector 90 degrees to the left of that points to September 14, which was the 2012 high (at about the 9:30 position) and it crosses through 1705. A bounce up to that level this week has the potential to be the top of the bounce correction since it "vibrates" off the 2009 low and 2012 high (the projection to 1702 shown on the 30-min chart would certainly be close enough). There's also a relationship between 1706 and the September high at 1729.86 -- they're 45 degrees apart, which is commonly associated with corrections.

I don't show a vector through the September high (1729) but it's at 125 degrees (between the 10:00 and 11:00 positions) and is half way between the one through 666/667 and the one through 1705, which makes both the 1729 and 1705 levels potentially important to each other and the March 2009 low. A bounce correction to 1702-1705 could be all we'll see this week as this chart is showing strong correlation between time and price for an important high (we're rallying into this time/price correlation and therefore a reversal to the downside is expected rather than a rally). Obviously we'll know in hindsight but Gann is telling us, through this chart, to be looking for an important high this week and the start of a more serious decline. The upside levels to watch for resistance are 1697 (reached Tuesday) and 1705.

The index that has been the weakest actually now has the most bullish setup that I see among the indexes. It helps support the idea that we might see some rotation out of the techs and small caps and into the bluest of the blue chips. Today's low tagged its uptrend line from November through the August 28th low (an untested trend line before today). It might be good for the start of a bounce to correct the September decline but at this point that's all I'm expecting to see (if that).

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 15,760
- bearish below 15,300

We've got a parallel down-channel for the DOW's decline from September 19th, the top of which was tested yesterday and again today. It's still holding inside the down-channel, which is obviously bearish, but the bullish divergence suggests it could be ready for a breakout.

Dow Industrials, INDU, 30-min chart

I've been showing the 30-year Bond chart recently but tonight I've updated the 10-year yield chart, TNX, to keep the bigger moves in perspective. The 3-wave bounce off the July 2012 low made it back up to the downtrend line from 1981-2007, poked above it into the September high and has now dropped back below it. So far that's a failed breakout attempt. I have the 3-wave bounce labeled as a correction to the larger decline, which points to another leg down into next year and I have a downside target around 1%. But if we see yields consolidate near the current high and then press higher (shown with the light green dashed line) we'll have an impulsive move up from July 2012 and that would be longer-term bullish for yields (bearish for bond prices). The bullish view calls for rates to essentially chop sideways through much of next year in a trading range roughly between 2.5%-3% before finally heading much higher into 2015. We've got some time to figure out the larger pattern but for now, if the decline into next year is to happen, yields are only at the start of what should be a larger decline.

10-year Yield, TNX, Weekly chart

The banking index remains weak and the bounce attempts remain corrective. It's trying to hold support at its August low but should be close to breaking down. It might first bounce up to its 20-dma, at 63.32, or slightly higher to its neckline (blue), near 63.60, but I see no reason to be bullish the banks.

KBW Bank index, BKX, Daily chart

The dollar remains weaker than I expected and now looks to be headed for its next support level near 79.55, which is its H&S neckline from February 2012. If that doesn't hold there is the price projection at 78.58 for two equal legs down from its July high. That would also be a test of its September 2012 low at 78.60. The bullish divergence against the June low continues to suggest another rally leg is coming but from what level is the question.

U.S. Dollar contract, DX, Daily chart

Gold's spike down Tuesday morning was followed by a spike back up this morning. The spikes occurred at the same time on both days so someone is playing games or is confused about what to do with gold. I would imagine more than a few gold traders got whipsawed out of their trades yesterday and today. I've been looking for another leg down for gold, following it’s a-b-c bounce off the June low and the short-term whipsaws haven't changed my opinion. Monday's high was stopped by its downtrend line from February-April (log price scale), the price-level resistance band at 1336-1345 and its crossing 20- and 50-dmas (both near 1348 on Monday) so as long as gold remains below 1350 I'll continue to be bearish the yellow metal.

Gold continuous contract, GC, Daily chart

Other than the brief flare-up on September 18th silver has been struggling to get back above price-level S/R at 22, which is also where its 50-dma is now located. Stay bearish silver below 22.

Silver continuous contract, SI, Daily chart

Along with the metals, oil got a nice little bounce today as well (helped by the declining dollar). But so far the bounce made it up to its broken uptrend line from April for a back test. A higher bounce would likely test its declining 20- and 50-dmas, currently near 105-106. Above that would be more bullish but back below 102 would be bearish.

Oil continuous contract, CL, Daily chart

With many of the government's non-essential offices closed we will not get some of their economic reports. Other than Friday's Payrolls report there wasn't much that should move the market anyway. Once the trading day gets going it seems to completely ignore how it started.

Economic reports and Summary

The techs and small caps have been strong this week but it's hard to tell if it's more of a blow-off top as fund managers chase performance or if it's just the HFTs chasing momentum. Regardless, the techs and small cap indexes have now made it up to upside targets I've been eyeing and could be setting up for a major reversal. At the same time the blue chips look like they could bounce at least a little higher to correct their declines from September. But corrections to their declines should then lead to a stronger decline and that would get all the indexes back in synch.

Bonds have been holding up well and there remains the potential for money to start rotating out of stocks and into bonds. Rotation out of the higher-beta stocks into the blue chips is also a possibility. But if none of this happens and the techs and small caps continue to press higher we'll have a bullish market on our hands. The waning momentum (bearish divergences) suggests that's not the higher-odds scenario. Look for reversal setups and some shorting opportunities. I don't think October is going to be kind to the bulls.

Good luck and I'll be back with you next Tuesday (Jim and I will be swapping days 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