When the market picks a direction it gets relentless about it and it's now the bulls struggling to get this ship turned around. The good news for the bulls is that it looks like a bigger bounce is coming. The bad news for them is that it might be short-lived.

Wednesday's Market Stats

This morning started out in what has become a familiar pattern the past two weeks -- another gap down. But this time the bounce off the gap-down start for the day was not followed by more selling to a new low. While there was a pullback from the morning bounce it's looking like we'll get a larger bounce. There is the potential for the start of another rally leg to a new high but at the moment the reversal off the July highs looks like it could turn into something more significant to the downside.

While price is king, which is the reason we use various technical analysis tools on price, we've had plenty of warning that the selling was coming. Picking a top is always a challenge and this one was no different. It's always in hindsight that you slap yourself on the forehead and utter "Doh"! The minor new highs in July with significant bearish divergences and worsening market breadth told us the market was likely to break down before heading higher. Now we have to figure out if the decline is more significant than just a pullback correction to the longer-term uptrend. In January 2014 we had a sharp selloff and it looked like the end of the uptrend. But the market went on to make new highs over the next six months. Do we have the same opportunity for the bulls here?

All eyes are on the uptrend lines from November 2012 and October 2011, which define the longer-term uptrend. Looking at SPX, the uptrend line from November 2012 is now close and depending on how it's drawn, SPX has either broken it or is close to testing it. As I'll get into, SPX 1900 is a critical level for the bulls to defend and if we get a high bounce into next week (opex week) we'll probably have a lot of bulls breathing a sigh of relief while the bears will feel like they'll have to go back into hibernation. But the setup following the bounce could be very painful for complacent bulls if they don't lighten up their exposure to the stock market. They need to heed the warning with the shot across the bow of the USS Bullship.

While we review price action to see what the patterns are telling us, it's important to keep in mind how weak the current market is. With the 2-week decline it's easier now to see some weakness but it was the weakness leading up to the high that was important and still is. Hayes Martin, a consultant at Market Extremes, identified three indicators that have predicted every bear market. Once the three indicators are present together there has been a bear market that started within about a month and his indicators have occurred so he's recommending his clients get out of the stock market now. These are his indicators:

1. Extreme reading in bullish vs. bearish sentiment. I've discussed the very bullish readings in the past month several times, especially the bullishness by investment advisors.

2. Stocks are overvalued based on a historical average. Starting at the end of last year the RUT's P/E ratio, after excluding negative earnings (which makes the P/E ratio infinity), rose to its highest level ever! It was higher than it was in 2000 and 2007.

3. The percentage of stocks participating in the rally to new highs falls sharply lower, which started to show a quick deterioration in July. I had been showing a couple of measures of this in the decling number of new highs for stocks vs. the indexes that were making new highs. There was a deterioration of the advance-decline line, which again showed fewer stocks participating in the rally. The indexes were making new highs on the backs of fewer and fewer stocks. Another measure is the number of stocks above their average price over the past four weeks. This number declined from 82% at the beginning of July to less than 50% at the July 24th high for SPX.

As Martin noted, the deterioration in the internals was "the sharpest breakdowns in market breadth that I've ever seen in so short a period of time." So the above three indicators were clearly present in July as the market pushed higher and by Martin's analysis this points us to the start of a bear market. While I'll show a price pattern that supports the idea for one more new high by September/October (to mimic the 2007 high in July and then minor new high in October?), I think the higher-odds scenario suggests we should be looking for a bounce to a lower high to correct the decline and then a sharper selloff to follow.

There have been a number of reasons given for the selling, mostly geopolitical news. That makes it so much easier for investors -- "well, I'd still be up in my account if it hadn't been for that damned (fill in the country). I still haven't heard many analysts say the selling simply triggered more selling following an overbought market. Analysts don't make money making simplified comments like that. Today's lackluster performance by the market was blamed on more geopolitical news with Russia beating on the war drums. But in fact the market is due a bounce and this morning's gap down might have been an exhaustion gap to finish the leg down from July 24th. The news has nothing to do with it.

Last night Jim mentioned Rupert Murdoch pulled his $80B offer for Time Warner (TWX) in a surprise announcement, blaming TWX management for not trying to negotiate seriously. But I know the real reason his bid was pulled -- he doesn't want to be blamed for the start of the next bear market. That's of course said tongue-in-cheek but back on July 23rd I showed a chart of stock market peaks that coincided with Rupert Murdoch's previous large purchases, which coincided with the 2000 and 2007 highs. His offer for TWX looks to be pretty well timed with the July 24th high, don't you think? It's too late Rupert, the damage is done (wink). As I had mentioned back on July 23rd, "Batten down the hatches, we're going down." If only trading were as easy as a Rupert Murdoch signal to short.

Rupert Murdoch tops, chart courtesy Financial Insyghts

There were in fact multiple warning signs of a top and major indexes were hitting price projections and resistance lines at a time when the EW (Elliott Wave) count was looking complete. But we've had so many previous tops come and go with yet another rally leg and this left bears with the feeling the market was never going to decline. They were more than justified in not believing we were topping in July. And now with the strong decline in the past two weeks there's still some question about whether the decline is the kickoff to a much larger decline (the next bear market) or if it's just another (scary) pullback, like we had in January 2014.

We're starting to read more reports that describe a strengthening economy, improving earnings, lower unemployment rate (cough), etc. and if the market has peaked we're going to have a lot of bulls baffled why the market would sell off on all this good news. Yes, there are some geopolitical events muddying the waters but don't we always? The news only matters when the market moves and then the news is used as the excuse. Ignore the news. Market tops occur on good news and a stronger economy (it's not strong so I can't use that word but it is relatively stronger). Employment typically peaks when the stock market does. So be careful thinking the market should rally more on all this good economic news. It's already priced in. We'll also starting hearing more worries about the Fed pulling the spiked punch bowl away from us since the improving economy and rising inflation will require them to start tightening.

Moving to the charts, I'll start with SPX and review the setup for the top. Following the attempt by SPX to get through the 1990 price projection that I've been showing on the weekly chart (where the c-wave of the A-B-C move up from October 2011 is 162% of the a-wave), with a high of 1991.39 on July 24th, the rounding top pattern since the beginning of July did in fact lead to a sharp breakdown. What looked like a bullish consolidation pattern broke down instead, which was what I had been expecting to see (a failed pattern usually fails hard). The wave count strongly suggested we should be looking for a high back then. And if it was THE high we should now be looking to sell bounces.

I've got two uptrend lines on the weekly chart, both starting from the November 2012 low and one going through the October 2013 low and the other going through the February 2014 low. The one through the October 2013 low is where the decline in April found support and where it found support last week. This week we've got a little weekly doji candlestick on that uptrend line, currently near 1927, which was broken and today it acted as resistance. If the decline continues I will be watching the next uptrend line from November 2012 - February 2014, currently near 1902. Not shown on this chart (but is on the daily chart further below) are the Fib retracement levels for the rally from April and the 50% retracement is at 1902.88. This is why I have 1900 as a key level to the downside.

S&P 500, SPX, Weekly chart

The uptrend line from November 2012 defines the intermediate trend and therefore a break of the uptrend line would signify at least an intermediate-term trend change. The longer-term trend is defined by the uptrend line from October 2011 - November 2012, currently much lower, near 1765. This is the trend line for the 2nd leg of the rally from 2009. BUT, and this is a big but, that uptrend line when viewed with the log price scale is currently near 1891. So the really important level for the bears to break is 1890. That would be a strong signal that the longer-term uptrend has been broken. For now most are looking to buy this "dip" down to 1900 support. And one thing that makes me wonder what will happen from here is that the market rarely accommodates "most."

S&P 500, SPX, Daily chart

Key Levels for SPX:
- bullish above 1955
- bearish below 1900

The wave count for the decline from July 24th counts well on SPX as a completed 5-wave move, as shown on the 60-min chart below. If the July 24th high was the completion of the rally then the impulsive 5-wave move down signifies a trend change to the downside and that's the reason to look for a higher bounce into next week as a shorting opportunity. But what can't be ruled out yet is the idea that the decline is the completion of a larger a-b-c pullback from July 3rd (expanded flat correction since the b-wave high on July 24th was a higher high). I consider this a lower-probability but as I said, it can't be ruled out yet. A larger bounce as depicted that's followed by a drop below this decline's low would confirm THE top is in place and welcome to the next bear market. There's a lot of money to be made in a bear market so don't frown about that possibility.

S&P 500, SPX, 60-min chart

After getting back into positive territory (above 16577) for the year in May, the DOW struggled for two months to tack on almost 600 points by the time it topped on July 17th at 17151. It then gave up all those points in two weeks. It then proceeded to shed more points and has joined the RUT in negative territory for the year. NDX is still up almost +8% for the year so we've got quite a split between indexes. As can be seen in the first table at the top, SPX is splitting the difference and is up +3.9% for the year. There's still a lot bullish enthusiasm for owning the techs and I suspect it might not be long before the DOW starts to show some relative strength (all in a decline but the DOW declining slower as money rotates into the relative safety of the DOW).

Dow Industrials, INDU, Daily chart

Key Levels for DOW:
- bullish above 16,880
- bearish below 16,340

The picture of water pouring out of the pitcher (rising wedge) is a perfect example of why you want to play these rising wedge patterns -- when they break they tend to break hard. While a show an expected bounce into next week, stay aware of the possibility for the DOW to simply head lower through next week to get back to the starting point of the rising wedge (the April low at 16015). Getting down there would very likely set up a strong bounce reaction.

For the DOW I'm tracking an idea for one more new low before we'll see a higher bounce, which I've drawn out on its 60-min chart below. Interestingly, this is a setup for the usual head-fake drop into the end of the week before opex and then reversed into a rally into opex. The wave count shown on the chart supports the idea that this morning's low was the completion of the 3rd wave in the decline from its July 22nd high and that today's bounce, and likely into Thursday morning, will be followed by one more decline to finish the 5th wave. Then start the higher wave-2 bounce into next week.

Dow Industrials, INDU, 60-min chart

NDX sliced through support levels last week as it dropped below its 20-dma, currently at 3927, and its uptrend line from April-May, which will cross the 20-dma by Friday. The 50-dma at 3855 held on the test this morning, the first test since NDX climbed above it in May. It looks like a good setup for a higher bounce into the end of the week at least. But then the larger pattern suggests you'll want to short the bounce for a stronger decline to follow.

Nasdaq-100, NDX, Daily chart

Key Levels for NDX:
- bullish above 3975
- bearish below 3850

The RUT has been the weaker index, topping on July 1st with a picture-perfect double-top pattern with its March high. It was significantly weaker into the July 17th high for the DOW and July 24th high for SPX and was another clear warning to bulls at that time. But now the RUT is warning us that things might get more bullish. This index is actually supporting the idea that we could get another rally leg to new highs in September/October. I'm not ready to buy in to that idea yet but it has me watching very carefully for evidence that it could happen. The decline from July 1st is a 3-wave move and as such could be an a-b-c pullback correction to the longer-term rally. The 2nd leg down, from July 24th barely exceeded the price projection near 1113, where it's 62% of the 1st leg down. Two equal legs down points to 1081, which is also the February low. So that's a possibility but first it has to break two uptrend lines -- the first that's being tested now is from March 2009 - October 2011 and then a little lower, near 1101, is from October 2011 - November 2012. These are the longer-term uptrend lines for the RUT and therefore very important for the bulls to defend, which they're doing at the moment.

Russell-2000, RUT, Daily chart

Key Levels for RUT:
- bullish above 1160
- bearish below 1082

For the RUT, I show a drop down to its uptrend line from October 2011 - November 2012 before a higher bounce/rally but it's not clear enough to make a reliable prediction about that. If it happens then the DOW projection for one more new low before bouncing would also likely happen. If the a-b-c pullback wave count (pointing to new highs in September/October) is not correct then a bounce to a lower high, as depicted in bold red, would be a setup for a very strong decline in a 3rd of a 3rd wave down. That kind of move would likely drop the RUT quickly (in September) to about 1000 and then stair-step lower over the next few weeks. Again, we've got time to figure out which way the pattern is pointing but it would be another reason to lighten up on long positions if we get a higher bounce into next week.

The story is very similar with many of the other index and sector charts so I'll just show the TRAN, which supports the idea we'll get a bounce from here. This morning it dropped down to its uptrend line from June 2013 - April 2014, at 7978, and is just above its June 12th low near 7960. A bounce to retrace 50% of its decline would take it back up near 8250 and perhaps a back-test of its 20-dma by then. Currently near 8284, the 20-dma is coming down. The longer-term wave count strongly suggests THE high is in place for the TRAN and therefore only a bounce to a lower high is expected.

Transportation Index, TRAN, Daily chart

The U.S. dollar continues to do battle with the top of its trading range that it's been in since the October 2013 low and it could pull back to its uptrend line from May 2011, currently near 80.32, but the expectation continues to be for a stronger rally in the dollar once it breaks out of its trading range at 81.50 (on a weekly closing basis).

U.S. Dollar contract, DX, Weekly chart

My expectation has been for another leg up in gold from its June 3rd low. It looks like it might have started today with the break of the downtrend line from the high on July 10th. A rally up to its downtrend line from August 2013 (the top of a sideways triangle that I'm interpreting as a bearish continuation pattern), near 1350-1360, should then set up a stronger decline in the shiny metal.

Gold continuous contract, GC, Daily chart

Oil has dropped to its uptrend line from June 2012, as can be seen on its weekly chart below. Ideally we'll see one more leg up to the top of its rising wedge pattern (the trend line along the highs from March 2012) to complete the large A-B-C bounce off the November 2008 low. The move up from January 2014 fits as the 5th wave of the rising wedge pattern and typically finishes with a small throw-over above the top of the wedge, which is what I depict (finishing with a test of its May 2011 high at 115.76). But there are times when the 5th wave truncates at a lower high, which means the high at 107.73 on June 20th might have been its final high. A break below 96 would be a break of its uptrend line, its 200-week MA (96.04) and a price projection at 96.27 where the move down from June 20th would have two equal legs for just an a-b-c pullback. Therefore a break below 96 would confirm the next bear market for oil has started.

Oil continuous contract, CL, Weekly chart

The rest of the week is very quiet as far as economic reports go so the market will be left to react to global news instead of domestic.

Economic reports and Summary

There will always be different interpretations of chart patterns and it's no different right here. I could argue the current decline will lead to new highs into September/October just as the sharp decline in January led to new highs. It would also mimic 2007 where we had the July high that was followed by a pullback and then minor new highs in October. But that's not the way I'm currently leaning.

The wave count had been suggesting a top of significance in July and now we've got an impulsive 5-wave decline (that looks finished this morning but might need one more leg down to complete it) that signifies a trend change to the downside. The one index that completely disagrees with this is the RUT, which has a 3-wave pullback and suggests we could see higher prices. The TRAN, which often trades similarly to the RUT, does not agree with the RUT and in fact is strongly confirming we've seen the completion of the bull market and have now started the next bear market leg down.

With the odds favoring THE high is in place, and assuming we'll get a decent bounce into next week, it will be a time to short the bounce. There's bearish potential for a continuation lower (the DOW's rising wedge suggests a quick retracement back to its April low near 16K) so that's the risk for trying to catch falling knives here to play at least a bounce up into opex next week. So stay conservative in your trading and by this time next week we'll hopefully have confirmation that we're looking for a bounce to get short for an even stronger selloff than we've seen so far (3rd wave down).

Good luck and I'll be back with you next Wednesday.

Keene H. Little, CMT

In the end everything works out and if it doesn't work out, it is not the end. Old Indian Saying