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The real story of the moment is the 5-day decline in the S&P 500 last week following the trading range breakdown. The S&P 500 entered the week at a critical juncture, at the low end of its 1,350 to 1,425 trading range, corresponding to 135 to 142.5 on the SPDR S&P 500 ETF (NYSEARCA:SPY), as we noted in our previous update (Market Update: JPMorgan And Europe Bad News Drive Market To Trading Range Bottom).

The market responded with five days of declines and the SPY closed the week at 129.74, clearly below the previous trading range.

click to enlarge images

(Click to enlarge all charts; Source for charts, unless otherwise noted: FreeStockCharts.com)

The market peaked before Q1 earning season. Without support from company earnings it is more likely to trade based on macro news and concerns in the near term.

In our review of key indicators below, we look at some parts of the market that are showing weakness. Financials, energy stocks and Apple (NASDAQ:AAPL), were important drivers of the market in Q4 and Q1, but are now declining and the rising VIX is indicating increasing fear.

Review of Key Indicators

The banking sector has been a source of bad news for the last few weeks.

JP Morgan (NYSE:JPM) has been falling since it announced a $2 billion trading loss on May 11. News reports this past week suggested that the loss may be larger than originally reported, adding downside pressure to the stock. After the sub-prime crisis of 2008, investors were once again reminded that they have little visibility into the balance sheets of the large banks and that these institutions are prone to massive mistakes. JP Morgan closed the week at $33.49 per share having fallen through its 200 moving average. The stock seems headed down to the $28 per share lows of September and November 2011.

The declines in bank stocks have been widespread and the Financial Select Sector SPDR ETF (NYSEARCA:XLF) declined all week to close at $13.77, just above its 200 day moving average. If the XLF falls through this level, financials could be in for more declines.

Spain and its banking system also continue to come under pressure. Last week, Moody's downgraded 16 Spanish banks (Santander Among 16 Spanish Banks Downgraded By Moody's). Rating agency downgrades often lag the news, but the downgrade of Spanish banks is still significant and there is probably more bad news to come on this front. The following weekly chart of Banco Santander (STD) going back to 2003 is indicative of the situation in Spain.

More worrisome is the fact that the 10 year Spanish bond yield is still above 6% and rising. Similarly, the Italian 10 year bond yield is rising to the 6% level. These levels are high in comparison to the 10 year German bond yield of 1.42%, as of Friday.

(Source: Bloomberg.com)

WTI Cushing Crude Oil closed the week at $91.48 per barrel. Since the beginning of May, the price of oil has declined approximately $15 per barrel. Although natural gas prices have rebounded, the decline in the price of oil is putting pressure on the sector, as seen Energy Select Sector SPDR ETF (NYSEARCA:XLE).

(Source: Bloomberg.com)

We continue to note the weakness in Apple. Apple was one of the market leaders in the rally in Q4 and Q1 and is the largest single component in the S&P 500, so its share price movements have ramifications on the broader market. Last week there was talk about a rotation out of Apple shares to free up capital for money managers to invest in Facebook (NASDAQ:FB). While we are skeptical of this thesis, we are more concerned that it will be difficult for the market to stabilize and trade up if Apple continues to fall.

All of this bad news can be summed up in the chart of the CBOE Volatility Index (VIX), which is sometimes referred to as the fear index. During market declines and crashes, the VIX usually jumps higher. Following the US downgrade last August, the VIX jumped from the mid-20s to the mid-40s as the market declined. Currently, the VIX is at 25.10, which is somewhat elevated.

The Bear Case

The bear case calls for the market to continue to decline and slide through key levels that it will soon face, such as the SPY 200 day moving average at 128. Catalysts for near term declines could be more bad news from the banks or Europe, Facebook trading below its $38 per share IPO price or something else that is not on our radar screen yet. At the beginning of the month, there was a lot of talk about the "sell in May and go away" trade. With the recent market declines, this mantra may become a self-fulfilling prophesy and could lead to more selling.

Looking toward the end of the year, we are concerned about the potential for a budget stand-off and the Fiscal Cliff, which could lead to tax increases. Investors may sell over the next few months in advance of these events. Furthermore, the US election in November may add uncertainty to the market and act as a catalyst for more selling.

If the Bear Case plays out, the SPY would fall through the 128 level and may decline to the lows of last summer in the 110 range in the next few weeks or months.

The Bull Case

Despite the recent declines, the market may still pull off a reversal at the SPY 200 day moving average and stabilize. The Federal Reserve may become a game changer. With Operation Twist set to expire at the end of June, the Fed may launch another round of quantitative easing or some other program to support the market. Although the sentiment following the last Fed meeting seemed to suggest that such a move was not guaranteed or even likely, the increasing pressure on European sovereign debt as well as European banks may push the Fed to come up with some policy action. Such action by the Fed, if meaningful enough, could be the catalyst for a market rebound.

Since the market did not rally through the recent earnings season, as we noted previously (Market Update: Q1 Earnings Are Not The Catalyst Investors Are Looking For), we do not think that company specific news will drive the market higher in the near term. The next earnings season may have a more bullish impact on the market, but that is a few months away. Many companies are still in good shape and there is value to be found in the market at these lower prices. At some point, new buyers may come into the market attracted by the lower valuations and provide support.

Longer term, we still believe in the US recovery and think that the declining unemployment rate is an important driver for future economic activity and growth.

If the Bull Case plays out, the SPY may halt its decline around 128 and rebound off that level.

Investment Plan

In the short term, we remain cautious and have reduced our exposure to the market. Although we are still net long, we recently sold some long positions, increased our cash position and initiated some short positions. We do not want to be too aggressive in either direction and favor having a large cash balance until there is more clarity about the market's direction.

Disclosure: We have a position in JPM and the ProShares Short S&P 500 ETF (NYSEARCA:SH). We may trade these positions or the stocks/ETFs mentioned in the article in the next 72 hours.

Source: Market Update: S&P 500 Trading Range Breakdown And Key 'Risk Off' Indicators