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Follow-Up On Last Weeks Market Top Call – Where Do We Go From Here?

|Includes:Apple Inc. (AAPL), GLD, SPY, UVXY

A week ago last Wednesday I wrote a blog piece stating that I believed the following day would be the market high and thereafter we would move sharply and rapidly lower. I followed that blog post with an article on Monday offering a more in depth view on my reasons for believing that April 11, 2013 would be the high.

As it turns out we did peak -- at least for the moment -- on April 11 at 1597.35 on the S&P 500. Thereafter we moved to a low on April 18 of 1536.03 -- a drop of 61.32 in just 5 trading sessions. On December 31, 2012 we closed at 1426.19. From the close on December 31, 2012 to the current high on April 11 we gained 171.16 representing a 12% gain in 72 trading days. From the April 11 top to the April 18 low we gave back 61.32 points of the 171.16 gain or 35.8% of the years gain in just 5 sessions.

So far the call looks to be a good one. I am writing this as a follow-up to the previous articles and want to share a few of my thoughts at this point. To put things in context I just spent about 2 hours with my friend Andy discussing my views on the markets and why I am so certain that the market will suffer a free fall sell off in 2013. I eventually came up with an analogy that made sense to him.

I explained the "law of diminishing returns" in laymen's terms by comparing it to a rocket that is launched into space with a limited quantity of fuel. If the fuel is sufficient to push the rocket high enough to escape the earths gravitational pull them it doesn't follow that gravity will result in the rocket plunging back to earth when it runs out of fuel. If it doesn't reach that altitude then something different will happen. Specifically, it won't immediately start to descend as its upward momentum will allow it to continue to climb -- even after the fuel is expended -- for a short time.

Rather quickly though the rocket will stop climbing and start a descent that will accelerate as it falls further and further back toward the earth. I see the monetary and fiscal policy of recent years as similar to the rocket fuel in that these policies have not provided sufficient fuel to propel the economy into escape velocity mode. Maybe with just a little more fuel it would have happened but the truth is we are now seeing the economy hit stall speed and start the descent. A look at these charts tends to illustrate my point.

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The last chart reflects where unemployment would be had the labor participation rate been left at the level it was when Obama took office. The real take away here is that despite massive fiscal and monetary stimulus the economy never reached escape velocity and we are now stalling out. I think the rocket analogy is a good one as we can all visualize what happens to the rocket when the fuel runs out and the rocket doesn't quite manage to escape the earth's gravity pull.

My friend Andy didn't care much for my view on this matter. He continued to argue for a long time that I was missing something - that there was a solution. He was particularly bothered by the fact that I wouldn't even concede that there is a 5% chance we avoid recession or that we avoid a severe, steep and rapid descent in stock prices.

Andy kept asking me what I would do to fix the problem and I kept telling him there is nothing to be done at this point. The stock market is suspended in mid-air without enough fuel left to push it on through into escape velocity.

So what do the coming days and weeks hold in store for the markets?

I rely heavily on the macro fundamentals to make trade decisions but I also believe that a little technical analysis is crucial to identifying turn points in the market. My call on a market top on April 11 was made using both methods. A close look at the charts suggests we are getting precariously close to a breakdown.

Since early last week we have had a significant paradigm shift in market action. We will talk about that in a moment but first a look at the price action in the last few days. To illustrate a few points I am using the S&P 500 E-mini futures chart. The reason for using futures is that action in the overnight futures markets has been setting the tone of the market for the following day of late - kind of a "tail wagging the dog" situation.

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On Thursday we penetrated the trend line at 1540 setting the stage for a move to the second support level around 1480. That is coincidentally also close to the old high set back in September following the announcement of QE3. I would expect a rather rapid decline to this level over the course of a week or two.

We know that bullish sentiment is not very high at the present and the recent spike in VIX (NYSEARCA:UVXY) indicates a growing defensive posture in the market that should result in a lot of selling pressure on stocks if we penetrate the support line on a close basis. Here's the VIX:

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Let's take another look at a chart that I use to set target objectives and stop loss levels. Here is the close only version (NYSEARCA:SPY) of the chart dating back to January of 2012.

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Here is the same chart with a grid work overlay.

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By using the standard OHLC chart in conjunction with the chart above one can usually predict with some degree of accuracy the turning points in the market. The chart grid is constructed by calculating the mean and one and two standard deviations above and below the mean.

Mind you this grid is not magic. Price action is usually contained within the outer bands but doesn't necessarily identify the top of the market. It is useful as a tool for employing a mean reversion strategy but not infallible as the market can continue to move higher for a prolonged period as the mean (moving average) moves higher. That said, the grid does provide empirical support for the fact that momentum shifts are identifiable and occur at the outer range of the grid.

The "buy" and "sell" points on the chart above reflect the points where a trend shift occurred -- that is, the trend shifted at that point where the price moved a full standard deviation in the opposite direction of the trend after moving to the outer bands. A close examination of the chart shows that a head fake occurred twice -- once at the lows and once at the highs. In other words the price moved a full standard deviation above or below the outer bands and then resumed trend moving back to the outer bands. Again, the grid is a very useful tool for calling market trend shifts but it is not infallible.

Additionally, once the trend has reversed the grid is useful for setting short term profit objectives. I have inserted an arrow at the -2 standard deviation band that indicates my target objective before the market stabilizes and/or reverses trend again. The target objective is consistent with the gap on the S&P futures chart above. In other words the near term downside objective is in the 1400 range for the S&P on the OHLC futures chart and the -2 standard deviation band and indicate a trend reversal at this price level.

Another useful aspect of the grid chart is the ability to assign an approximate time frame to the move. A close examination of the chart shows that from the point where the trend actually turned down it took about 60 days to reach the -2 standard deviation level. There are two instances where the trend shift turned lower on the chart above and each time it took 60 days -- give or take a day or two -- to reach the bottom. This is particularly useful when trading options in that it offers a useful method for identifying possible trend shift points and the time frames. In other words long and short option strategies can benefit from a reasonable guesstimate on the outer boundaries of price action within a given time frame.

A paradigm shift

As those who follow me know, I believe the markets have demonstrated a very contrived nature for the last several months. The market has moved higher starting with the onset of QE and most of that move was justified by the fundamentals. In other words corporate profits have been outstanding and the move higher was fully justified based on profits.

Those profits though were the result of two very significant policy actions and one very significant response to the recession by corporations. Here are the two policy initiatives -- unprecedented deficit spending and equally unprecedented monetary policy through QE. The other significant action that produced high profits is that corporate America has undertaken aggressive actions to reduce costs primarily through reduction of labor costs.

What is relevant to this discussion is the fact that absent aggressive monetary and fiscal policy and aggressive cost cutting corporate profits would have been dismal. We reached a point last year where it was obvious to those who look at fundamentals that the strategies that were employed to stimulate the economy were suffering from the "law of diminishing returns". That said, the market has continued to move higher based almost solely on the incredible faith the investing public has placed in the Fed's monetary policy.

Much of the rally in recent months has been based on the fact that the market was propped up by heavy buy side volume during the last 30 minutes of each trading session. This ramp up in price at the close has kept the market in an upward trajectory regardless of the amount of negative data that we have seen of late.

Last week it became evident that keeping a floor under the market with the late day ramp in price was no longer in play. A look at the intraday chart for the S&P 500 over the last 5 days demonstrates that point. Three of the last five days reflect no late session ramp up.

Equally important is the relative lack of volume in the last 30 minutes. A look at the chart below shows that the only surge in volume in the last 5 days actually pushed the market down - not up. This too is a major shift in market dynamics in the last week.

Spy 5 minute tick chart

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Here is the point - whoever has been keeping a floor under the market is no longer doing that and the result is a loss of 3.5% from the peak in just 5 trading sessions through Thursday's close. This is a very important point and one that readers need to understand. The market hasn't been moving higher based on the underlying fundamentals - it has been moving higher based on the lack of selling volume and that has been based on the fact that negative data has had no impact on price. The reason that the selling volume has been so muted is the late session ramp that has kept stocks moving higher.

All good things end at some point and I think this rally has ended based on the paradigm shift referred to here. What should be a little disconcerting to the bulls is that the underlying fundamentals are rapidly deteriorating. If the late session buyers have withdrawn their support this market will rapidly recalibrate and stocks will move lower to reflect two things - the overbought nature of the market and the deteriorating fundamentals.

Concluding thoughts

Markets don't always move based on the fundamentals although the fundamentals always come into play at some point. Markets move because buyers are willing to pay more and more over time and market makers are more than happy to oblige them with higher and higher offers to sell. That is what pushes price higher over time and it is based on investor sentiment -- not the fundamentals. In fact I think it is safe to say that a large percent of investors don't really understand the fundamentals in the first place.

The thing about investor sentiment is that it is generally optimistic -- the result being that the market usually moves beyond the point where it should based on unreasonably high expectations of corporate profits. Despite the fact that we know that all bull runs do end at some point the large majority simply refuse to accept that inevitability until the price action finally convinces them.

Recent evidence of this rapid recalibration is demonstrated in Apple (NASDAQ:AAPL) and gold (NYSEARCA:GLD). After the sell off the pundits attempt to explain why it happened. The majority initially define the sell off as an anomaly and a good place to buy. When the market continues to move lower these same pundits rapidly change their rhetoric and begin to bring the fundamentals into the picture.

Three stocks - two capitulations (SPY), (AAPL), (GLD)

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We all remember the pundits talking of Apple going to $1000 and gold to $2000. These were the darlings of the bulls just a few months ago. Keep in mind that an explanation for why Apple had sold off so hard wasn't offered until the stock had fallen by $150. With gold we are still searching for the reason and there are still those who see gold as a bargain.

The verdict isn't in yet on whether the market has put in a top but the fact that this week's pull back is substantial and the largest one week drop since November 9 of last year suggests that there probably isn't much upside over the next few months. Price matters and with the fundamentals deteriorating at the point where we are still within a stones throw of all time highs should give one pause.

We finally got the sell-off everyone's been looking for but one has to wonder -- is this really a time to be buying the dip? Maybe the overlay of this year compared to last year will convince you it is not.

There are a few possible scenarios -- a break through of support right away or a short lived ramp up to the 1570 area forming a right shoulder and a head and shoulder top before breaking through support. There is of course a third and fourth possibility -- a push into all time new highs or a test of the recent highs forming a double top. I don't think the odds are very high that the third and fourth scenario materialize but regardless of the way we do it we should break through the support line and very soon.

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Disclosure: I am long FAZ, TZA, TECS, UVXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.