If anything human group think is predictive as it is repetitive. Tops are processes and are accompanied by similar and comparable behavior patterns. Key elements include an increasing sense of invincibility and incredible ingenuity to rationalize the irrational. Since nobody can predict price or markets rationalizing the irrational is a common byproduct of wanting to explain a market’s levitation to ever higher levels. In the process unfortunately price gets confused with value. The truth is that in every market bubble there ever was people are willing to pay prices for assets which have no real justification to be at the levels that humans trade them.

Another common element during tops is to relentlessly mock or dismiss those that outline concerns or want to provide a reality check as perma bears or negative nellies or whatever labels of the day suit the desire to dismiss. Never mind that these voices have been right during every single bubble that ever existed. As mentioned above tops are processes and not events (like bottoms often are). Thus predicting a top is virtually impossible and hence is making those expressing concern look wrong during the process. It’s all part of human psychology of course.

The recent market’s break-out to new highs into June and July provided another interesting case study in such human behavior. While price ignored all that seemed to demand caution (think Ukraine, Syria, Iraq, Israel/Gaza, Libya, Ebola, crashed planes, missed economic reports, Argentina default, etc) it was price that dominated sentiment and won out over analysis and caution.

People piled into stocks with record debt and the resulting price action caused a self-fulfilling loop with airwaves, media and analysts eager to cheer them on to do more of the same all the while dangerous and false narratives were used to justify price whilst ignoring value. Anybody can think of dozens of examples, but below are a few I found particularly poignant with the timing of their occurrences making them instant classics:

Now the market hasn’t crashed nor have we had a serious correction of any sort yet, but the plain evident fact is that all of June’s and July’s market gains have been erased within a few days. That’s a lot of trapped buyers and don’t believe for a second that everybody got out. Most didn’t. But many now want to as fear came back with a vengeance this week.

Now if you have been following my writings this sudden drop should hopefully not have come as a surprise. In my weekend charts segments I’ve been pointing out the weakening internals and negative divergences. While I trade the daily action long and short with premium members I also pay very close attention to the larger picture and the underlying issues. Even just over a week ago I pointed out a key monthly trend in “Can you spot the change”. The monthly chart I posted showed (even for this strong bull market) an unusual trend: The $SPX had disconnected from its monthly 5EMA for two months in a row. It had never done that during the entire rally and that disconnect in trend demanded that markets would reconnect to that level by month end. When I posted the chart on July 22 the $SPX was at 1982 with the monthly 5EMA at 1927 with 7 trading days left in July:

Well here’s what happened by the end of this week and note the price level at 1925:

Reconnect and fast. Now what does this all mean? As the daily chart above shows the sudden flush this week has produced some notable daily oversold readings with the $SPX deeply outside its daily Bollinger band and just above its daily 100MA. Also several key MAs were broken this week the most notable one being the 50MA as it had acted as strong support in recent months. Not this time however, it just sliced through like butter.

Yet it is the weekly chart that highlights in what critical state the market finds itself all of a sudden:

Fear much? The $CPCE ratio all of a sudden raced to its highest level in years and with good reason. The trend line going back to November 2012 is being tested. Since this rally has been so massive the consequence of that trend line being lost would be sizable. No trend line lasts forever and it will be broken and it’s just a question of when. Now the $CPCE ratio indicates fear and protection more associated with bottoms. The same could be said of the $NYMO, yet the $TRIN reading would be a concern as it shows no signs typically associated with a bottom rather indicating a lot more downside possible.

Yet it is not only the $CPCE ratio that outlines the sudden concern with markets. The advance decline figures in $NYAD show that some people wanted to get out and get out fast:

Are they done? Recent similar readings are associated with a bottom being close at hand. Yet a look at the larger time frame makes clear we may also just be at the very beginning of it all:

We have just ended the longest uninterrupted sequence of a positive High/Low divergence in years. As QE is ending in October the risk remains that we will see a similar sell event as in previous periods where QE was ending. Regular readers know about my concerns about the Russell 2000 and the monthly chart should make clear how precarious the set-up is at the moment with a negative cross-over on the monthly MACD:

The $RUT is not the only major index flagging major trouble signs. This past week was a major trend line disaster for the $DJIA as two major trend lines were broken, including the one dating back to November 2012:

Now that the $SPX is on notice and is close to breaking with fear building up the obvious question is whether we will bounce here yet again and on to new highs or will this market finally correct and remove some of the excess? If we do break it should be clear that things can move farther and faster than people might expect. I’ve been pointing out the record disconnects from the long term moving averages this rally has produced. My favorite remains the weekly 100MA as the vertical stretch really puts everything in proper perspective:

In other words: We could have a long way to go and fast. It is August with September and October just around the corner. These months have traditionally packed the biggest punch when it comes to corrective activity. So fasten your seat belts, the days of low volatility and low range market action may swiftly come to an end. I had pointed out the changing character in volatility price action and the weekly chart of the $VIX certainly makes clear that there is a lot more upside to be had on a break through the upper descending trend line:

For now this hasn’t happened. What has happened is that the $SPY is as far below its lower Bollinger band as it has been this year. In the two previous occasions see saw bounces. One was sold further into following a quick re-connect with the 5EMA (see January), the other bounced above the middle Bollinger band. So the immediate question is are we seeing a repeat of January or April?

One thing seems for certain: The next two to three months could be quite the roller coaster ride to trade. If you want to join us for the day to day action you are welcome to do so here.

Good luck and safe trading!