Let the Fireworks Begin

The NASDAQ market index fared just as poorly, falling nearly 27 points to close at 1778. Our volume and momentum indicators also continued to fall, providing further confirmation for our ongoing bearish scenario.

To summarize, we have been following a four week consolidation period in the broader stock indices—including the DJI, NYSE, S&P 500, and NASDAQ—which has formed a "triangle" (a.k.a., "wedge") formation in each of the aforementioned indices. This triangle formation provided us advance warning that a sharp move—either to the upside or the downside—was imminent. As it turns out, this particular wedge formation would appear to be of the bearish variety, much as we had predicted in previous commentaries. As of this week, we can now label five points (A through E) where the Dow Jones price trend touches either the upper or the lower region of the triangle's boundaries, providing us with an Elliott Wave confirmation that this consolidation phase has been completed and the market has now decided upon its near-term direction: downward. Today's close on Wall Street saw the Dow Jones break out of its triangle and head toward near-term support of 8900.

Psychologically, we knew the one-month consolidation phase was nearing completion when, last week, a teenage boy in a small Oregon town went on a highly-publicized shooting rampage, killing his parents and injuring dozens of students at the high school he attended. Five days later, a bomb exploded in an Illinois church, injuring several parishioners. While these two events may seem isolated and insignificant, they actually provide further Elliott Wave confirmation that a stock market consolidation period has culminated and a major trend change has arrived. Bob Prechter and A.J. Frost, in their seminal work, The Wave Principle, pointed out that bad or shocking news typically accompanies the "E" wave (the final wave) of a triangle consolidation phase immediately prior to its termination. This also happened in early February, when news of President Clinton's alleged sex scandal with White House intern Monica Lewinsky made front page headlines. This event also occurred in an "E" wave of a three-month consolidation phase and directly preceded the Dow's meteoric rise to above 9000. Last week's bad news was obviously the psychological confirmation needed to show the market had arrived at a critical juncture.

Providing further psychological proof that a top is firmly in place was the recent front cover of Newsweek magazine, featuring a drawing of a bull in a wedding dress, with the headline: "Like it or not, you're married to the market." Mainstream magazine covers have historically provided excellent proxies as to the psychology of the crowd, and ultra-bullish covers tend to accompany market tops and precede turning points in the market.

That the Dow has arrived at the critical juncture was highlighted today when the DJI rapidly fell 150 points late in the trading session after an initial gain of 50 points in early morning trading, followed by a nearly sideways market for most of the trading day. We fully expect this sell-off pressure to continue in the coming days, and our technical indicators provide further credence for this assumption.

Market momentum has slowed significantly over the past two months and the Dow managed a net gain of only 300 points during that period. The aforementioned consolidation period (known in Dow Theory as a "line") gave warning that the market's upward momentum was ending and a slowdown was on the way. As mentioned in recent commentaries, the Dow Jones Transportations Average has also topped and is now trading in a downward sloping trend channel, with immediate-term support at 3300 and resistance at 3500. The Transport's stochastics are in technically over-sold territory right now, so a minor rally can probably be expected over the next few days. Still, the overall trend for this index is clearly downward.

The Dow Jones Utilities Average also topped in head-and-shoulders fashion last month and continues to trade within the confines of a downward-sloping trend channel. The Utilities are presently testing overhead resistance at 280, but we expect the direction for this index will also continue downward in the weeks and months ahead.

Perhaps the most elucidating chart of the all the U.S. stock market averages is the NASDAQ Composite Index. This index has also recently traded within a narrowing triangle formation and recently broke to the downside upon reaching the triangle's apex. This tech-laden stock average gave advanced warning that a bear market in U.S. equities had begun, and several major tech stocks have been experiencing a decline in share price in recent weeks as Asian economic- induced woes plague the high-tech sector. The NASDAQ is now trending below its 50 period moving average, and its stochastic chart is pointing firmly downward, so expect the tech stocks to continue their fall in the near term.

Mutual fund money flow indicators continue to reflect heavy amounts of cash being pumped into the market by U.S. investors. According to mutual fund tracking service Mutual Fund Trim Tabs, U.S. equity funds took in an estimated $4.29 billion in new investment cash during the three-day period ending Thursday, May 21. Yet the market continues to fall in the face of this bountiful liquidity—a sure sign of an over-bought market that has simply exhausted its upside potential.

We will continue to follow closely this latest bearish turn in the U.S. stock market. If our analysis is correct—and we have good reason to believe it is—this could finally be the "big one" we've all been waiting for. Short sellers, get on your marks, get set…