The following is commentary that originally appeared at Treasure Chests for the benefit of subscribers on Tuesday, July 20th, 2010.

As anticipated, last Friday, which marked options expiry for July, witnessed a down day in stocks, which in fact turned out to be a 90% down day. In a bull market this would not occur, as the trend would be up, so one must conclude Friday's 90% down day on increasing volume is a negative omen even though it was not re-enforced by follow-through yesterday. Of course in order to establish the short-term trend as being down, stocks need to continue falling, this, along with taking out what could be considered a new neckline in the S&P 500 (SPX) head and shoulders pattern (now slanted) at 1015 to be considered confirmation this is in fact the case. Seasonally this is the weakest week in July and is most often down, so it will be interesting to see where we end up. If this week ends up off the lows, or higher surprisingly, then from a seasonal perspective odds favor a recovery next week that would likely see gold do the same considering put / call ratios for COMEX contracts in August (the current front month) at strikes all the way up to $1225 are above unity. This means like the stock market(s), which are always running open interest put / call ratios greater than 1 (and as evidenced last week yet again), gold would enjoy a short squeeze into next Tuesday, the 27th.

That would be the price for manipulating stocks higher in a low volume rally this week, where the international brotherhood of central bankers appears to be on the job in this regard, jamming key markets in the directions they desire. When one looks at the high frequency bars for gold and silver you can clearly see five-waves down in the most recent sequence since July 15th, followed by what appears to be a three-wave corrective sequence over the past 24-hours, suggestive of further downside. It's important to note in the larger picture that both gold and silver could be finishing up larger degree corrective sequence this week however, looking for squeezing price action into next week as per our opening remarks. This of course does not mean precious metals are about to 'take-off', not with the dollar ($) in need of a correction higher. However it does mean this correction (s) in precious metals could prove both fleeting and 'flat', leaving the post COMEX options expiry to first week of August (drag associated with the Bradley Model turn) window for a final downward sequence that witnesses an overdue $ correction. Of course precious metals have been correcting lower while the $ has been falling, so perhaps this will not matter, however caution is still the word in terms of short-term trends until a move higher in the greenback is witnessed.

Adding to concern the short-term pattern for equities is lower this week is found in the five-wave sequence in the high frequency bars, seen here, suggestive at least one more five-wave sequence down should be witnessed before a more lasting low is established. And again, it should be remembered this week is a seasonally weak period, so this should not be surprising to anybody. What would surprise bearish speculators however, which there are increasingly supportive numbers based on a preliminary look at post expiry US index open interest put / call ratios (which will be examined on Thursday), is if stocks did not fall hard this week, with a high percentage of the population undoubtedly focused on the seasonals. If Bernanke comes out and hints that he is succumbing to pressure to institute Quantitative Easing II (QE II), which supply side Keynesian's are calling for, it should be noted early that this might end up being the case this week, which could alter the pattern for the remainder of the year. (i.e. especially if he actually follows through because he sees investors throwing in the towel.) Therein, while bullish speculators are looking at things like plunging ECRI readings, a sliding Baltic Dry Index (BDI), and even things like deteriorating home builder sentiment as contrarian indicators, which is why stocks appear to be stuck in limbo, they likely won't be when a consensus of the investing public throws in the towel.

Now one might think this is the case at present with volumes so low, however one should be careful in making such assumptions because history has some valuable lessons in this regard. That is to say just because the larger investing population has not panicked out of stocks just yet doesn't mean this is still not coming. And a study of previous post bubble behavior(s) both in the US and abroad are actually suggestive we could in fact be quite close to such an outcome, if not right on the precipice of the next round of grand scale deleveraging. This is what an analog based comparison of the post Nikki and NASDAQ bubbles would suggest, where on a calendar day basis the Super-Cycle pattern for the latter should be turning lower any day now if the former's profile is to be maintained. (See Figure 1)

Figure 1

When comparing these two markets on a trading day basis it should be noted the 'big picture' doesn't get any better for stocks, as the NASDAQ topped right on cue back in April, and is now in position to accelerate lower. (See Figure 2)

Figure 2

And the picture does not improve when comparing the Nikki's post crash pattern to that of the SPX either, where again, it appears US stocks could begin to fall impulsively at any time if this history is to be considered a good guide. (See Figure 3)

Figure 3

It should be noted however that as one can see on all of the charts presented so far, but particularly clearly below, due to Quantitative Easing I (QE I), which was a collaborative effort on the parts of Greenspan and Bernanke that fostered the housing bubble, since about 2004 the patterns diverged somewhat, with more significant rallies in US stocks due to greater largesse, suggestive it could extend further. (We will discuss this further when referencing Figure 6.) Of course when the selling comes you can see stocks end up in the same place, but try and telling that to the Keynesians. (See Figure 4)

Figure 4

In moving onto a US market comparison now, although more dated in being from the post 1929 stock market (Dow) crash (but people never change when it comes to manias), we can see below that here too stocks should fall directly, however the fall should only take us down to the 900 area, consistent with the measured move associated with the head and shoulders pattern in the SPX. Here, we would measure from a neckline closer to 1040 than 1015, viewing the spike low as noise. And for short sellers looking to cover any positions, this is the way you should look at any spikes below 960, as noise, because as you see below, this could be the low before a multi-quarter rally into next year takes hold. (See Figure 5)

Figure 5

Based on a trading day comparison, which can be seen below, it might take some months for stocks to finally hit a low if history repeats in this respect, however the basic message is the same, expect a rally into next year either way - this being an apples to apples comparison of what to expect out of US stocks. And even if the effect is muted due to diminishing returns associated with mature inflation cycles (that run short of hyperinflation), it only makes sense that if Bernanke and company implemented QE II that a positive reaction from stocks should be expected. (See Figure 6)

Figure 6

Again, as we can see directly above then, and in this regard, while it may take more time and losses in stocks before the Fed (and larger bureaucracy) feel justified in trying to fly QE II past the public again, the point is one should be prepared for such an outcome. And believe me when I say if the SPX breaks the large round number at 1,000 to the downside that many who oppose such a move right now would do a 180 quickly when staring down the barrel of a gun loaded with hyper-deflation. You can count on this, the political will, to be there for QE II when it appears the chips are down.

And in the 'if you need further convincing more downside in stocks is probable' department, we have this next chart that is suggestive either bond or stock market traders are on some powerful drugs. If this is not the case, then how, short of manipulation, could such a profound divergence between stocks and Treasury yields exist? I will let you answer this question on your own. (See Figure 7)

Figure 7

In finishing up today, and to reiterate our opening remarks, it should be remembered that COMEX options expiry for gold and silver is next Tuesday, the 27th, and that put / call ratios are calling for yellow metal prices to make it back up to $1225 by then or the puts will need to be paid. (See August gold options here) So, don't be surprised if gold and silver don't go much lower this week no matter what the stock market does, where horizontal support in the $1150 to $1160 range should be worst case scenario.

Knowing Bernanke's testimony before congress on Wednesday and Thursday may bring out further sympathetic selling / price management at the time, not to mention the larger equity complex might come under further pressure, one would be well advised to ease into trading positions this week. One should be fully invested going into the weekend however, as Tuesday will come fast. And of course don't expect the metals to remain buoyant post expiry, where cyclical forces will still be attempting to work prices lower into the first week of August.

See you on Thursday.

Special Note: Charts provided courtesy of The Chart Store.