As part of my daily market preparation, I write a daily market letter for Waverly Advisors which focuses on global macro themes and short-term price structure for the US Equities markets.  Much of what I do there is not really relevant for this blog, but as I was doing my weekend work I kept coming back to the price structure in the S&P and the Russell 2000.  I think there is a very good chance that we could be at a critical inflection point in the stock market, and I thought it was important enough to share my market playbook for tomorrow with our readers.

The US Stock Market traded down in a strongly directional, classic trend day Friday. Volume was higher than previous sessions, and, to all appearances, sellers were fully in control. Small caps were remarkably weaker than large caps, with our micro cap index off -5.2% to the S&P 500’s -3.4%. We saw widespread weakness in Industrials, Basic Materials and Financials, while the traditionally defensive Utilities, Healthcare, Telecomm and Consumer Non-Cyclicals were relatively stronger. We also saw the beginnings of what could be some significant breaks in market-leading stocks. Taken together, all of these factors suggest that the bears are fully in control, and we would normally consider this an appropriate setup to be prepared to fully press shorts. However, we must temper our enthusiasm.

Consider two points: 1) this market has failed to do what it “should” at every turn for the past several weeks. As jittery as buyers have been, sellers have also failed multiple times to press their advantage below support, so we have had one headfake after another. 2) Though we believe the dominant technical structure is the break out of the daily bear flag, we do note that the 1060-1072 area is a very wide, messy area of support. Until we see clear selling and holding below that level, the market is still rangebound in a wide range around 1060 to 1100.

Short-term traders need to consider three separate scenarios today. The most likely is that we will break support, possibly on the open, and continue to trade lower, extending Friday’s losses to new lows. The distinguishing characteristic of this action will be strong selloffs on good volume, with rallies that terminate at successively lower levels—the classic “lower lows and lower highs”. The second scenario is that the market finds support here and works its way back toward 1080. If this scenario is in play, we can expect more of the same action we saw last week with crosscurrents and false starts. The least likely scenario is that strong buying will erupt from a test of the extreme lows, but this possibility deserves our attention because of the danger it poses to aggressive shorts.

Bigger picture, the 1044.50 low in the S&P Cash from early February is a critical inflection point. This marked the exact low of the January selloff, and the test below this level was the catalyst that set off the 50 point (S&P Cash) rally that capped off last month’s trading. If we see strong selling below that level, the next stop could well be around 975, but also be alert to the possibility of a failure test around 1037 on the June futures. If we trade a few points below that level, strong volume comes in, and we immediately rally 10-20 points in the futures, the correct play will be to get long with a stop at the new lows and hold for a swing of several days to several weeks. Understand that there is a very low probability of this scenario playing out, but if it does there will be no better way to lose a lot of money very quickly than shorting into that rally. Traders taking short-term positions today should look at days like 3/14/2007, 8/16/2007 (not against a clear level), 3/17/2008 and most recently 5/25/2010, to gain some intuition about how the broad market can act on a failure test of previous lows.

World markets continue to underperform our domestic markets in recent trading, and the price structure suggests that this is likely to persist over the next several months. Measured move objectives for the next swing down in European indexes could trim as much as 25% from current levels, while equivalent swings in major US indexes would be a loss of 15%. We hold no outright position in foreign stocks and caution investors seeking international diversification to be especially conscious of the potential risks in these markets over the next several months.