A Few Reasons to Anticipate a Stock Market Downturn

US stocks didn’t do much of anything yesterday. They spent the entire trading session dancing around the unchanged level like Victorian schoolgirls around a Maypole. The Dow Jones Industrial Average gained a smidgen, while the S&P 500 Index slipped a skosh.

The commodity markets danced a little more purposefully – perhaps like a couple of junior high kids “grinding” at a school dance. The RJ/CRB Index of Commodity Prices advanced to a new 9-month high, while gold jumped to a new all-time high. The now-and-again precious metal tacked on $8.00 to $1,348.70 an ounce. Nothing new there…Gold is going up because the world is full of well-meaning central bankers who mean well to debase their national currencies in the pursuit of economic vitality. Sounds wacky, we know; but that’s what the top universities are teaching these days. The top universities are also teaching that a few highly educated men in nice suits can turn enough dials and pull enough levers to cure recessions and create non-inflationary recoveries.

The men in nice suits are busily turning nobs and pulling levers, but the economy still flounders and gold still soars. Apparently, gold didn’t go to college.

Turning our attention back to the stock market, yesterday’s subdued trading action might soon yield to something a bit more raucous. At least that’s the informed opinion of two guys who monitor this kind of thing. First up, Jay Shartsis, a seasoned options trader from R.F. Lafferty in New York, has identified a few “cracks in the wall” of the recent stock market rally.

Shartsis, who has been expecting an intermediate-term market top for more than a week now, is finding more evidence in support of his caution. He observes that many of the high-profile stocks that have been leading the market higher suffered big sell-offs yesterday. Netflix (NASDAQ:NFLX) slumped 4%, Salesforce.com (NYSE:CRM) dropped 8%, VMware, Inc. (NYSE:VMW) fell 9% and Citrix Systems (NASDAQ:CTXS) tumbled 14%. “These are leading stocks and have market-wide implications,” Shartsis warns.

“I was also surprised to see only 272 new highs on the NYSE Tuesday,” Shartsis continues, “versus 674 last April 26 and 306 recorded on Sept 20. That’s a non-confirmation of importance. Further, as the S&P 500 has continued higher, the VIX Index – aka, ‘Fear Gauge’ – has not continued lower, as would be expected. In fact, the VIX bottomed at $20.93 on Sep 13 and has not made new lows as the S&P has made new highs. This non-confirmation suggests the VIX will soon rise and stocks will fall.”

Picking up on this same bearish theme, Dan Amoss, editor of The Strategic Short Report, remarks, “The September rally looks tired… The market is at risk of another sharp move lower. The S&P 500 is encountering strong ‘resistance’ at 1,150. One can easily imagine a return back to 1050 – the starting point of the latest sprint.”

Amoss believes the recent rally has less to do with underlying economic trends than it has to do with the Fed’s easy money tactics – both actual and anticipated. He suspects the stock market has already priced in the Fed’s next round of quantitative easing – the process by which the Fed conjures money out of thin air.

“Because the markets have already anticipated ‘quantitative easing 2’ by pushing up stocks and Treasury bond prices,” says Amoss, “the actual implementation of ‘QE2’ is less likely to be imminent.

“Here’s another ominous sign for stock market bulls,” he continues, “the darling momentum stocks are looking weaker. Ridiculously overvalued stocks (but good businesses) including Priceline, Amazon, Netflix, and Salesforce.com are weakening. Perhaps traders don’t want to own these stocks at triple-digit P/E multiples heading into earnings season…

“There’s plenty of room for 2011 earnings estimates to come down,” Amoss concludes. “This market is not cheap. I’m evaluating several short ideas…”

So there you have it; the stock market will fall very soon…unless it doesn’t.

Eric Fry
for The Daily Reckoning

The Daily Reckoning