It appears the Federal Reserve has added just enough uncertainty to ding the bull. The question now lies how far this correction will take us or has the rally over the past two days signaled the end of the downturn.

ODDS IN FAVOR OF ADDITIONAL DOWNSIDE

There are several reasons to believe the market will continue lower over the course of the next few weeks and months, in our view.

VOLUME

The first item that we are watching closely is volume. The rally on Tuesday was not supported by robust buying and at the time of this writing (3:30 Wednesday) it appears volume will also be anemic at the close. The technical and emotional damage that was inflicted in last week’s violent sell off was done on big volume. We just don’t see market participants’ running back en mass.

We are also of the opinion that 2Q13 corporate earnings are going to disappoint (more info on that below).

LOOKING FOR A MUCH BROADER SELL-OFF

We are watching the percent of companies in the S&P 500 trading above their 200DMA. In a healthy correction, we typically want to see this percentage fall to 59.5% before getting back in. We are currently at 78.8%, not nearly enough to call this correction a done deal.

Historically, when a correction starts with violent action (we define violent action as greater than 1% downside move in the SPX on volume that is at least one standard deviation above the 30 day average) there is a very high probability (86%) that this model is correct. On 6/20/13 the SPX fell 2.5% on volume 2.27 standard deviations above the mean.

As we mentioned earlier, there is a high probability that we are going lower.
Light volume on the upside, a weaker than anticipated earnings season and the high levels of companies in the SPX above their 200DMA are just a few reasons that we are convinced there is another leg down.

INCREASING SHORTS

We are increasing our inverse (short) positions around the 1600 level on the SPX and will take further action to the downside if we reach 1615-1620 which is the 50DMA acting as resistance.

For a further discussion on the earnings puzzle please visit our blog  Money & Finance – The Earnings Puzzle

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