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Technical Indicator Shows Increased Risk of Market Crash

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Picture yourself stretching a rubber band. Eventually, either the rubber snaps back or the band breaks.

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Tuesday's drop brought the equity market's decline into my "crash" template. The template identifies unusually significant risk of accelerating within the next 1-3 sessions, or August 4-8.

This is not a forecast for a crash. Rather, I aim to warn that all of my technical elements for a crash are present. More often than not -- much, much more often than not -- these requirements tend to coincide with a decline's end, producing a bottom that turns up suddenly, and a rally that extends sharply higher.

So, why not announce the likelihood of a major rally, with the crash potential as a caveat? Because this is a directional warning, not a trade recommendation. Without dwelling on a technical definition of "crash," suffice it to say that your emotional response to the term is probably how I intend it to be perceived. A crash means prices tumbling by an order of magnitude measuring several times any recent cumulative drop, in a fraction of the time.

In brief, the US equity market is approaching an inflection point. Either the current decline's pace will suddenly steepen and extend down to a degree that dwarfs its recent losses from July's highs, or else the direction will reverse up to quickly retrace much of those losses.

My template considers only technical factors, not fundamentals such as the Eurozone's debt crisis, a US debt downgrade, corporate earnings, Jupiter's alignment with Mars, or ladies' hemline lengths. (At least, I am not considering the latter item for this warning's purpose.) Indeed, the fundamental stories I reference above are not new, and the list is not complete. Their narratives are widely disseminated and largely discounted in market prices. In fact, Barton Biggs this morning on Bloomberg laid out the bullish case. Kevin Depew also listed many of the technical factors that could resolve bullishly on the Buzz & Banter (click for a free trial).

The market's first problem is the uninterrupted duration of this current decline. Ten consecutive sessions containing only one or two non-consecutive positive closes reflects strong sponsorship. Basically, there is a race between the decline's sponsorship depleting its selling pressure and the ongoing decline attracting new sponsorship.

In either case, the next leg's slope will be much steeper than the current downleg. And if the next leg is down, then it will cover much more ground than the current one has dropped.

Picture yourself stretching a rubber band. Eventually, either the rubber snaps back or the band breaks. The snap back is the crash template's bullish scenario. The bearish scenario's crash is created by the break suddenly releasing all of the stored energy that the rubber had been absorbing.

The market's second problem is that the rubber band tends to snap back from support, but support may be broken already when the tenth session arrives. The sequence's end may be greeted from under support with no elasticity to recover.

My crash template identifies that inflection point where the rubber band should either snap back or break. Of the setup's ten consecutive sessions, Tuesday was the seventh or eighth day (S&P cash closed fractionally positive, while futures closed slightly negative). There has yet to be a positive close. The prior low's support -- June's S&P low -- was tested already on Tuesday.

As it happens, I have noticed damage being done to the charts of individual equities, from high-profile momentum stocks to industrial backbones. Various names have fulfilled major rally targets and failed to maintain higher highs, while others have broken under key supports.

If the perception of risk does not match reality, then selling can end abruptly. Price can rise sharply, due to rising demand relative to fewer sellers. The sudden price rise can then attract actual buying pressure to create an "up-crash." It's a vicious circle, especially if short.

Perhaps the actual risk is no worse at yesterday's price than it was at last week's. Obviously, perceptions have changed considerably. The deteriorating perception may continue to attract more sellers, which would drive prices lower. The expectation of lower prices may continue to drive away bigger buyers capable of absorbing those selling pressures. Another vicious circle.

Wednesday's Closing Update: Sharply lower lows were reversed up into positive territory. This qualifies as the crash template's overdue counter-trend session. Regardless, while this doesn't disprove the crash template, it doesn't yet prove it.

Editor's Note: See more from Rod David at ifthensignals.com.

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No positions in stocks mentioned.
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