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Charts: Watch the SPX and RUT as Keys to Where the Market Is Going

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So far trading in this earnings season has illustrated that investors are looking for winners -- and a sense of a security.

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Earnings season almost always brings surprises with big hits and misses accompanied by lots of price gyrations. This is especially true among the small-capitalization stocks, but this season, wild price swings in larger-cap stocks have become the norm. In trying to make sense of that phenomenon, the only conclusion one can seemingly draw is that stock valuations are so stretched at this juncture that any stock missing the numbers game is being severely punished; those that do beat are finding huge capital inflows as money seeks a winner in the narrowing list of winning candidates.

Here's an example on each side of the equation. Just last week, Amazon (NASDAQ:AMZN) reported earnings of $25.6 billion, or a 20% increase from a year earlier. The problem is that this was about $400 million less than analysts' expectations for the quarter. The guidance ranged from losing $200 million to making $200 million. Typical Amazon. This time the Street reaction wasn't typical, though, as the stock was sold -- and sold hard -- after years of hope. If you're still holding and hoping, I believe you need to get a stop in and consider an exit plan.



Although the disappointments have been greater in number, there are plenty of large caps that have huge gaps higher in price on earnings. The most recent came yesterday when Michael Kors (NYSE:KORS) just blew the competition away. Revenues grew 59% (so much for the worries about discounting) and growth margins expanded to 61%. Income also grew at a phenomenal pace of 68%. The Street was impressed.



There are many more examples on both sides of the divide but rather than discuss what has already happened, let's consider what is happening now.

We now have a breakdown in the indices -- one that my firm considered to have a high probability of occurring. Up until then, the focus was on exploiting the long side of the tape while the majority kept preaching for months on end about the downside. Although you almost always have to give something up at turns, the key is to recognize if the possible is probable, and if so, whether or not it carries a reasonably large downside. If it does, then it can hurt you and you need to seek safer ground. If it can't, then why worry? In the case of this potential sell-off, the structure was there, suggesting that it really could hurt. This is why we pulled in our horns on January 27. Now that the selling has blossomed, what's next? How far can it carry, and how quickly is that likely to happen?

There are three indices leading the charge to the downside. From weakest to strongest, they are the Dow Jones Industrial Average (INDEXDJX:.DJI), the S&P 500 (INDEXSP:.INX), and the Russell 2000 (INDEXRUSSELL:RUT).

The Dow is in a full-blown breakout dive at this point, having broken multiple swing-point lows on multiple time frames and seeing follow-through on those breaks (see weekly chart here).



The good news is that the confirmed bearish ABCD structure is about done, so the pressure escape valve is engaged at this point and should provide some downside relief before long.

The SPX and the RUT are the ones to watch though, for they seem to hold the keys to the near-term future. The SPX has broken a newly printed swing-point low on the weekly chart, and if price cannot get back above $1,767.99 by Friday's close, then the potential for further downside over the next two to three weeks increases significantly.



The RUT is on the cusp of a significant breakdown and probably is the most significant of the three at the moment for it has been far more bullish up until now. With the RUT at the ledge and trying to decide whether to jump, it's here that we are likely to find our answer before this week ends. Note the two swing-point lows that are clustered together on the short-term time frame (daily bars). It just so happens that the December 12 low on this time frame is also a swing-point low on the weekly time frame.



A break of these lows that sticks by the ending bell on Friday creates a high-probability play to the downside both immediately and over the next two to three weeks.

With the Dow already breaking and extending lower, and with the SPX having just broken, will the RUT join forces and break too? Although significant losses have already been experienced in a relatively short period of time, there's nothing to stop us from seeing even more debilitating losses mount. Just think back to last year: Gains begot more gains, whether they were rational or not. Bull markets don't let you in and bear markets don't let you out!

With increasingly suspect economic data points from most corners of the globe, a Fed that now has turned the steamship from expanding to contracting, earnings unable to produce the kind of results a sky-high market demands, and fewer shorts in the fold to become natural buyers on the way down, a fast move to the downside that extends much further than expected could, in fact, occur.

Personally, I expect another bounce to take hold and some nested bearish ABCD structures to form before a further push lower occurs. With the employment number on Friday however, that becomes the make-or-break day for the bounce idea. If this market starts to break further, and if you have yet to heed the call to get safer, then you had better do some mental preparation now just in case. There's a lot of damage done on the charts now, and it is highly unlikely that we get one of those V-shaped moves to eternity this year as was so common in 2013.

Editor's note: L.A. Little is a professional trader, author, and money manager who has written several books and contributed material to many financial sites in addition to authoring his own: Technical Analysis Today. He brings a unique perspective to technical analysis, incorporating his extensive engineering and modeling skills when analyzing the markets.

Twitter: @tatoday
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