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Volatility Precedes Price

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The dollar is our currency, but it's your problem.
-U.S. Treasury Secretary John Connally, 1971

If the dollar is the world reserve currency, it is fair to say that what happens in the U.S. does not stay in the U.S.

Within the network of global financial markets, more interconnected than ever, Bernanke's experiment with money may have consequences that are unforeseen and unintended that will show up elsewhere first.

Violent disintermediation in U.S. markets is likely in the wake of consequences in the emerging markets due to nature of the leverage in U.S. markets presently.

Alhambra Investment Partners said last week that not only has margin debt hit a record, but there has also been a massive rise in overall leverage.

As soon as the calendar flipped from 2012, it was as if investors suddenly lost all caution and embraced as much leveraged risk as could possibly be attained. The firm estimates that total margin debt usage last year jumped by an almost incomprehensible $123 billion while cash balances declined by $196 billion. This 142 billion leveraged bet on stocks surpasses any 12 month period in history.

Going into 2014, the US equity market was teetering at record levels on record leverage and margin debt. However, destabilization in emerging market foreign exchange has undermined the architecture of central bank cohesiveness: the hope that enough time has been bought for a new foundation of growth comes under stress in a short time frame as stress is magnified by leverage. This can happen fast. As volatility expands, it is harder for technical support in stocks to be maintained. The more times support is tested, the less resilient it becomes and the harder it is for bullish perceptions to be maintained.

No one knows if the current contagion in the markets is a squall or a storm. However, under the cocktail of conditions of record leverage combined with global interconnectedness, a dollar of selling pressure in one market can force many multiple dollars of selling in other asset markets half way round the world. This is occurring at a historic time when a new Fed chief takes the helm and when the Fed is promising to turn the fire hoses down and only point garden hoses at the U.S. It is historic because markets don't know what they don't know about an experiment that's both never been tried and exited before. At the same time, history shows the market has a penchant for testing new Fed heads.

So, when we noted last week that technically any top from here demands a very defensive posture because it may be "the big one," there are fundamental reasons why caution is warranted. It may not be business as usual.

Buying this pullback may be the wrong posture.

There will be rallies. However, if there is a rally just ahead, it is the character of that rally and whether it fails that will tell the tale and determine the nature of the primary trend.

A failed rally will signal that the primary trend has changed.

In other words, wherever the first meaningful rally should play out from, if in turn a subsequent decline violates the first low, players who have been successfully buying each and every pullback since 2009 and reloading on each decline, will, in a word, puke up their positions. That is how crashes begin. That would be the signature for a waterfall decline if one is going to play out.

We know by the roadmap of the Gann Panic Zone that by counting from the December 31 Dow Jones Industrial Average (INDEXDJX:.DJI) and S&P 500 (INDEXSP:.INX) highs that the most vulnerable period ties to February 7 to February 22.

If you count from the nominal new S&P high on January 15, the time frame is offset by two weeks. In that case, the panic window ties from February 22 to around March 11.

Interestingly, this ties to the March 6-to-9 low in 2009 and to the important fifth anniversary of that low.

Few, if any, on the street thought January would erase December's gains. In December, all we heard was that the despite a stellar 2013, big back-to-back years were not uncommon and should be the playbook for 2014. Yet, the S&P carved out bearish monthly Train Tracks in December and in January -- only barely avoiding an outside down month.

Monthly S&P Chart:

Since the major higher low in October 2011, the S&P shows no more than two consecutive monthly lower lows. Each occurred following a test of the upper rail of a rising channel. Each decline on the monthlies tested a mid-channel line. The declines in 2012 undercut the mid-channel. Since the mid-channel line was not tested at all in 2013, the presumption is that it will be fully tested in 2014. The mid-channel is presently around 1690-1700, which ties to a test of the 200-day moving average. Because this mid-channel went untested all last year, there is a stronger than average likelihood that the lower rail may be tested. This ties to a decline to around 1500.

The Dow is already verging on a test of its 200 DMA. This ties to a test of its yearly trendline carved out in 2013 at around 15,500. This is a trendline connecting the January and October 2013 lows.

Daily Dow Chart:

Click to enlarge

The October decline in the Dow tested the 200-day moving average, so there is a prospect that the second time around the Dow may not hold -- that the second mouse may get the cheese for the bears. This is underscored by the fact that the Dow is lumbering under a Rule of 4 Sell signal (a break of a 3-point trendline) and has violated prior significant resistance around 15,700, which should have defined new support. In other words, in November, the Dow broke out above triple tops (May through September), successfully backtested the breakout point in mid-December, but has failed below the breakout here in 2014. Fast moves in the opposite direction often follow failed moves. It looks like the Dow saw a failed breakout in late 2013. Further confirmation of that failure would come on a break of the above trendline (B) at around 15,500. Additional confirmation would occur on a turn down in the Quarterly Swing Chart. This would occur in the first quarter on a break of the October low, the fourth-quarter low in 2013.

Underscoring the notion of a fast, sharp move is the weekly VIX (INDEXCBOE:VIX), which is verging on a breakout over multiple resistance.

Weekly VIX Chart:

An authoritative breakout over 20 in the VIX suggests a waterfall decline in the indices is underway.

Conclusion: The market doesn't always talk, but when it does, when volatility rises as it did in January, often every word is like a sentence, and every sentence is like a paragraph. It looks like the market was not just speaking in January; it was swearing. January's black-and-blue streak of volatility is likely to precede poor price action in 2014.

Strategy: Last week's roller coaster may have carved out a droop right shoulder on the daily S&P. While the market may be oversold in the short term, the following surprises could happen in the direction of the trend: 1) a failure to rebound from oversold levels is bearish and often leads to washouts and 2) the primary trend may be on the verge of turning down. Caution is warranted.

Form Reading Section:

FireEye (NASDAQ:FEYE) Chart:

POSITION:  Positions in SPY and IWM