Market meltdown ahead?

Wall Street gives the new debt deal a big thumbs down as stocks and commodities plunge, taking out significant technical support.

It was an ugly, ugly session Tuesday. It seemed strange, considering Congress got its act together to pass a debt deal with not a day to spare. The deadline was Tuesday, when the bill was passed into law. How's that for cutting it close?
Stocks plunged anyway, with the S&P 500 dropping more than 2.6 per cent in its worst one-day loss in nearly a year. And it caps an eight-day 6.7 per cent losing streak for the Dow Jones Industrial Average, the worst run since May 2010, a month that featured the "flash crash" and the panicked start to the eurozone debt crisis.
Investors are reacting to a number of big negatives: the fact that the debt bill probably won't save America's AAA credit rating, the fact the economy is on the edge of falling into outright contraction, and the fact that the eurozone crisis is spreading like a disease into Italy and Spain.
As a result, significant technical support was taken out, clearing the way for a very nasty and dramatic market meltdown over the next few days. Here's why.
I'll have more to say about the economy and the debt deal in my next column. For now, let's set those issues aside and focus on the market action. And, boy, is there plenty to talk about.

The most important chart is the one above, which shows that the S&P 500 has violated the neckline of an epic six-month-long head-and-shoulders reversal pattern. This pattern is one of the most well recognized by Wall Street chartists, who were no doubt closely watching the 1,260 level today. Violation in the final minutes of trading triggered a wave of selling pressure as stop losses were hit.

Here's the bad news: The pattern traces to a price target of 1,150, which would be worth a further 8.7 per cent drop from current levels.

Other markets tell a similarly dour story. Copper, which is said to have a Ph.D. in economics for its ability to anticipate shifts in the business cycle, has just fallen out of its consolidation range.

Bond traders are also gearing up for a period of economic disappointment and price deflation, signalling that they expect a period of weak growth. You can see this in the ratio of inflation-protected Treasury securities versus traditional Treasury securities. The chart above illustrates this with the iShares TIPS (TIP.N) and the iShares 20+ Year Treasury Bond (TLT.N). Translation: Inflation expectations have dropped on growth concerns to levels last seen in December.

Bond traders are abandoning risk as high-yield bonds come under selling pressure. Drops in these so-called junk bonds closely follow the vagaries of the stock market, with the deepest market sell-offs accompanied by sizable drops in junk bonds.
What are investors to do?

Bing!

• What is the ideal salary?

If you're a risk-averse long-term buy-and-hold type, the best advice is to move to cash and wait for fairer weather. There is too much political and economic uncertainty. There is too much market volatility. And while we may get a rebound rally, the technical setups suggest the bottom could very well drop out of this market. It wouldn't take much. Maybe a U.S. credit downgrade from AAA to AA will be the catalyst.
For more nimble traders, there are plenty of opportunities on the short side, although many sectors have already made their move. Health care, for instance, was leading the decline but looks overextended to the downside now. Materials and consumer discretionary stocks, which are just beginning to show relative weakness, could be the next market laggards.

Thanks to targeted short positions in consumer, health care and materials stocks, my newsletter subscribers have limited their month-to-date decline to just 0.6 per cent versus a three per cent loss for the S&P 500. Highlights include a 7.5 per cent gain in high-end retailer Saks (SKS.N) and a near four per cent gain in CarMax (KMX.N) over the past few days.

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Both SKS and KMX will be added to my Edge Letter sample portfolio, which tracks a selection of picks for my MSN Money readers in real time here.
Admittedly, my performance could have been better if not for my short precious-metals positions. While my shorts in metal miners have done well, my gold-futures short underperformed as gold zoomed to a new high despite a rebound in the U.S. dollar. Word overnight that the Bank of Korea increased its gold reserves — which still remain a very small percentage of the central bank's overall assets — sent gold prices surging.
While I still believe precious metals are vulnerable to a pullback on a stronger U.S. dollar, I must respect the market's will in this case. Precious metals are highly speculative, and when a headline like the one out of Korea drops, it pushes all the right buttons for the gold bugs: currency debasement, abandonment of the U.S. dollar reserve standard, etc.
Disclosure: Anthony has recommended KMX and SKS short to his newsletter subscribers.
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The author can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.