Market tripwires: What now?

In my post time to be fearful yet of April 19, 2010, I wrote about the cross-currents in the market:

I believe that the market is in a fragile state, but that's the equivalent of riding around on a motorcycle at 100mph without a helmet on. It doesn't necessarily mean that you get hurt. It just means that if you hit a bump in the road the damage will be very, very bad.

My inner investor is therefore a blubbering nervous wreck. The Goldman Sachs news Friday is a typical "bump in the road". It remains to be seen what kind of damage it causes to market psychology and whether Goldman's failure to disclose the receipt of a Wells Notice is the beginning of a death spiral for the investment bank (or the market). My inner trader, on the other hand, tells me to stay with the positive momentum for now, watch for technical breaks and maintain very tight stops.

An intermediate term correction
Regardless of how tight the stops people have put on their long positions, the market action of the last few days have been the signs of technical breaks that I have watching for. The technical damage has been too great to ignore for the bulls and an intermediate term correction is most likely underway. The most important ones for me has been the action of the Shanghai Composite, which not only violated an uptrend but important support levels:

The other critical data point I have been watching is the relative price action of the Morgan Stanley Cyclical Index against the SPX. Many investors have piled into the cyclical sector as they became convinced that a sustainable economic recovery is under way. These stocks have also broken a relative uptrend and support level:

What’s the downside target?

A chart of the SPX shows the market is bouncing off initial support at the 50-day moving average. We’ll see if that level holds.

If this were indeed an intermediate term correction, then the logical support zone would be somewhere between 1050, the 50% Fibonacci retracement level, and about 1100, the 200-day moving average, which is also situated slightly above the 38% Fibonacci retracement.

By contrast, the more broadly based  NYSE Composite is not behaving as well as the SPX. This index has already violated its 50-day moving average support level, but it’s still above the uptrend line that began in July 2009, which should provide an area of technical support.

Watch how market psychology develops
Even though I have been leaning to the bearish side, I also recognize that markets don’t go straight up or straight down. Even the Crash of 1987 began with a top in August, which sparked various trendline violations, and the Crash didn’t happen until October, a full two months later. In the near term, the market is likely to stage some sort of reflex rally from current levels. At that point, we need to watch for signs of how the psychology develops.

Already I see a number of technicians calling for an intermediate term bottom at around the 1040 to 1100 level on the SPX. Given the weak action of the broader NYSE Composite, my best guess is that support materializes closer to 1040, which also coincides with the February lows. If the market does descends to those levels, how will market participants react should we approach those price zones?

I would watch the sentiment indicators. Is there widespread panic (which would be bullish) or are traders more constructive (which would be bearish) to see if this is just a 10-15% corrective air pocket or something more serious.