QQQQs Trapped in Three-Stage Breakdown

This column was originally published on RealMoney on Sept. 26 at 12:30 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

The major indices completed a round trip to the August lows last week.

These price levels will provide support for a bounce that will retrace part of the decline, but this rally should fail and set up a trip to the July "London bombing" lows by mid-October.

While Hurricane Rita got most of the headlines last week, don't forget this selloff began as a response to Tuesday's rate increase. Indeed it looks like smart money is selling this market and will continue to do so in the fourth quarter. In reality, that began well before Greenspan and Co. decided to raise interest rates.

The markets sold off on Wednesday, even though prices were down substantially in post-Fed trading on Tuesday. This was unusual behavior because the odds favor a reversal in the session that follows a Fed-day selloff. In fact, the markets have reversed gears in this scenario over 85% of the time since 1996.

The selloff marked distribution off the post Katrina highs and failure of upside momentum induced by massive short selling after the hurricane.

In many ways, last week's decline has brought sentiment into better alignment with the troubling economic realities we'll be facing in the fourth quarter and beyond.

Two weeks ago, I pointed out the growing divergence between weak buying pressure following the August lows and rising index prices. Last week's selloff took the first step in resolving this conflict to the downside. But there's no rush to the exits because we're still grinding through a transitional environment.

Note the Nasdaq 100 Trust's(QQQQ Quote) on-balance volume readings since July. This accumulation-distribution indicator barely ticked higher, while the stock rallied to its summer high. OBV then rolled over and broke support, even though the trust bounced at its August lows.

This looks like a three-stage breakdown in which the next selloff carries price through support and resolves the monthlong divergence. But that event must wait until this oversold bounce runs out of steam. That could take time with end-of-quarter window-dressing kicking in this week.

The bounce off the lows also raises the possibility of a diagonal pattern into October expiration. Diagonals look like triangles but elicit a broad range of variations on the theme. In any case, it may trigger a period of seesaw movement that rips stops in both directions and confounds most of the crowd, except for daytraders.

Gold Bugs: Beware the Light

Now let's talk about the gold bugs. They're an excited bunch these days because rising prices have renewed debate about currencies, inflation and predictions of doom. But there's a big problem, at least on the equity side of this phenomenon. Nothing at all is happening with gold stocks, despite popular belief.

The Philadelphia Gold/Silver Index (XAU) rallied to resistance at its 2004 highs this month, while the commodity tagged new highs. This is a bearish divergence because gold stocks should outperform the metal at breakout levels, not underperform it. In other words, the index is still range-bound and not in an active uptrend.

The trouble stems from the silver component of the index, which is still trading well-below historic highs. Unfortunately for the gold bugs, this triggers a second divergence because the metals should move together if this were the start of a secular uptrend. The bottom line: Look for the gold rally to fail soon and take the bugs with it.

Most folks who play the financial markets want perfect simplicity in a complex environment. They get frustrated when trends fizzle out and choppy action takes over the ticker tape. Unfortunately, clean trends in either direction are hard to find on Wall Street right now.