Last week I said 'Look out for a very sharp sell-off in the S+P 500 once it snaps beneath the 1390-1400 area, which is currently providing strong support. It will only take one nasty night to break through and then we will see a distinct shift in momentum.'

That very night in the US we saw the S+P 500 plummet 34 points from 1428 to 1394.

That's a 2.4% fall, and was one of biggest overnight falls for the year.

As expected, the weakness continued once the 1390-1400 level gave way. The S+P 500 closed this morning at 1380, and the 200 day moving average for the S+P 500 sits at 1381.

The big question from here is whether or not that 200 day moving average can hold...

On the chart below, I have circled each time the S+P 500 has come into contact with the 200 day moving average over the last couple of years.

S+P 500 Daily Chart

Click to enlarge Source: Slipstream Trader

It's quite clear that the 200 day moving average often provides support for the stock market when it's in a long term uptrend. But it's also clear that when the 200 day moving average can't support the stock market the results can be quite dramatic.

At the start of August 2011 the S+P 500 broke through the 200 day MA and then fell 200 points in the next five days. That's a 15% fall...in five days!

If you look at the chart again you'll see that the 200 day MA provided support in early June this year. The S+P 500 then rallied strongly into the announcement of QE3 (money printing) by the US Federal Reserve in mid-September. It has been downhill ever since.

Therefore the reality of QE3 isn't supporting the stock market as much as the threat of QE3 did.

Stock Markets on a Precipice

A couple of months ago I wrote that, 'If the spell is broken on the money printing voodoo there is a long way for the stock market to fall and I think the announcement of 'QEternity', as its becoming known, at multi-year highs for the stock market smacks of desperation. If the stock market continues to fall from here there is not much Bernanke can do, because he has already shown his hand.'

Well the markets did continue to fall from there, and now they are quite literally resting on the precipice of the 200 day moving average. Everyone is banging on about the 'fiscal cliff', but are they aware they are now staring at the '200 day abyss'?

I doubt it.

Even if we see a short term bounce from this level, I feel confident that we aren't far away from seeing the 200 day MA give way. The fact that QE3 has proven such a dud just increases my conviction level.

That's the US stock market, but what about the local market?

The Australian stock market finally started playing some catch up with offshore equity market weakness yesterday. I've said for months that the May 2012 high in the ASX 200 of 4448 was a line in the sand for our stock market.

On the 10th of October I wrote that:

'From here we need to see a weekly close in the ASX 200 below the previous high made on the 4th of May 2012 of 4448. If that happens there is a high chance we will see a move to 4325, which is the top of the current range of 4075-4325. A failure below that level could see some very sharp falls to 4200 initially and then perhaps to the bottom of the range at 4075.'

It's taken over two months from that moment for the ASX 200 to send the weekly sell signal that I was talking about. But a close this Friday below 4448 will spell trouble for our equity market.

If you have a look at the chart below you'll see why we fell 68 points yesterday:

ASX 200 Daily Chart

Click to enlarge Source: Slipstream Trader

The failure below the 'line in the sand' confirmed that the breakout to the upside was actually a 'false breakout' and not a real one. Two months of buying above the 4448 level will now be scrambling to get out as we return to the lower distribution that we have been trading in for over a year.

This is how markets move. They trace out widening distributions that constantly sucker people into the stock market at exactly the wrong time, and then they return to the Point of Control which is the mid-point of the distribution. The current point of control is at 4200 (the middle dotted line on the above chart).

The Wrong Side of the Trade

As they say, the stock market goes up by the stairs and down by the elevator. When the music stops the stock market can plummet a long way very quickly. All of the market commentators of the past few months who have been shouting from the rooftops that we are at the beginning of a five year bull market will have once again led their clients to the slaughter.

For instance, on 19 October (the day after the ASX 200 reached a one-year high) I sent this note to Slipstream Trader members:

'Richard Coppleson from Goldman Sachs Australia, who writes the well-known afternoon report, has become super bullish. He headlined his report yesterday 'We're back!!' I have a lot of respect for Coppo's report and have read it often over many years but it has to be said that he can be a great contra-indicator at times. I wonder if now will prove to be another one of those times.'

Coppos' full headline was 'We're Back! The Market hits 15 month high & has broken out on the upside'.

As I said, that stock market high was a false breakout, not a real one. And I'm sure Coppo wasn't the only stock trader caught off guard.

Yesterday's sell-off isn't a one day wonder. It's the confirmation that we have never actually left the range of the past year. If that is the case then we should see further steep falls in the short term. If the S+P 500 does snap below its 200 day MA then it is quite literally lights out and we'll all be surprised by the ferocity of the sell-off.

Once the dust settles on a steep plunge there may be a case for buying the market in preparation for a deal on the fiscal cliff. I'm sure there will be more can kicking ahead, and I accept that a kicked can will often cheer up the equity markets.

But that is a story for another day. Right now we need to traverse the '200 day abyss'.

Murray Dawes
Slipstream Trader

The Daily Reckoning Australia