How Low Will the Dow Go?

Yesterday, the U.S. dollar rose sharply following the Fed announcement that they would buy $400 billion of long-term Treasurys and sell short-term Treasurys. But the impact of the new quantitative easing plan, which The Street calls �Operation Twist,� was a broad-based, high-volume sell-off in stocks and commodities.

As the Fed wished, long-term bond prices rose sharply, driving the yields on the 10-year bond down to 1.871%. But investor confidence was shaken badly by the divided decision of the board as three members dissented.�

Volume on the NYSE rose to 1.2 billion shares and decliners outpaced advancers by almost 5-to-1 on both the Big Board and the Nasdaq.

The impact on the two major Dow indices, the industrials and the transports, was clear. Both smashed through their 20-day moving averages after turning away from the important 50-day moving averages. Now the challenge for the bulls is to hold these key indices above the reversal point of the industrials at 10,825 and the transports� lows at 4,205-4,208. A penetration of both would no doubt lead to another powerful sell-off.

While stocks were falling, the U.S. dollar, as represented by PowerShares DB US Dollar Index Bullish Fund (NYSE:UUP) was rising to a new high — putting pressure on emerging oil, which lost $1 per barrel late in the day, and sending the November light sweet crude contract to $85.92.�

And coal, as represented by the Market Vectors Coal ETF (NYSE:KOL), broke a triple-bottom on high volume and appears headed much lower. The impact of lower coal prices will no doubt impact the railroad stocks, and thus, the transportation index, since rail contracts are based in part on the price of the commodity being carried. In response, the Dow Jones Transportation Index fell almost twice the amount of the industrials.

And emerging markets, as represented by the iShares MSCI Emerging Markets Index (NYSE:EEM), suffered a similar fate, also breaking through a triple-bottom as foreign currency markets were hard hit by the sudden strength of the dollar.

Conclusion: The lack of confidence in the Fed decision, which was preceded by a Congressional plea to the FOMC to not engage in further quantitative easing, puts enormous pressure on stocks. If stocks cannot hold at current levels and proceed to break the lows of the six-week bear flag, look for an explosive sell-off.

But don�t rush into the market on the opening on the short side. In such an emotionally charged situation, new lows could lead to bargain hunting and an afternoon rebound. If we get that rebound, it will be time to pounce since last summer�s low at Dow 9,700 is our downside target.