Major Bearish Trend Change Overseas May Spell Trouble for U.S. Market

By: John Kosar of Street Authority

All major U.S. indices closed higher for the third consecutive week, led by the Dow Jones Industrial Average, which was up 2%. Year to date, by far the strongest major index has been the tech-heavy Nasdaq 100 (NDX), which is up 12.8%. This leadership by technology has been a key catalyst in the 2014 broad market advance, helping the SP 500 post a 7.6% gain despite a weak small cap sector. This strength in tech must continue to keep the broader market headed higher.

From a sector standpoint, last week's advance was led by financials, industrials and consumer discretionary, but all sectors of the SP 500 ended in positive territory.

Key Indices Held Major Support Levels in August

Many key indices, including the SP 500, Dow Jones Industrial Average and PHLX Semiconductor Index, have rebounded nicely from major support levels that were tested during the first week of August, and finished last week at or near their 2014 highs.

The SPDR Dow Jones Industrial Average (NYSE: DIA), which I first mentioned as a potential buying opportunity in the May 12 Market Outlook, closed out last week 3.7% above its Aug. 7 test of its 200-day moving average, a widely watched major trend proxy, and less than 1% below its July 17 all-time high of $171.32.

Although I remain cautiously positive on DIA heading into this week, I am still apprehensive about its more intermediate-term sustainability due to frothy investor sentiment, weak August-to-September seasonality, and major overhead resistance in the market-leading Nasdaq 100.

Technology Faces a Formidable Challenge

The next chart plots the Nasdaq 100 monthly since 1994, and shows that Friday's 4,053 closing level positions the index just 2.3% below its 4,147 September 2000 high.

Major benchmark highs like this one are seldom meaningfully and sustainably broken without at least a multi-week corrective decline first. So, especially considering that technology issues have led and fueled the 2014 broader market advance, I am watching the Nasdaq 100's reaction to 4,147 as a potential coincident or leading indication of an upcoming market correction.

Bearishness in Europe Could Spread to Our Shores

Another potential pothole to be aware of this quarter is European stocks, which are positively correlated to the SP 500 and whose economies have much more to lose than the United States on any further geopolitical tensions in Ukraine.

The next chart shows that, unlike the major U.S. indices, the iShares MSCI Germany (NYSE: EWG) recently declined below its 200-day moving average and its Feb. 3 low, indicating an emerging major bearish trend change. Moreover, the 50-day moving average (minor trend proxy) crossed below the 200-day, which I view as more evidence that a tangible bearish shift in intermediate-term price momentum has occurred.

Considering EWG closely tracks Germany's DAX index, and that the DAX has maintained a positive correlation to the SP 500 for the past 25 years, this suggests that either the 25-year correlation has suddenly become irrelevant, or one of these two indices is temporarily mispriced. I'm inclined to go with the latter, and more specifically, I think Germany is better handicapping upcoming economic and/or geopolitical risk in Europe that will eventually have an adverse effect on the U.S. market.

U.S. Bond Market Isn't Enthusiastic Either

Recent apprehension in the U.S. bond market appears to be increasing. In the July 28 Market Outlook, I pointed out that the 2-year/10-year yield curve had flattened below its March 2012 steep (meaning wide) extreme at 200 basis points (bps), saying, "This clears the way for an additional 15 bps of flattening to the next key level at 180 bps." I also pointed out this was likely to coincide with a decline in the yield of the 10-Year Treasury note.

The next chart shows that the curve has since flattened to 187 bps. Meanwhile, the yield on the 10-year note has coincidentally declined to as low as 2.3%.

A flattening yield curve amid declining long-term interest rates suggest that the typically prescient bond market sees some economic trouble/weakness ahead, which I view as another good reason to watch the Nasdaq 100's reaction to 4,147 overhead resistance during the next several weeks. Last week's flattening in the curve clears the way for at least an additional 7 bps move to the next key level at 180 bps.

Putting It All Together

Many key U.S. stock indices tested, held and aggressively rebounded from major support levels earlier this month, which, at best, means that investors still collectively believe the market is headed even higher this year and, at the least, indicates that the "buy the dip" mentality is alive and well as managers remain terrified of missing the next quantitative easing-fueled leg higher.

I am still cautiously positive on this market on a near-term basis, but I also believe investors need to be acutely aware of potential problems ahead due to a number of things including extreme bullish investor sentiment, an historically weak August-to-September period, an emerging bearish trend change in the German stock market, and falling long-term U.S. interest rates.

Considering these factors, I would view the Nasdaq 100's inability to rise and hold above overhead resistance at 4,147 as a good reason to more aggressively protect profits on long positions.

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