By: John Kosar of Street Authority
All major U.S. stock indices posted gains last week except for the Russell 2000, which lost 1.2% and is also the only major index in negative territory for 2014. Despite the weakness in small caps, the broader market, as measured by the SP 500, has managed to rack up a decent 8.9% gain this year, largely on the back of technology issues.
The Nasdaq 100 is up 14.2% year to date. However, as I have been stating in this space for some time, if and when technology stocks stop leading, the broader market may be in for some significant problems over the near term.
Dow Makes New High, but Problems Persist
In last week's Market Outlook, I warned that the early September new closing high in the Dow Jones Transportation Average had not yet been corroborated by a new closing high in the Dow Jones Industrial Average, which, according to Dow Theory, was a red flag for the overall market.
That situation was averted last week by a new high in the industrials, clearing the way for more near-term strength in both indices.
But it may be too early to celebrate just yet, as potential problems continue to exist.
The next chart plots the SPDR Dow Jones Industrial Average ETF (NYSE:DIA) daily since January in the upper panel with its daily total assets invested and 21-day (monthly) moving average plotted in the lower panel.
The yellow highlighted area in shows that the new all-time high set in the ETF at the end of last week was accompanied by contracting investor assets, which fell back below their moving average. This warns that a new monthly trend of contraction may be beginning.
The red highlighted areas show previous periods of contracting assets coincided with either flat or declining prices. These assets need to start expanding again -- and soon -- if there is indeed going to be more upcoming strength as suggested by Dow Theory. Without an expansion in assets, last week's rally is likely to fail.
Other obstacles include the Nasdaq 100's formidable overhead resistance looming just above at 4,147, the September 2000 high, and weakness in European stocks. Additionally, investor sentiment remains at historically bullish extremes , and seasonality data shows this is the historically weakest week of the third quarter.
So, although last week's new closing high in the Dow industrials was indeed a good start, until the market is able to resolve some of these issues, I am not yet convinced there are blue skies ahead into year end.
U.S. Interest Rates May be Bottoming
In last week's report, I said the 2014 trend of rising long-dated U.S. Treasury prices had stalled. The next chart plots the daily closing yield of the 10-year Treasury note, which moves inversely to prices. We can see the yield recently spiked higher after bottoming near 2.35% in mid-August.
The recent decline below 2.4% initially cleared the way for a potential move to the next key level of 2.07%. However, the strong rebound back above 2.4% to a closing high of 2.63% last week suggests the bond market may be betting that a sustainable bottom is in place at the recent lows.
One key to whether this is indeed the case will be the reaction to the 200-day moving average, which is currently situated just above at 2.66%. This moving average has closely defined the major trend in 10-year yields for the past 20 years. A significant and sustained move above 2.66% would help to confirm that a major bottom in long-term interest rates is indeed in place as the Federal Reserve winds down quantitative easing.
Keep an Eye on Japan
The next chart plots the Japanese Nikkei 225 weekly since 1994. Following multiple attempts during the past year, the index appears to finally be breaking out above its 1996 secular downtrend line. I am particularly interested in this index because of its long-term positive correlation to both the SP 500 and the yield of the U.S. 10-year Treasury note.
Last week's new closing high in the Dow industrials bodes well for a strong fourth quarter like the one we had in 2013. However, it is still too early to sound the "all clear" because of a short but significant list of potential headwinds, of which the most important is overhead resistance in the Nasdaq 100. Without any help from small-cap stocks this year, the broader market has been particularly dependent on technology to lead the way. A sustained rise above 4,147 is necessary for that leadership to continue.
Turning to U.S. interest rates, I would view a sustained rise above 2.66% in the yield of the 10-year Treasury note as evidence that a significant bottom may be in place as the Fed brings its bond-buying program to an end. Should this occur, I would view it as being potentially positive for stocks as it would suggest that the bond market believes the economy is strong enough to withstand and thrive amid higher interest rates.
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