All major U.S. stock indices finished in the red again last week except for the Russell 2000, which gained 2.8%, reversing the pattern that we have seen for most of this year where small-cap stocks lag the market. This emerging strength in small caps may be a good sign for the market between now and year end. But, for now, the broad market SP 500, blue-chip Dow industrials and tech bellwether Nasdaq 100 are all negative for 2014 with no clear sign of a bottom in sight.
All sectors of the SP 500 posted losses last week except for industrials, materials and utilities. One potential bright spot is that my own ETF-based metric shows the biggest inflow of investor assets last week went into energy. Should this continue, it may be a leading indication of a fourth-quarter buying opportunity in this downtrodden sector. Stay tuned.
Keep Your Eyes Focused on Europe
In last week's Market Outlook, I discussed a bearish head-and-shoulders formation in Germany's DAX index that targeted an additional 11% decline to 7,800. I said the positive long-term correlation between the DAX and the SP 500 implied that the broader U.S. market may also be vulnerable to more weakness.
Despite last week's modest rebound, the 7,800 downside target remains valid as long as the March 14 and Aug. 8 lows near 8,913 loosely contain the index on the upside.
The next chart shows the SPDR Dow Jones Industrial Average ETF (NYSE: DIA) broke down last week below the $165.51 support level that I first identified in the May 12 Market Outlook. The ETF has key resistance at $165.63 to $168.78, which contains the 200-day moving average (major trend proxy), the 50% and 61.8% Fibonacci retracements of the Sept. 19 decline, and the 50-day moving average (minor trend proxy).
This band of overhead resistance is where last week's rebound should fail, and where the September sell-off should resume, if this is indeed the beginning of a deeper decline in U.S. equities as suggested by the current configuration in the German DAX.
Frightened Investors Could Trigger Market Bottom
In last week's report, I said that the high CBOE Volatility Index (VIX) reading of 21.35 indicated that investors may be spooked enough to facilitate a near-term recovery in the stock market. The VIX rose even further last week, eventually moving above the 28 level.
The next chart shows that four of the past five times the VIX was above 28 either coincided with or led significant bottoms in the SP 500.
We don't know yet whether this latest instance will be an immediate bottom like the ones in February 2010 and June 2012, or an emerging bottom that takes a couple of months to evolve like those in May-July 2010 and August-December 2011.
Although the bearish configuration in the German DAX currently suggests the latter scenario is more likely, the VIX does indicate that investors should be viewing any further U.S. market weakness as a potential longer-term buying opportunity.
Rally in U.S. Treasuries Nearing Completion?
In the Sept. 15 Market Outlook, I said: "I see the potential for one more move to fresh highs in long-dated Treasury prices between now and year end, while the yield of the benchmark U.S. 10-year note declines to the 2.23% area."
Since then, the iShares 20+ Year Treasury Bond (NYSE: TLT) rose 13% into last week's highs, while yields declined as expected, falling 41 basis points to close last week at 2.2%.
While there may be a little more downside in the yield of the 10-year note, perhaps to the next key level at 2.07%, my work now suggests the decline in long-term U.S. interest rates is near completion. Therefore, downside risk now outweighs upside potential in U.S. Treasury prices.
Putting It All Together
A bearish chart pattern in the German DAX index with a downside target 12% below last week's close warns that the current September decline in the positively correlated U.S. stock market is not complete. If this is indeed the case, a band of overhead resistance at $165.63 to $168.78 should contain DIA on the upside, and a new move to fresh lows should begin from it.
Ironically, the potentially good news is that investors are now collectively afraid enough for a bottom to emerge before year end.
Meanwhile, last week's collapse in long-term U.S. interest rates suggests that my 2014 call for rising long-dated Treasury prices is either at or near completion, so Market Outlook readers who are long Treasuries may want to consider locking in profits.
Finally, I continue to see evidence of bottoming in commodity prices in general, and specifically, in industrial and precious metals. Readers should start watching them more closely as my work suggests there will be a good buying opportunity in these assets between now and year end.
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