Do Bearish Chart Patterns Overseas Spell Trouble for US?
By John Kosar
Most major indices finished lower for the second consecutive week. Only the small-cap Russell 2000 managed to eke out a 1.2% gain.
The U.S. markets were pressured by a number of factors. These included sharply rising long-term U.S. interest rates and worries of a debt default in Greece. Generally favorable U.S. economic data had investors concerned the Federal Reserve will begin raising short-term interest rates sooner rather than later. Another negative factor last week was generally declining global equity prices, which I'll discuss in more detail later in the report.
At the sector level, only financials, consumer discretionary and industrials finished in positive territory last week. Financials were driven by rising interest rates and a steepening yield curve that will help banks become more profitable. The weakest sector last week was utilities as rising interest rates lured yield-seeking investors out of this sector and into safer U.S. Treasuries.
Keep a Close Eye on Technology This Week
In last week's Market Outlook, I discussed the importance of the 5,133 March 2000 tech bubble high in the Nasdaq Composite. I said, “Historic benchmark highs like this one are seldom appreciably and sustainably broken without at least a multiweek decline first.”
What I didn't say was how deep of a decline would be necessary to indicate that a correction from this level is actually under way.
This week's first chart identifies minor underlying support at 5,006 to 4,990, which represents the index's 50-day moving average, a widely watched minor trend proxy, and the rising trendline from the Feb. 2 low.
It would take a close below this support area to indicate that at least a minor corrective decline is beginning, which would then clear the way for a potential test of major support at the 200-day moving average at 4,757.
Moreover, the tight trading range between 5,133 and 4,990 is an important inflection point for this market-leading index, from which its next intermediate-term directional move is likely to begin.
Fear Still the Missing Ingredient for a Correction
In the May 4 Market Outlook, I said a lack of investor fear was the most important reason we hadn't seen a stock market correction yet despite the end of quantitative easing in October.
This remains true heading into this week. But with the Nasdaq Composite up against a major overhead resistance level, it is time to pay special attention to this “fear factor” via the Volatility S&P 500 Index (VIX).
The VIX traded above its 50-day moving average on Thursday and Friday. I use this moving average as a baseline to determine whether investors are collectively complacent enough to support a rising stock market or fearful enough to trigger a market decline.
The move above this moving average suggests that investors are indeed fearful enough to fuel a deeper decline this week, but the VIX must remain above 13.64 to this. A quick retraction back below the moving average this week, like the one that occurred in early May, would likely coincide with the resumption of the S&P 500's larger advance.
As Goes Europe, So Goes the United States?
Last week, I pointed out a bearish chart pattern in the German DAX that targeted a 4% decline to 11,000 and said that the long-term positive correlation between the DAX and the S&P 500 warned of a similar decline in the U.S. market.
That downside target remains valid heading into this week. In addition, the next chart shows that a similar bearish head-and-shoulders pattern was confirmed in the London FTSE 100 index on the close Friday. It also targets a 4% decline to 6,550.
I view this pattern in the FTSE, which is also positively correlated to the S&P 500, as corroborating evidence that European stock indices are peaking. This is another reason for investors to pay particular attention to the U.S. markets this week.
Although unmet price targets in two key indices — Nasdaq 100 4,600 and Russell 2000 1,320 — continue to suggest the potential for an additional 3% to 5% rise in the U.S. market, we are increasing vulnerable to a long overdue correction.
This week, looming secular resistance in the Nasdaq Composite and bearish chart patterns in two major European indices suggest the potential for an additional 4% decline in the S&P 500. This is especially true considering last week's spike in long-term U.S. interest rates.
Right now there appears to be more near-term downside risk than upside potential in the U.S. stock market. Investors are advised to have a plan in place to protect their portfolio should the Nasdaq Composite decline below 1,990 this week on increasing market volatility as evidenced by the VIX.
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