Equities—Serious Correction Straight Ahead?

This starting to get interesting. Instead of bouncing up as was usual for the last one and a half years, the S&P500 dropped almost 2.7% last week. The NASDAQ went down even more. Volatility jumped notably—the VIX index rose to about 17 after spending most of the prior week below 15. And volume also rose, suggesting that there was some conviction behind last week’s selling.

All that said, the S&P is off only about 4% from its most recent highs. Not good, but certainly not a serious correction. For now, this is merely a scratch.

Technically, the S&P remains very overbought on the weekly charts, while on the daily charts, last week’s sell-off alleviated this condition, but only slightly. Breadth indices weakened a good deal. The McClellan Oscillator fell to one year lows. New highs minus new lows hit zero. And the percent of stocks above their 50 day moving averages fell to only 39% by Friday’s close. So the damage to market internals looks even worse than the 4% drop in price, suggesting that the equity markets—beneath the surface—are weaker than they appear.

US macro data continues to disappoint. Wholesale trade figures missed expectations. Import prices were much higher than predicted; this will put pressure on corporate earnings. Producer prices, both headline and core, were much higher than expected; this will also put pressure on earnings. But initial jobless claims were better than expected. Interestingly, almost all US recessions start around the time initial jobless claims reach their lows of the cycle. This could possibly be happening….right about now.

Last week, we noted that if the S&P500 was going to revert back to form—the form that has defined it for the last 18 months—then it was going to have to bounce back markedly by last Friday’s close. Instead, the S&P lost almost 3 percent. It’s now trading visibly below the 50 day moving average and the next stop can be—and will probably be—the 200 day moving average at about 1,765.

It’s likely to test the 200 day, because it failed to march on to new highs last week. And that’s where this will get very interesting. The S&P500 has NOT tested (truly closed below) the 200 day moving average since late 2012. In many ways, then, this test is overdue.

For the bull market run that started in 2009 to continue, the S&P will have to find its footing at or around the 200 day moving average. This is were many, if not most, long-oriented trend traders will draw the line. Because if the 200 day doesn’t hold, then many of them will get out, which will almost guarantee an even greater sell-off, a sell-off that could accelerate because the Fed is now tightening by methodically cutting back its QE program.

Either way, a more serious correction is now more likely. Simply moving down to the 200 day moving average will mean that the S&P will be down about 7% from its highs.

And if the 200 day doesn’t provide a firm foundation, then a 10-15% sell-off becomes a distinct possibility…..for the first time since 2011.

 

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