Fed Chairman Ben Bernanke said on Wednesday that if the economy improves, monetary easing could be toned down. That is the equivalent of weaning a child from his or her bottle, because a big part of the rally has been the central bank's stimulus.
With Bernanke's mention of a reduction of bond purchases, equities got spooked, even though Bernanke's language -- as always is the case with the Fed -- was vague. The market's volatility on Wednesday and Thursday was due to such vague language and to a weaker China, but in the days ahead, volatility should subside.
The pair below is of S&P Equal Weight ETF
There was a breakout higher in early May, and the recent downturn has provided a much-needed pullback to the support line. It does not look as if Bernanke's statements have derailed the current trend higher, but have merely provided some relief to an overbought market.
The next pair is of SPDR MidCap Trust Series
Strong rallies tend to be led by smaller-cap stocks versus larger-cap defensive companies. The price action below shows that the smallest 400 companies in the S&P 500 have led the index higher throughout this past rally, and have just recently hit resistance.
The pullback has come in the face of speculation that the market is overbought and is due for correction. The variability of economic data has kept markets questioning the sustainability of the rally, and now with the uncertainty surrounding stimulus, markets have found a reason to pull back. As long as the pullback stays within the downward channel pattern, there looks to be room for a break higher.
Volatility has been a threat to markets lately, as evidenced by Thursday's wide price swings in the equities market. Generally, with volatility, funds rotate into more defensive sectors.
The chart below acts as a form of volatility measure. It compares the Dow Jones Select Dividend Index Fund
The relative strength of large-cap, defensive stocks moves inversely to a risky economy, and correlates strongly to volatility.
The pair below is approaching yearly lows that have been reached only one other time since early in 2012. The pair has yet to show a convicted move either higher or lower, which means that for now, markets hang in the balance.
If the pair spikes higher, look for volatility to return with vigor in the markets. If it breaks lower, look for equities to push through their all-time highs.
The last chart examines the Treasury yield curve. The pair below is of Barclays 1-3 Year Treasury Bond Fund
As long-term Treasuries are sold, their yields rise in an inverse manner. When short-term bonds outperform long-term bonds, it steepens the yield curve, which is a bullish sign, widening the gap between short-term and long-term yields.
The chart below shows that the yield curve has traded in a sideways pattern for the better part of two years. With the recent upturn in equities, the yield curve has steepened in stride with equity markets.
The pair is fast approaching a point of resistance, which is concerning to the trend of risk assets, but a push through resistance could propel equities higher and trigger a move upward in the 10-year yield, above the 2% threshold.
At the time of publication the author had no position in any of the stocks mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
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