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In The Week Ahead: Scared Investors Could Trigger Another Drop In Stocks

Most major U.S. stock indices closed in positive territory last week, led higher by a 0.9% gain in the small-cap Russell 2000 and a 0.8% advance in the tech-heavy Nasdaq 100. However, these indices remain in the red for 2016 and are much weaker than the S&P 500, which is up 0.4% year to date.

This trend is important because technology and small-cap stocks typically lead the broader market both higher and lower. As long as the Russell 2000 and Nasdaq 100 are underperforming the S&P 500, it warns of more overall weakness. However, we are seeing some promising longer-term signs in the form of rising interest rates and commodity prices, which I will discuss in detail today.

Last week's strongest market sectors were energy (1.8%) and financials (1.4%), while real estate (-2.3%) and utilities (-2.2%) were the weakest. The rise in long-term interest rates was behind most of these moves, as higher rates benefit banks but are a drag on real estate sales.

The table below shows the biggest sector-related inflow of investor assets last week went to financials. Over the past one-month and three-month periods, the biggest inflows went into energy, which represents a bet by investors that oil and energy-related asset prices are bottoming.

 

Confirmed Breakdown In Blue Chips Points To More Weakness

In last week's Market Outlook, I said the Dow Jones Industrial Average had just confirmed a bearish head-and-shoulders pattern, but I wanted to see another day or two of weakness to confirm the breakdown. We got that confirmation last week as the blue-chip index fell as much as 204 points into Thursday's low before recovering slightly on Friday.

 

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This bearish pattern continues to target a decline to 17,000, which is 2.9% below Friday's close. The target will remain valid as long as the 50-day moving average, now at 17,693, loosely contains as overhead resistance.

Increasing Fear Supports Decline

Investor fear is necessary to trigger and fuel stock market declines, and one common measure shows fear is growing. The Volatility S&P 500 (VIX) spent most of last week above its 50-day moving average, which I use as a baseline to determine whether investors are collectively fearful or complacent.

 

The last time the VIX spent a significant amount of time above its 50-day coincided with the Dec. 8 to Feb. 19 decline in the S&P 500. 

Last week's rise above the moving average, which is currently situated at 14.71, warns that another market decline is beginning. As long as the VIX remains above 14.71 this week, the level of investor fear is high enough to drive the Dow down to our 17,000 target.

Editor's note: Trading expert Jared Levy also recently predicted a decline in the market. Using a simple put option strategy, he risked just $800 and booked an 18.5% gain on a 1% drop in the market… in one day (6,759% annualized).

We're offering a special deal where Market Outlook readers can start receiving his weekly trades for $49 a month. Access it here.

Long-Term Interest Rates May Have Bottomed

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Last week, I pointed out that the recent close below 1.75% in the yield of the U.S. 10-year Treasury note indicated a bet by investors that the larger November decline in yields was resuming. I targeted a drop to 1.44% as long as the 1.75% area loosely contained yields on the upside.  

Broken chart patterns are relatively rare because they indicate a sudden change in investors' collective expectations for market direction, but that is precisely what took place in long-term U.S. interest rates last week.

Just hours before the minutes of the April 26-27 Federal Open Market Committee meeting were released to the public on May 18, yields spiked above 1.75%, moving back into the boundaries of the sideways indecision area.

 

Although a move of this magnitude right before the release of major information from the government is highly unusual (and certainly can engender its share of conspiracy theories), it does indicate that the market has collectively decided a sustainable bottom is now in place in long-term interest rates. Moreover, it suggests a move back to at least the 2% area in the yield of the 10-year note in the months ahead.

Emerging Bottom In Copper?

Over the past several months, I have been monitoring the slow stabilization and strengthening in commodity prices. It started with precious metals at the beginning of the year and gradually spread into industrial metals, oil and lumber. If this trend continues, it should help lift the malaise investors have felt over the past several quarters due to fears of global deflation.

The next chart shows copper prices appear to be in the midst of a major bullish trend change and may potentially offer a new buying opportunity. This trend change was indicated by the rise above the 200-day moving average in Global X Copper Miners ETF (NYSE: COPX) on April 18.

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The ETF is now retesting that widely watched major trend proxy from above while technically oversold according to the 21-day stochastic oscillator shown at the bottom of the chart.

If an emerging bullish trend change is indeed occurring, then this combination of formidable support and a monthly oversold extreme should trigger buying pressure that drives COPX above the $17.54 high, made on May 2. Once it becomes apparent that the 200-day moving average, now at $13.56, is holding as underlying support, I would view COPX as a relatively low-risk buying opportunity.

Putting It All Together 

The recent breakdown in the bellwether Dow industrials amid an increase in investor fear warns of the stock market's vulnerability to more near-term weakness. However, an emerging bottom in long-term interest rates combined with strength in commodity prices suggests that U.S. and global economies are slowly improving. This bodes well for equity prices over the next several quarters.

This article originally appeared on ProfitableTrading.com: Scared Investors Could Trigger Another Drop In Stocks

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