Volatility continued last week. While the S&P 500 and its tracking exchange traded fund, SPY had a fairly quiet week, the market still moved 1-2% intra-day for most of the week, and many cyclical stocks continue to move 2-3% intra-day as well. Even though the Nasdaq was not quite as volatile, with Apple (AAPL) leading this index higher, volatility levels in this index remain elevated as well.
The first reason the market could plunge this week is that many leading cyclical companies are likely moderately to significantly overbought. While I've advocated investing in cyclical stocks several times within the last month, the rally in market leaders within cyclical sectors such as energy and the industrials has been strong. Exxon-Mobil (XOM) is up over 6% in the last month, from around $80 a share to $85 (as of Friday). GE (GE) is up nearly 10% in the last month, from around $18.50 a share in early July, to over $20 a share today. Market leaders such as Citigroup (C) and Caterpillar (CAT) have also rallied hard in the last couple weeks. The recent nearly 10% rally in many cyclical stocks has also been on weak volume, with little improvement in the underlying fundamentals.
Many leading cyclical stocks in the industrial and financial sector were likely oversold prior to the rally last week. Still, the nearly 10% move in many of the more oversold sectors-- that were hardest hit during the sell-off over the last several months-- was significant.
The second reason the market could plunge this week is the European Union and European Central Bank are unlikely to take new and substantial actions near-term to further address the eurozone's fiscal woes. While Germany's ratification of the European Stability Mechanism framework was important, the ESM still has just $30 billion in funding, and most eurozone parliaments are yet to approve this new attempt by the EU to backstop the PIIGS debt. The Netherlands, Finland and other European countries are also increasingly questioning the use of EU capital to directly buy bonds and recapitalize the PIIGS banks.
The third reason the market could plunge this week is that the dollar looks ready to breakout.
The dollar index appeared to be topping out around the 84 level in mid-May, but, the dollar has now held its early June support levels, and is less than 1% of its late 2010 highs. While oil prices rallied nearly 10% over the last two weeks on the Euro stabilizing-- with inventories in the U.S. at the highest levels they have been at in the world's largest economy in four years-- oil, copper, and other leading commodities, will likely continue to decline if the dollar breaks out.
To conclude, while the recent rally has been impressive, economic activity in the eurozone remains weak, and the ECB is unlikely to take aggressive action prior to further actions being taken by Germany and other EU governments. Germany's ratification of the ESM framework was important. Still, opposition to increasing the size and role of the ESM remains strong, and significant additional action by EU leaders and the ECB remains unlikely. While the nearly 10% rally in cyclical stocks and leading commodities has been impressive, traders and investors will likely wait for a pullback to initiate new positions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.