With short term support levels now violated, a decline toward the January highs is very likely. The support ranges around the January highs are 1153 to 1140 on the S&P 500 and 10730 to 10655 for the DJIA.
The question now is; what is the probability of the January high holding?
From a purely technical perspective, we can argue that the January high should hold. Daily momentum oscillators are near oversold and longer term technical indicators that measure breadth (Advance Decline Line, % Above 150-Day Average etc) have not shown the kind of erosion that typically precedes a major market top. The only significant evidence of technical erosion is the rising Selling Volume, and that can be short term in nature.
However, there are two points to consider from a technical perspective: first I detailed in last week’s Market Update, there is evidence that the leading tendency of these indicators was not reliable in past liquidity driven rallies. Second, I noted that the period from May 04th to May 14th, with a focus on May 5-7 should be a period with a potential for increased volatility. From experience, this could include a sharp decline and reversal.
Other than support levels, some leading indications of investor outlook toward the economy are painting a less than optimist picture:
· 10 Year US Treasury Yield: over the past ten years rising treasury yields have been a positive for the equity market as they have reflected economic growth or “reflation”. Falling yields have been indicative of a slowing economy. The 10 Year Yield peaked in early April and has now (as of today) confirmed that the rally in yields from the October ’09 low is over.
· Japan: we have detailed in past issues that Japan’s Nikkei 225 has been a consistent leading or coincident indicator of the US market and reflation vs. contraction since 1998. Unfortunately, Japan’s equity markets are closed for the week due to their holiday.
· Australia: Australia’s commodity exports rely more on China and Japan than the US and thus could reflect the rate of growth of those economies. Latest reports show that Australia’s exports to China are twice their exports to the US. Their exports to Japan are three times their exports to the US. The Australian equity market, as indicated by the ASX 200, peaked on August 15th and has already retraced more than half its gains from the February low. The amount of this decline suggests a retest of the February low, for the ASX 200, is a reasonable expectation.
· Basic Materials are a leading sector in this decline, including weakness in copper and now oil. If investors were optimistic about growth, this sector should be leading at this stage of the rally.
Putting it all together: if the decline in the S&P 500 and DJIA violates the January high support levels, it would suggest investor expectations of slowing growth global and U.S. economies, in addition to the sovereign debt issues in Europe, outweigh any positive current economic news. The probabilities would then favor a retest of the 200 day average or the February low.
If the support levels marked by the January high hold, then the probabilities would favor another rally attempt and retest of the April high.
Matthew Claassen, CMT
Disclosure: No Positions