Risk of a deeper correction remains high despite a holiday-shortened week. Watch for technical warning signs, as well as a potential topping formation in the bond market, writes Tom Aspray.
Stocks finished the week a bit lower, but once again, the heavier selling last Thursday was well supported. This past week started off with a bang, as comments from Fed chairman Ben Bernanke suggested that he was ready to help in order to increase job growth. This sparked impressive one-day gains and led the Nasdaq Composite to reach its highest closing level since November 2000.
Stocks then declined for the next three days, and many on Wall Street expected a further correction still. Early in 2012, many strategists were not very bullish for stocks in 2012.
The most bullish has been Binky Chadra of Deutsche Bank, who was looking for the S&P to reach 1500. As the Wall Street Journal chart below indicates, the median forecast was for the S&P 500 to end the year at 1362, which is more than 3% below Friday's close. Therefore, some of these strategists are now looking for a 3%-5% correction before the market can resume its uptrend. Such a correction could give some the opportunity to raise their forecasts.
So what should investors expect in April? Over the last 40 years, the month of April has been one of the better months, averaging a gain of 1.56%. Typically, the period from November to May is the best time for the stock market.
I have found over the years that when the majority expects a correction, it often comes from higher levels and is more severe than many will tolerate. Technically, Friday's positive action suggests that this may presently be the case.
Some of the important market sectors have already had their corrections and could easily spur another rally to significant new highs. If the major averages do break out of their recent trading ranges, we could then see another 2%-3% on the upside. This might be enough to swing the other sentiment measures to more extreme levels.
Currently, the sentiment measures have become a bit more positive, as the number of bullish financial newsletter writers rose to 50.5%, up from 43.4% just three weeks ago.
The number of bearish individual investors dropped 2.3%, to 25.5% last week, while the number of bulls was 42.5%. This is well below what is seen at significant market tops, although the newsletter writers are getting closer. It should be noted that these sentiment measures only give very good signals one or two times a year and always need to be supported by the technical action.
The other main focus is now on the bond markets, both in the US and overseas. Rates surged early in March but have now come back down. I wrote here on Thursday that the technical action of the inverse bond ETFs indicates they may now be reaching a critical juncture, as they have pulled back to test key support.
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This wonderful long-term chart of ten-year note yields from the Financial Times dates back to 1982, when yields peaked near 16%. If you are not familiar with the history of the bond market, this chart illustrates some of the key turning points.
Noted on the chart is the 1998 drop towards a yield of 4%, which came in reaction to the collapse of the hedge fund Long-Term Capital Management, which I also discussed in Friday's Charts in Play column.
Higher rates in the US would boost the dollar and could help to complete the long-term bottom formation that I will discuss later. In the overseas markets, another drop in the German bunds could make it more difficult for European banks to recover, as it would adversely impact their balance sheets.
The Eurozone problems have been on the back burner for the past few weeks, but that may not last much longer. The rescue fund was boosted to EUR 700 million late last week, but many still think it needs to reach EUR one trillion.
The inflation rate is still too high, and riots in Spain over further austerity measures are keeping many on edge. Though the charts of major European stock markets like the German Dax and the French CAC-40 look much stronger than we might expect, they are badly lagging the US market.
The US economic data last week was mixed, as pending home sales were weaker than expected, but the good news was that home prices declined less than the initial projections. Durable goods were weaker than anticipated, while the GDP data came in as expected.
In this holiday-shortened week (the markets are closed for Good Friday), there is plenty of data for the market to contemplate, ending with the monthly jobs report on Friday. On Monday, we will get the widely-watched ISM Manufacturing Index and construction spending.
On Tuesday, factory orders and the release of the FOMC meeting minutes will be out, followed on Wednesday by the ISM Non-Manufacturing Report and ADP Employment Report.
Weekly jobless claims come out on Thursday, as do the latest numbers on chain store sales.
WHAT TO WATCH
Sharp gains last Monday clearly resolved the prior week's indecision. The early drop last Thursday took some of the major averages back to their first key levels of support, which now appear to have held. Friday's higher close supports the positive outlook.
Though the Advance/Decline (A/D) line on the NYSE Composite still shows a short-term negative divergence, this is not the case for the A/D lines on the S&P 500, Dow Industrials, and Nasdaq 100. This supports a test, if not a breakout above, the March highs this week.
Given the holiday-shortened week and the monthly jobs report coming out on Friday when the markets are closed, risk remains quite high. I have been concerned that we could see a disappointing monthly jobs report in the not-too-distant future, and that could come this week.
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The daily chart of the Spyder Trust (SPY) shows the 12-day trading range, as the rising 20-day exponential moving average (NYSEMKT:EMA) was tested again last Thursday. There is support now at $138.55-$139.09 with resistance at $141.83, which was last Tuesday's early high.
A move above this level would project a move to the $145.50 area, which corresponds nicely to the major Fibonacci projection target at $145.27.
The S&P 500 A/D line has moved back above its weighted moving average (WMA) and held above the prior lows last week. It did make marginal new highs, confirming the price action.Â The uptrend in the A/D line from late last year was tested last week, and a decisive break of this uptrend would be negative and signal that a deeper correction was underway.
A daily close below $138-$138.55 would indicate a test of the early-March lows at $134.36, or 1340 on the S&P 500.
The flag formation, or continuation pattern, is more evident on the SPDR Diamonds Trust (DIA). There is resistance at $132.61 and support at $129.71, so the range is 2.9 points wide. Therefore, a close above $132.61 will project a move to $135.51, which should be enough to bring some money in off the sidelines.
The Dow Industrials' A/D line also shows a flag formation (dashed lines) that was nearly completed on Friday. Positive action on Monday should do it. The A/D line has more important support at the uptrend, line e. There is more important support now in the $127-$128.50 area, line d.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.