How Low Can This Market Go?

Various market performance charts

The U.S. stock market posted its second consecutive weekly loss, led lower by the blue-chip Dow Jones Industrial Average, which shed 0.8%.

The roller coaster week saw the broader market S&P 500 spike 3% by Wednesday's close only to give up all of those gains and more by the close on Friday. With less than two weeks left in 2015, all major indices are in negative territory for the year except the Nasdaq. As I said last week, it's time for investors to be on the defensive.

The two best-performing sectors last week -- of only four that posted a weekly gain -- were utilities and real estate.

Both sectors benefitted from the decline in long-term interest rates as investors made a defensive move back into the relative safety of U.S. government bonds. When interest rates decline, higher-yielding utilities become more attractive to investors while helping to spur real estate purchases.

Apple: A Canary In The Coal Mine?

In last week's Market Outlook , I said recent price activity in market bellwether Apple (Nasdaq: AAPL ) indicated a near-term top was in place at the early November high and that we could see a retest of the Oct. 1 low at $107.31. AAPL actually collapsed below $107.31 on Friday, closing down 6.3% for the week at $106.03.

AAPL Stock

This clears the way for a decline to the next key level at $104.10, which is 1.8% below Friday's close and the 61.8% retracement of AAPL's August-to-November advance. According to retracement theory, $104.10 is the deepest the November decline can extend and still be considered a countertrend correction within the larger August advance.

3 Support Levels To Watch

Now that the market has apparently entered a corrective phase, identifying underlying support levels becomes particularly important to help us discern the next near-term bottom and potential intermediate-term buying opportunity.

The chart below highlights three significant levels of support in the benchmark S&P 500:

-- The Dec. 14 low at 1,993, located 7% below the index's all-time high, made on May 20

-- The Oct. 2 high at 1,951, 9% below the all-time high

-- The 1,867 Aug. 24 low, 13% below the all-time high

SPX Chart

In last week's report, I identified 1,965 as a downside target for the S&P 500 based on its Dec. 11 breakdown from a month of sideways investor indecision. That target remains valid and implies 1,993 support will be broken over the next few weeks, which could clear the way for a deeper decline to support at 1,951.

Investor Fear Warns Of More Market Weakness

Last week, I pointed out that the Volatility S&P 500 (VIX) index had risen above its 50-day moving average on Dec 10-11, which I use as a baseline to determine whether investors are collectively fearful enough to trigger a decline. I said, "As long as the VIX remains above that moving average… readers are advised to implement defensive strategies to protect their assets against a deeper market decline."

The VIX has indeed remained above its 50-day moving average, finishing last week at 20.70.

VIX Chart

The last time the VIX made a sustained rise above its 50-day moving average coincided with the August-to-October decline in the S&P 500. So, according to this metric, the market is vulnerable to a deeper decline between now and year end.

It would take a sustained move back below the 50-day, currently situated at 16.73, to indicate investors have collectively become complacent enough to support and sustain a new market advance -- ideally one that begins at or near a the support level defined in the previous chart of the S&P 500.

Bond Market Remains Apprehensive

A flattening yield curve typically suggests the bond market, which in my opinion is more forward looking and prescient than the stock market, is expecting a slowing U.S. economy.

The next chart shows the U.S. 2-year/10-year yield curve has aggressively flattened by 25 basis points (bps) since November. It begins this week situated at 122 basis points, near its July 2012 and February 2015 narrow extremes of 121 bps.

TNX Chart

The immediate takeaway is that the bond market's future expectations for the economy have taken a significant turn for the worse over just the past six weeks, which has at least indirectly contributed to weakness in the stock market.

The second and more influential takeaway in the intermediate term is that this is a pivotal inflection point for the yield curve. From here it either begins to steepen, indicating improving expectations for U.S. economic growth, or it collapses below 121 bps, which would warn that recent stock market weakness could be just the beginning of a larger and more sustainable decline.

I will keep a close eye on this metric in the weeks ahead for an indirect indication of how much more pain stock market investors may have to endure before the sun comes out again.

Putting It All Together

Last week's collapse in Apple, which is positively correlated to both the S&P 500 and Nasdaq 100, warns of more overall market weakness in the near term. This negative bias is supported by rising market volatility amid a flattening yield curve in U.S. Treasuries. This indicates near-term fear by equity investors and intermediate-term economic apprehension by bond investors.

I will closely monitor underlying support levels in the S&P 500 in upcoming weeks to hopefully get an early indication of an emerging market bottom. Until then, Market Outlook readers should remain on the defensive.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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