Market Rallies, But Here's the Problem

All major U.S. indices closed higher last week, led by the downtrodden small-cap Russell 2000, which was up 1.5% but is still down 2.8% year to date. In comparison, the tech-heavy Nasdaq 100 and broad market S&P 500 are up 8.2% and 4.5%, respectively, so far in 2014.

From a sector standpoint, last week's rebound was led by consumer discretionary and materials. My own metric shows that the largest inflow of sector-related investor assets over the past one-week, one-month and three-month periods was, not surprisingly, into consumer discretionary. This not only explains last week's strength in the sector, but also portends continued strength and relative outperformance versus the S&P 500 in the weeks and potentially months ahead.

In last week's Market Outlook , I said that a corrective decline appeared to be getting under way in the broader market due to a significant increase in investor fear, recent weakness in small-cap stocks, and an overextended technology sector, all of which remain intact heading into this week.

Although Friday's sharp rally may have given some new hope to the bulls, a look under the hood shows investor assets did not significantly increase in the SPDR S&P 500 (NYSE: SPY ) and are actually at their lowest level since late May. This means that, despite the Friday hoopla, investors were unwilling to establish new long positions and carry them over the weekend amid what has become a powder keg of geopolitical tensions. Unless investors are willing to start meaningfully increasing their exposure to U.S. equities again, Friday's rebound is likely to be short lived.

'Buy the Dip' Strikes Again

One key reason for Friday's rebound was that many indices and individual stocks were testing major support levels, among them the Dow industrials, which rebounded from their 200-day moving average at 16,349. The first chart shows that the SPDR Dow Jones Industrial Average ( DIA ) simultaneously rebounded from its 200-day moving average at $163.25.

For the past six quarters, within this quantitative-easing-fueled economic environment, investors have been rewarded over and over again for "buying the dip," so this widely watched major trend proxy was an obvious place to at least expect a good bounce in the market, one that may continue this week.

Deeper Correction Coming, or Was That It?

Despite Friday's euphoria, the market remains vulnerable to a deeper decline for all the reasons mentioned above, plus an historically bullish extreme in investor sentiment and a 56-year seasonal tendency for the S&P 500 to decline from the third week of July through the last week of September ( see July 14 Market Outlook ).

One way to determine whether Friday's bounce from support is corrective and likely to be short lived or the resumption of the previous uptrend is by gauging the market's reaction to overhead resistance. The next chart plots the bellwether S&P 500 since May and highlights a band of overhead resistance between 1,949 and 1,959.

This resistance, which represents the July 10 and July 17 lows and the 50% and 61.8% retracements of the decline from the July 24 high, is where Friday's rebound should fail if it was just a minor bounce within a larger, uncompleted corrective decline, which is what my analysis favors heading into this week.

At first glance, Friday's big rebound suggests the pullback from the mid July-highs is over and the larger 2013 advance is resuming. However, a lack of new long positions being initiated in equity index-based ETFs amid declining long-term interest rates warns that Friday's strength may have been more of a Pavlovian "buy the dip" response following six quarters of quantitative easing, rather than a sustainable new commitment by investors.

A significant and sustained rise above 1,949 to 1,959 in the bellwether S&P 500, amid expanding assets in ETFs like SPY, would be necessary to indicate that the larger bullish trend is resuming. Until/unless this materializes, though, my work suggests that the current market pullback is not complete.

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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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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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