Markets

In The Week Ahead: This Crucial Support Line Must Hold To Fend Off The Bear

The major U.S. indices closed sharply lower last week, following a sharp-but-short-lived, two-week broader market rally.

Last week's sell-off was led by the tech-heavy Nasdaq 100, off 6%, and small-cap Russell 2000, down 4.8%. This weakness could be especially problematic since high-beta technology stocks and small caps typically lead the broader market higher and lower.

The only sectors to post meaningful gains were materials, boosted by a strong rebound in gold prices , which I will discuss in more detail in this report, and defensive utilities.

The table below shows that, according to Asbury Research's own metric, the biggest inflow into sector bet-related ETFs over the past one-week, one-month and three-months periods went to utilities, fueling last week's strength in that sector. As long as these positive inflows continue, utilities are likely to remain strong and continue outperforming.

Market At Important Crossroad

Since I warned traders in the Dec. 14 Market Outlook that it was time to adopt defensive strategies to protect assets in the short term, the S&P 500 lost 6.6% through Friday's close.

The decline resulted in a test of important support at 1,821 on Jan. 20, a level I identified in the Jan. 19 report. After this test, the index quickly rebounded to a high of 1,947 on Feb. 1, before relinquishing about half of those gains by the end of last week.

This rebound from underlying support, combined with a number of market indicators I track, collectively indicate that the 1,821 area is where the S&P 500 should stabilize and begin an eventual retest of the May 2015 highs. Of course, that is only if the recent decline was just a correction within a healthy bull market. If the market cannot stabilize at this level, it warns equities are in the midst of an emerging bear market.

Small Caps Vulnerable To More Weakness

The Russell 2000 fell below its March 2009 uptrend line in mid-January, suggesting an end to its seven-year uptrend. The chart also shows a bearish head-and-shoulders pattern, which targets a decline to 880 -- 10.7% below Friday's close.

Russell 2000 Market Outlook Chart

Considering small-cap stocks typically lead the broader market higher and lower, this chart warns that we may indeed be in the early stages of a bear market.

Investor Fear Remains Elevated

In last week's Market Outlook , I suggested readers watch market volatility to see whether investor fear would abate enough to facilitate a sustainable stock market rally. The next chart shows investor fear is still too high.

The Volatility S&P 500 (VIX), a widely watched investor fear gauge, remained above its 50-day moving average, which I use as a baseline to determine when the market is collectively fearful or complacent.

S&P 500 VIX Market Outlook Chart

The VIX has been above its 50-day since Dec. 8, which has coincided with weakness in the S&P 500. History suggests that as long as the VIX remains below this line, currently situated at 20.37, the broader market will remain under pressure.

Declining Interest Rates Are Another Red Flag

Last week, I said the decline in the yield of the 10-year Treasury note below 2% cleared the way for a move to the next key level at 1.85%. This target was essentially met on Friday as yields closed out the week at 1.86%.

TNX Market Outlook Chart

The decline in long-term Treasury yields is a direct result of the recent shift in investor assets out of stocks and into safer Treasury securities, which drives their yields lower. The next key level is 1.68%, the January 2015 closing low, and I will view any further drop in yields as an indirect indication of more weakness in stocks.

Bullish Trend Change In Gold?

Since I first told readers to pay closer attention to gold prices in the Dec. 28 Market Outlook , the SPDR Gold Shares (NYSE: GLD ) is up 9%, closing Friday at $112.32. Last week's strong performance positioned GLD meaningfully above resistance at its 200-day moving average at $108.45 and the November 2014/March 2015 lows around $109.67.

GLD Market Outlook Chart

GLD is now negotiating its next overhead resistance level at the October high of $113.99. A sustained rise above it this week would clear the way for a move to $118, which is 5.1% above Friday's close.

The recent strength could very well be the beginning of a new sustainable bull market in gold prices, so Market Outlook readers should hold any long positions initiated per the late-December report until there is tangible evidence that prices are peaking.

Putting It All Together

If January's sharp decline in the broader market was just a countertrend correction within a healthy bull market, stocks should stabilize and begin to work higher from important support at S&P 500 1,821.

However, weakness in the market-leading Russell 2000, high levels of investor fear and declining long-term interest rates collectively warn that a deeper stock market decline may be imminent. If this happens, readers should consider long-term Treasuries and gold as alternative investments.

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This article was originally published on ProfitableTrading.com:

This Crucial Support Line Must Hold to Fend Off the Bear

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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