In The Week Ahead: Surprise Reversal Could Change Market's Technical Bias

Last week, the major U.S. stock indices closed in positive territory for the second consecutive week. Once again, they were led by the small-cap Russell 2000 and tech-heavy Nasdaq 100, which both gained 3.4% for the week.

As I have stated in this space on numerous occasions, technology and, to a lesser degree, small caps, typically lead the broader market both higher and lower. So, the quality of the recent rally is encouraging.

Another encouraging sign is that all sectors of the S&P 500 finished in positive territory last week. After technology, financials were the best-performing sector. Financial stocks are a direct beneficiary of the sharp rise in long-term interest rates following the minutes of the April 26-27 Federal Open Market Committee meeting.

Ironically, the recent rise in interest rates -- which the stock market has lived in fear of since the Federal Reserve's quantitative easing program came to an end in October 2014 -- may have helped fuel the current stock market rally. Investors now seem to be taking rising rates as an indication that the extremely cautious Fed is finally growing more confident in the U.S. economy.

Dow's Bearish Pattern Now In Question

In last week's Market Outlook , I pointed out an emerging bearish head-and-shoulders chart pattern in the bellwether Dow Jones Industrial Average that targeted a decline to 17,000. It also suggested a significant top was put into place on April 20 by the failed test of the June and July 2015 highs.

But what a difference a week makes. Last week, the Dow moved back above its 50-day moving average, a widely watched minor trend proxy, calling the bearish implications of the May 12 breakdown into question.

If the Dow can clear the May 10 high at 17,935, which is just over 60 points above Friday's close, it would negate the bearish implications of the head-and-shoulders pattern, indicating the February advance has resumed. This would set the index up for a retest of resistance at 17,902 to 17,978.

A Tale Of Two Patterns

Meanwhile, the Dow's bullish reversal also resulted in an emerging bullish pattern on the weekly chart with more intermediate-term positive implications.

In late April, the Dow rose out of a year of sideways investor indecision, suggesting the larger 2009 advance was resuming. The key to maintaining the pattern's bullish implications is the Dow's ability to remain above the upper boundary at 17,530.

Back on May 19, this was very much in question, as the Dow hit a low of 17,331. However, as of Friday's close, the pattern has come back into serious consideration.

Following the successful retest, as long as 17,530 holds as support, the pattern targets a move to 20,400, which is 14% above Friday's close.

Abating Investor Fear Supports More Strength

A key reason for last week's stock market rally was subsiding investor fear. Ironically, the Volatility S&P 500 (VIX) began declining the day after the release of the hawkish FOMC meeting minutes.

At the end of last week, the VIX collapsed back below its 50-day moving average, which I use as a baseline to determine investor complacency or fear. The next chart shows that the last time the VIX spent a significant amount of time below its 50-day helped trigger and fuel the mid-February to mid-May advance in the benchmark S&P 500.

But, as I've said before, too much investor complacency isn't a good thing for stocks either. Specifically, declines to 12 in the VIX have historically either coincided with or closely led near-term stock market peaks. For now, though, last week's decline below the 50-day moving average, currently situated at 14.53, should be a positive for stocks.

Oil Bulls Should Lock In Some Profits

In the May 2 Market Outlook , I said a meaningful bottom was emerging in West Texas Intermediate ( WTI ) crude oil. Since then, oil prices have risen by more than 7%.

While I continue to believe that oil prices have bottomed and there may be more upside in store later this year, Market Outlook readers that bought oil-related assets a month ago based on my analysis should consider taking some profits off the table.

The sharp rise in oil prices last month has positioned them right at the $49.45 October 2015 closing high.

Considering the technically overbought conditions and multiyear bullish extremes in investor sentiment metrics I track, a break of $49.45 resistance is unlikely without at least a multiweek corrective decline first.

Putting It All Together

The single-most influential piece of economic data this month looks to have been the May 18 release of the April FOMC meeting minutes. The Fed's hawkish tone appears to have triggered a quick and significant rise in long-term U.S. interest rates, as well as an unexpected rebound in the stock market.

If stocks continue to move higher, this will mark a complete reversal in the technical bias of the bellwether Dow industrials. And if the index remains above critical support at 17,530, it will target an eventual rise to 20,400.

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Surprise Reversal Could Change Market's Technical Bias

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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