In The Week Ahead: Time To Put A Defensive Plan In Place

After five weeks of consecutive gains, the major U.S. stock indices closed in the red last week. They were led lower by the Russell 2000, which declined 2%.

In the March 14 Market Outlook , I said that a chart pattern in the Russell 2000 targeted an eventual 19% decline to 880 as long as the 1,096 area loosely held as overhead resistance. The small-cap index traded as high as 1,104 on March 21 before closing at 1,080 on Friday. As long as resistance continues to contain on the upside, my 880 target remains valid.

Every sector of the S&P 500 finished in negative territory last week except for health care, which gained 1.6%. This was the reverse of the previous week, which saw all sectors finish higher except for health care.

Asbury Research's proprietary metric shows that the biggest sector-related inflows of investor assets over the past month went into energy and technology, which are up 2.5% and 1.8%, respectively, for the year. As long as these two sectors continue to attract investor assets from other sectors, they are likely to outperform the S&P 500 in the weeks and potentially months ahead.

Focus On Technology This Week

In last week's report , I mentioned declining long-term interest rates would indicate the forward-looking bond market is getting nervous. Specifically, I said that if the yield of the 10-year Treasury note remained below 2%, it could be a precursor to a stock market decline in the second quarter.

After closing as high as 1.98% on March 11, yields quickly reversed lower, finishing last week at 1.91%.

I also pointed out last week that the next overhead resistance level in the benchmark S&P 500 was 1.6% above the market at 2,082. The chart below shows a similarly important resistance level in the tech-heavy Nasdaq 100 is much closer. Along with the Russell 2000, the Nasdaq 100 tends to lead the S&P 500 both higher and lower.

The Nasdaq 100 finished last week at 4,406, just below a formidable band of overhead resistance at 4,415 to 4,486. This band represents the 61.8% Fibonacci retracement of the index's Dec. 2 through Feb. 8 decline, the 200-day moving average and the Nov. 16 low. According to retracement theory, 61.8% is the most that a market decline should be retraced if it is just a countertrend rebound within a larger move lower.

Although resistance at 2,082 in the S&P 500 remains important, Market Outlook readers should pay special attention to resistance on the Nasdaq 100 this week. If the stock market is indeed about to begin another decline, as my analysis suggests, it is likely to be led lower by technology stocks. Thus, this resistance area would be a logical place for such a decline to begin.

Bad Things Can Happen When Investors Are Complacent

Evidence of an emerging near-term market top can also be seen in sentiment indicators. They are showing complacency, indicating investors are pretty comfortable being long stocks and do not see any imminent danger. History suggests this is precisely when investors should be the most afraid.

The next chart shows the S&P 500 and the CBOE Put/Call Ratio (five-day moving average, inverse scale), a widely watched barometer of market sentiment. It is currently retracting from a least bearish extreme -- i.e., a relatively small amount of put volume versus call volume.

The CBOE Put/Call Ratio is a contrary indicator. As we can see, such extremes have coincided with or closely led every significant peak in the S&P 500 over the past year. This metric warns of the market's vulnerability to another decline now, potentially from overhead resistance at 4,415 to 4,486 on the Nasdaq 100.

Another measure of investor fear, the Volatility S&P 500 (VIX), is also hovering near a historic complacent extreme.

These two charts show investors are in a relaxed state from which they can quickly become fearful and liquidate equity positions.

Oil Prices Pose Another Potential Problem for Stocks

Two weeks ago , I pointed out that West Texas Intermediate ( WTI ) crude oil prices were testing formidable overhead resistance at $38.25 per barrel, saying this was particularly important because of oil's positive correlation to the S&P 500 since October.

This resistance level was broken as oil prices ran to a closing high of $41.57 on March 21 before backing off a bit to finish last week at $39.78.

Major overhead resistance levels like this one are seldom meaningfully broken without at least a corrective decline triggered by liquidations of long positions that lasts several weeks. I would view any further weakness in crude oil from this critical level as an indirect warning of upcoming weakness in the stock market.

Putting It All Together

Heading into this week, there was no clear confirmation that a meaningful stock market peak is in place. There are, however, a growing number of reasons for investors to be careful and to have a defensive plan in place should things turn south.

Watch the market-leading Nasdaq 100's reaction to overhead resistance near 4,420 this week. A bearish reversal from this area -- especially on a rise in the CBOE Put/Call Ratio and/or the VIX amid declining oil prices -- would warn that the stock market decline I've been expecting all year is getting under way.

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Time to Put a Defensive Plan in Place

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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