This Indicator Warns a Deeper Decline is Coming

Last week, the major U.S. stock indices added to the previous week’s modest losses as investors seem to be wrapping their heads around an inevitable interest rate hike, which many believe will happen before the end of the year.

The small-cap Russell 2000 (-2%) and tech-heavy Nasdaq 100 (-1.2%) led the way down, as they typically do, but the market weakness was broad based. All sectors of the S&P 500 closed lower except for utilities (+1.3%), real estate (+1.2%) and consumer staples (+0.1%). However, if interest rates manage to rise between now and year end, the gains in real estate and utilities are unlikely to last, as rising long-term rates act as a drag on home sales and make Treasuries more competitive for yield-seeking investor dollars.

From an asset flows standpoint, Asbury Research’s own sector ETF-based metric shows that the biggest positive percentage change over the past one-month and three-month periods was in energy.

If this strength continues, it should push the energy sector higher, which would suggest a strengthening global economy and would bode well for higher equity prices overall into 2017.

The Fear Factor

In last week’s Market Outlook, I reviewed the Volatility S&P 500’s (VIX) big influence on market behavior. The “fear index,” as it is sometimes called, has been hovering near historic complacent extremes since July. Although a complacent market may sound like a good thing, it actually acts like an invisible barrier, keeping equity prices from making a sustainable move higher.

After trading as low as 12.21 on Oct. 7, the VIX finished last week at 16.12, above its 50-day moving average. I use the 50-day as an indication of whether volatility is trending toward fear or complacency, and right now it’s trending toward fear.

As long as the VIX remains above its 50-day moving average this week, currently at 13.53, fear is likely to put downward pressure on the S&P 500. However, it would take a big spike to 23 or higher to suggest that the stock market is bottoming. Until then, this metric indicates equity prices are vulnerable to a deeper decline.

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Know Your Overhead Resistance Levels

Now that we know a larger sell-off may be in the cards, the next thing to be aware of is where overhead resistance is. In the chart below, we see a band of overhead resistance in the S&P 500 between 2,155 and 2,165. This represents the 50% and 61.8% Fibonacci retracements of the Aug. 15 to Oct. 13 decline, and the 50-day moving average, a widely watched minor trend proxy.

If the broader market is indeed headed lower this week, then any potential rallies are likely to be capped by this band of resistance. Moreover, it would take a sustained rise above the 2,180 Sept. 22 high to suggest that the recent market pullback is over and that the larger 2016 advance has resumed.

Rising Interest Rates: First Bad, Then Good

Late last week, the yield of the benchmark 10-year Treasury note closed above its 200-day moving average, a widely watched major trend proxy, for the first time since Jan. 6. This suggests the bond market is already starting to price in rising long-term interest rates.

As long as the closing yield remains above 1.75% (the 200-day moving average) to 1.73% (the Sept. 13 closing high), this emerging trend will remain intact. This should also clear the way for a potential rise to the next key overhead level at 1.94% to 1.98%, the March/April closing highs.

At first, the stock market probably won’t like the idea of rising long-term rates, as it means the Federal Reserve will no longer be coming to the rescue every time there is a hint of a weakening economy. However, once the market gets over the initial shock that interest rates won’t remain at 100-year lows forever, rising rates should be positive for stock prices because they indicate that the extremely cautious Federal Reserve is finally confident the U.S. economy can stand on its own.

Commodities Showing Strength

Earlier in this report, I said positive investor asset flows in the energy sector boded well for a strengthening U.S. economy into 2017. We’ve also been seeing strength emerge in commodity prices in general.  

The PowerShares DB Commodity Tracking ETF (NYSE: DBC) seeks to track changes in the level of the DBIQ Optimum Yield Diversified Commodity Index Excess Return Fund, which invests in a portfolio of exchange-traded futures contracts including light sweet crude oil (WTI), gasoline, natural gas, gold, wheat and sugar.

On Sept. 29, DBC broke out from almost three months of sideways investor indecision. The breakout targets a move to $16.20 — 6% above Friday’s close — that will remain valid as long as prices hold above the base of the indecision area at $14.63.

Putting It All Together

A rising VIX portends more near-term stock market weakness this week. If this weakness materializes, then the 2,155 to 2,165 area in the S&P 500 should keep a lid on any rally. 

Bigger picture, however, if we see a continued rise in long-term interest rates and commodity prices, it would suggest a strengthening global economy that would bode well for stocks heading into 2017.