Bears May Wait Till After the Election to Strike

All major U.S. indices finished in negative territory last week, giving back the previous week's modest gains. They were led lower by the small-cap Russell 2000, which lost 2.5%. However, the four "majors" -- the S&P 500, Dow Jones Industrial Average, Nasdaq 100 and Russell 2000 -- are all still up 4% or more for the year.

The key level to watch is underlying support at 2,121 in the S&P 500, which has already been tested and held twice, on Sept. 12 and Oct. 13. A sustained decline below this level would represent a breakdown below the current three-month trading range. It may also clear the way for a deeper sell-off in the weeks ahead.

Last week's strongest sectors were the defensive utilities (1%) and consumer staples (0.8%) groups, while real estate (-3.4%) and health care (-2.8%) were the weakest performers. Real estate was adversely affected by last week's aggressive rise in long-term interest rates, which I will discuss in more detail later in the report.

Market Fails to Rally From Oversold Conditions

One way to determine the health of the market's advance is by watching to see how it reacts to certain indicators and conditions. One of these conditions is short-term oversold extremes as indicated by the 21-day stochastic oscillator.

The green highlight in the middle of the chart shows that the S&P 500 became oversold on a short-term basis on June 27, after which the index immediately bottomed and proceeded higher into the Aug. 15 all-time highs. This is how a healthy bull market reacts to oversold extremes.

The red highlights show that in November and December of last year, the S&P 500 made three shallow bounces from oversold extremes, yet continued to move lower overall into the January lows. This is how a weak market reacts to oversold conditions.

We may be facing a similar situation now, as oversold extremes on Sept. 14 and Oct. 14 triggered shallow bounces from support at S&P 500 2,121, but were unable to fuel a move to fresh highs. This chart warns that a third test of this support level could result in a larger pullback, perhaps below psychological support at 2,100.

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Seasonality Warns of Mid-November Weakness

Now that we've determined that the broader market is vulnerable to a deeper decline, the question is, when? Seasonality could help provide an answer.  

The next chart shows the weekly seasonal pattern for the fourth quarter in the S&P 500 based on data since 1957. According to this, the first, second and fifth weeks of November are some of the strongest of the entire quarter. However, the third and fourth weeks of the month are among the weakest.

So, if we are to see a bigger sell-off in the S&P 500, seasonality tells us it is likely to occur after the Nov. 8 presidential election.

Rising Interest Rates: A Bet on a Strengthening Economy

In the Oct. 17 Market Outlook, I pointed out that the closing yield of the benchmark 10-year Treasury note had recently edged above its 200-day moving average at 1.73%, a widely watched major trend proxy. I said this suggested an emerging trend change toward rising long-term interest rates.

Since then, 10-year yields have risen by 9 basis points to finish last week at 1.86%, their highest level since late May.

This apparent major trend change targets a move to at least 1.94% to 1.98%, which represents the March and April closing yields. 

A significant rise in long-term rates could initially have a negative effect on the stock market, which would fit into the scenario suggested by the previous two charts, as it would suggest that the Federal Reserve is not intending to come to the rescue with more accommodation at the first sign of economic or stock market weakness.  

Bigger picture, however, I view the recent jump in long-term rates as evidence that the historically prescient bond market is betting that the notoriously cautious Fed is serious about raising rates this time. In other words, the central bankers think the economy is finally strong enough to start slowly removing accommodative measures.

Oil Prices at a Decision Point

In last week's Market Outlook, I discussed how OPEC's late-September announcement that it would cut oil production resulted in the emergence of a bullish chart pattern in the PowerShares DB Oil ETF (NYSE: DBO) -- one that targets significantly higher oil prices in the months ahead.

DBO actually reversed lower last week and is now closing in on a test of $8.75, which represents the upper boundary of the big sideways investor indecision area that the ETF broke higher from in early October.

If $8.75 can hold as support this week, the bullish implications of this pattern will remain intact and I will view it as a potential buying opportunity. On the other hand, a sustained declined below $8.75 would indicate that the market has once again changed its mind on the direction of oil prices and would negate my $10.50 target.

Putting It All Together 

The S&P 500's recent inability to sustain a meaningful rally from important underlying support at 2,121, despite ideal conditions in which to do so, is characteristic of a weak market and warns of a deeper decline. And 60 years of seasonality data suggests it could come after the election on Nov. 8.  

Bigger picture, though, and barring any election surprises (such as Donald Trump winning the presidency or the Democrats taking back both the House of Representatives and the Senate), rising long-term interest rates suggests the bond market is betting the U.S. economy can finally stand on its own without any more stimulus from the Federal Reserve. And that confidence should help support a stronger stock market into next year.

[Market Outlook] Why I Can't Stop Talking About The 200-Day Moving Average
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Many investors hold strong opinions about the 200-day MA... but is it actually important?