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Two weeks ago, I warned that rising market volatility, a low put/call ratio and June seasonality collectively warned of a near-term pullback. A week later, I said the market was gearing up for a major move with a bias to the downside.
My worst fears were realized on Friday when the much-anticipated Brexit vote shocked global markets as Britain chose to leave the European Union (EU), triggering a massive decline in stocks around the world. It is particularly noteworthy that Friday's collapse pushed all major U.S. indices back into negative territory for the year.
Last week's decline was led by the tech-heavy Nasdaq 100, which lost 2%. And every sector of the S&P 500 finished lower for the week thanks to the one-day market rout. The hardest hit sectors were financial services (-3.3%), materials (-2.5%) and industrials (-2.4%).
The weakness in financial services was directly attributable to the sharp decline in U.S. interest rates, which adversely affects the profitability of lending institutions, as investors flocked to the relative safety of U.S. Treasuries.
A Bearish Resolution to Recent Indecision
In last week's report, I pointed out that the Dow Jones Industrial Average was trading right in the middle of two months' of sideways investor indecision, saying a sustained move through either boundary would signal the bellwether index's next move.
The Dow broke out of this pattern to the downside on Friday, as did the SPDR Dow Jones Industrial Average ETF (NYSE: DIA).
Friday's breakdown confirms a near-term top in DIA at its April high, when it failed to break overhead resistance at its 2015 highs. The breakdown targets a decline to $168.50, 3% below Friday's close, which will remain valid as long as the lower boundary of the indecision area at $175.30 contains as overhead resistance.
Investor Fear Could Spell Opportunity
For months, I have been telling readers the Volatility S&P 500 (VIX) index has been hovering at a complacent extreme near 12, which has historically coincided with or led significant market declines.
That decline reared its ugly head on Friday, and the chart above warns there is more near-term pain to come. The good news is that while complacent extremes typically precede market tops, extremes in investor fear historically lead market bottoms.
The VIX finished last week at 25.76, above the threshold of investor fear at 23 that has previously either coincided with or closely led every significant bottom in the S&P 500.
This chart suggests the market's collapse could lead to a buying opportunity in the weeks ahead, perhaps once DIA meets its $168.50 target.
Moreover, a longtime colleague of mine who holds a PhD in economics believes Britain's upcoming exit from the EU will have a minimal (if any) effect on U.S. GDP. This supports a near-term, fear-induced stock market decline rather than an emerging bear market.
Seasonality Suggests a July Recovery
Seasonality also supports the potential for at least a near-term market rebound. July is the seventh strongest month of the year in the benchmark S&P 500 based on data going back to 1957.
We can see that July represents a significant one-month rebound in the index from June, the second weakest month, before more seasonal weakness emerges in August and September.
US Treasuries: Opportunity or Trap?
Investor grabbed Treasuries on Friday like they were life preservers on a sinking ship, but history suggests long-term interest rates (which move inversely to prices) are probably much closer to a bottom than a top.
The yield of the benchmark 10-year Treasury note finished last week at 1.57%, which is just slightly above its 116-year monthly closing low of 1.55% to 1.51%, reached in July 2012 and November 1945.
This level is clearly a secular inflection point for long-term interest rates and, in my view, not a place that investors should fall in love with bullish positions in long-dated U.S. Treasuries.
Buying Treasuries as a near-term hedge against a deeper stock market decline is still a good idea, as there is currently no indication that Friday's carnage is over. But once a market bottom becomes apparent, investor assets are likely to leave Treasuries just as fast -- if not faster -- than they came in. So, while Treasuries' value as an insurance policy is still intact, history favors a bet on rising rates.
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Putting It All Together
The stock market's vulnerability to a near-term decline, which I have been warning of for weeks, materialized with a vengeance on Friday. The unexpected outcome of the Brexit vote resulted in technical breakdowns in U.S. markets that portend more downside follow through this week.
The potential silver lining is that a big spike in investor fear combined with seasonal factors suggest this weakness may provide a better buying opportunity in the weeks ahead, perhaps after my initial downside target in DIA is met.
Meanwhile, the yield of the 10-year Treasury note is now situated just above 116-year monthly closing lows. I continue to watch this level closely as the potential starting point of a new trend of rising long-term interest rates, which the Federal Reserve has been telegraphing since it ended its quantitative easing program in October 2014.
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