Fear Sparks Sell-off, but How Long Will It Last?

After two months of sideways market action, during which I've been warning of a stock market correction, the dam finally broke on Friday.

The decline was led by the small-cap Russell 2000, which lost 2.6% for the week. But the move was broad-based, as all major indices finished more than 2% lower last week.

Depending on what you read, Friday's sell-off was either triggered by institutional bond investor Jeffrey Gundlach of DoubleLine Capital's talk of surprise tightening by the Federal Reserve or Boston Fed President Eric Rosengren stating that it has become increasingly risky to delay an interest rate hike.

In my opinion, though, Friday's collapse was the result of two months of extreme investor complacency, as evidenced by a historically low Volatility S&P 500 (VIX) index (which I began talking about in the July 18 Market Outlook), rather than any particular statement by an influential market voice. In other words, the market has been vulnerable to a scare for months, and last week's remarks by Gundlach and Rosengren were just the trigger to a gun that was loaded and waiting to be fired.

From a sector standpoint, energy was the only sector of the S&P 500 to show a gain for the week (+0.5%). Asbury Research's own metric, which measures investor asset flows in sector ETFs, shows that the biggest inflow of assets over the past one-week and three-month periods went into energy. This was directly responsible for the sector's resilience during last week's market rout.

As long as the inflow of investor assets into energy continues, I expect the sector to continue to outperform.

Fear Finally Grips the Market

In last week's issue, I said a lack of investor fear was keeping the stock market afloat. The VIX had been below its 50-day moving average since June 30, indicating a level of complacency that historically coincided with a sideways-to-higher stock market. But on Friday, the VIX spiked above its 50-day, showing investors were finally fearful of a market decline.

As long as the VIX remains above its 50-day moving average, currently situated at 12.86, I expect Friday's decline to continue on a near-term basis.

In the Aug. 15 Market Outlook, I pointed out that the market-leading Nasdaq 100 (NDX) was testing its 4,816 tech-bubble high. I said, "Before the Nasdaq 100's 16-year high is appreciably broken, the index is vulnerable to a near-term pullback. [This] also warns of a pullback in the broader market S&P 500, which the Nasdaq indices tend to lead."

The next chart shows that the Nasdaq's 4,838 Aug. 15 high actually marked the rally's peak. Since then, the index has declined 3.2% through Friday's close.

The chart also shows that the next significant level of support is located at the 4,574 April 19 high, which is 2.3% below Friday's close. As long as the VIX remains elevated, this level is a reasonable next downside target for this market-leading index.

Mission Accomplished in Texas Instruments

Last week, I advised Market Outlook readers to tighten their stop-losses in Texas Instruments (NASDAQ: TXN) to $68.30 to protect their profits. The stock declined below $68.30 early in Friday's session and closed at $66.67.  

Those who followed my advice should have captured a 7.7% gain since my initial July 11 recommendation, outperforming the S&P 500 by a wide margin.

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Minor Trend Change in Long-Term Bond Prices

In the Aug. 8 Market Outlook, I pointed out that the iShares 20+ Year Treasury Bond (NASDAQ: TLT) was hovering just above its 50-day moving average, a widely watched minor trend proxy. I said a decline below that level would portend more weakness. More recently, in the Aug. 22 issue, I said TLT had been unable to rally from that support and continued to look vulnerable.

The next chart shows TLT's 50-day moving average was finally broken on Thursday and Friday. This breakdown indicates that the 2016 minor uptrend in TLT, as defined by the 50-day moving average, is over.

Last week's collapse also positioned the ETF, which is a proxy for long-dated Treasury prices, right on top of the next important support level -- the February high at $135.25. A sustained decline below this level would suggest more weakness and clear the way for a potential test of the 200-day moving average (a major trend proxy) at $131.29.

Putting It All Together

The stock market pullback I have been warning of for two months finally emerged at the end of last week. As long as market volatility remains elevated, almost 60 years of seasonality data warns that the decline could potentially extend through the end of the month. Statistically, the last week of September is the poorest-performing week of the entire third quarter in the S&P 500.

As I've been saying, though, as long as this emerging decline does not exceed the late-June Brexit lows, it could provide us with a buying opportunity heading into the new year.

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