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Last week, the major U.S. stock indices posted their fourth consecutive weekly gain. The rally was led by the tech-heavy Nasdaq 100, which advanced 1.7%, lifting this market-leading index further into positive territory for the year.
From a sector standpoint, the rally was led by technology (1.8%) and utilities (1.5%), while energy (-1.3%) was the week's big loser.
In last week's report, I warned investors of a potential pullback in stocks in late July due to extremes in investor complacency that were apparent in both the Volatility S&P 500 (VIX) and the CBOE Put/Call Ratio. These extremes indicated historically low market volatility and extremely low put volume relative to call volume. Both of these conditions remain heading into this week, so caution is still warranted.
Watch Semis for Signs of a Pullback
Now that we know the market is vulnerable to a pullback, the next logical question is: Where is the pullback likely to start?
This week's first chart shows the PHLX Semiconductor (SOX) index closing in on a test of formidable overhead resistance at its 751 benchmark high from June 2015. That line is only 1.2% above Friday's close.
Since semiconductors tend to lead the broader market both higher and lower, I am viewing 751 as the potential starting point of an upcoming pullback. A strong bearish reversal from this level over the next week or two would be a solid indication that the decline I'm expecting is materializing.
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How Low Can the Dow Go?
Now that we have determined a market decline of some degree is likely coming -- and soon -- and have identified exactly where to look for signs of early weakness, we need to determine how far the market can fall and still have it be considered just a correction in an otherwise healthy bullish trend.
The next chart shows a bullish chart pattern in the Dow Jones Industrial Average, which I discussed in the July 5 Market Outlook, that targets a move to 20,400 -- about 10% above Friday's close.
We can see the initial breakout in mid-April after about a year of sideways action. In late June, the Dow retested the upper boundary of this indecision area, hitting a post-Brexit low of 17,063. Since then, the index has run to new all-time highs.
For the bullish implications of this pattern to remain intact, a decline in the Dow must be contained by the upper boundary of the indecision area at 17,404 or the 200-day moving average at 17,270. This means the index can theoretically correct as much as 7% from Friday's close without negating the positive longer-term implications of the chart. Conversely, a drop below 17,063 would suggest a meaningful top is in place.
Treasury Prices Vulnerable to a Deeper Decline
In the July 11 Market Outlook, I pointed out a lack of positive investor asset flows during the most recent rise in long-dated U.S. Treasury prices, saying it warned of an upcoming market top. Though I didn't know it at the time, the iShares 20+ Year Treasury Bond (NASDAQ: TLT) had actually peaked on July 8 at $143.62. The ETF then declined by as much as 4.6% into Thursday's lows.
So, was this just a minor pullback within an ongoing uptrend, or the beginning of an even deeper decline in long-dated Treasury prices? I think it's the latter, but for this to be true, benchmark 10-year Treasury yields (which move inversely to prices) must break some formidable overhead resistance.
The next chart shows that, after bottoming at 1.37% on July 5, these yields approached the 1.63% area last week.
The 1.63% level is the beginning of an important band of resistance that extends up to 1.71%, which represents four important closing lows set between February and April. It would take a peak in prices and a sustained rise above the 1.63% to 1.71% area to help confirm that an important bottom is in place in yields. This would also clear the way for a test of the next key area at 1.91% to 1.98%.
Steel Continues to Show Strength
I pointed out an emerging buying opportunity in the VanEck Vectors Steel ETF (NYSE: SLX) in my July 5 report, saying it targeted a move to $33. SLX rose as much as 10.7% to a high of $31.40 on July 18, which is just about 5% shy of our target.
The chart also shows that SLX rose above overhead resistance at the $30.74 April 20 high for several sessions during the past two weeks. This indicates resistance is in the process of being broken. Once prices can hold above it, it should clear the way for a run to my $33 target.
Putting It All Together
For the second consecutive week, we are at historic extremes in investor complacency, which have previously coincided with or closely led most near-term stock market peaks. Readers who have been kicking themselves for missing the move to all-time highs should stop kicking and start being patient, because a better buying opportunity appears to be right around the corner.
I expect a minor correction to begin in the next week or two. As long as this decline does not exceed 17,063 in the Dow industrials, I will view it as a potential new buying opportunity.
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