How Much Higher Can Stocks Go Before a Correction?

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After a one-week breather, the U.S. stock market resumed its post-election romp last week, with many indices setting new all-time highs. The rally was led by the small-cap Russell 2000 (5.6%) and tech-heavy Nasdaq 100 (3.3%).  

The advance was driven by expectations that a Trump presidency will be extremely favorable to U.S. businesses, with the loosening of government regulations and dismantling of Dodd-Frank being two expected changes.

Last week's rally was about as broad-based as they come. Every sector of the S&P 500 ended the week deep in positive territory, led by financials (4.9%), technology (4.2%) and real estate (3.8%).  

Dow Industrials Closing In on 20,400 Target

In last week's Market Outlook, I displayed three charts that warned of a market pullback by mid-December. However, the post-election feeding frenzy in the stock market resumed last week, and the S&P 500 rallied 3.1%, making a series of new all-time highs.

At Friday's close, the Dow Jones Industrial Average was just 3% below my 20,400 upside target, which I first mentioned in the July 5 Market Outlook. Meanwhile, the calendar is closing in on the year-end window dressing period, also known as the Santa Claus rally.

This suggests the post-election rally could extend a bit further to my 20,400 target, and then start a seasonal decline.  

The next chart plots the seasonal pattern in the S&P 500 since 1957. It shows December is the second strongest month of the year, advancing 1.46% on average, while posting a positive monthly close 73% of the time -- the highest of any month.

Recall that at the end of last year, the S&P 500 peaked on Dec. 29, and then proceeded to decline 13% into the February lows. We could see a similar situation this year.

Low Volatility Remains a Red Flag

Another reason I don't expect the market to take off to the upside from here is low market volatility. The Volatility S&P 500 (VIX) has been hovering near 12 since mid-November, a level that marks a historically complacent extreme. Similar instances have either coincided with or closely led every near-term peak in the S&P 500 since April.

So, although the market could potentially extend its gains a bit further, both seasonality and volatility suggest a sustainable market advance is unlikely to emerge without a meaningful pullback first.

Treasury Bond Yields Peaking?

In the Nov. 21 Market Outlook, I pointed out that the yield on the benchmark 10-year Treasury note was testing formidable resistance at 2.36%. Considering it had risen nearly 80 basis points since the end of September, I said this was a likely place to expect some backing and filling.  

But yields continued to move even higher and are now testing the next key overhead level at 2.5%, which represents the June 2015 high and October 2013 low.

Although the current position well above the 200-day moving average indicates the major trend in long-term U.S. interest rates is up, nearly vertical rises such as this are atypical and usually followed by an equally sharp decline to put the market back in balance. 

So, even though I expect rates to move even higher during 2017, I think we could see a correction in yields begin around 2.5% or 2.63%, which would mean a corresponding rebound in long-dated Treasury prices.

Silver's Breakdown Points to More Weakness in Precious Metals

In the Nov. 28 report, I pointed out an emerging breakdown in SPDR Gold Shares (NYSE: GLD), which targeted a 7% decline to $104.50. GLD has since declined 2% and appears to be on its way to reaching my target, perhaps by early next year.

The next chart shows that a similar breakdown occurred in iShares Silver Trust (NYSE: SLV). On Nov. 10, shares broke below their 200-day moving average, a widely watched major trend proxy, validating a bearish head-and-shoulder pattern. This pattern targets a drop to $13, which is 19% below Friday's close and would essentially be a retest of the January lows.

The negative implications of the pattern will remain valid as long as the 200-day moving average, currently situated at $16.81, loosely contains the ETF as overhead resistance.

Gold and silver prices have historically been positively correlated to one another, so I view the breakdown in SLV as corroborating evidence that gold prices are headed lower.

Putting It All Together 

The bullish chart pattern in the bellwether Dow industrials, market volatility and 60 years of seasonality data in the S&P 500 suggest the potential for an additional 3% rise in the Dow between now and early January, followed by an overdue correction. 

A pullback in stocks would likely be accompanied by a decline in the yield of the 10-year Treasury note, as investor assets move from stocks back to the relative safety of U.S. bonds, driving yields lower.

Meanwhile, I expect the recent weakness in precious metals to continue, which should extend the current rise in the U.S. dollar.

[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?