Market's Advance May be About to Stall

The U.S. stock market resumed its rally last week, following three weeks of mostly sideways price activity within a narrow range. Following a much-better-than-expected July jobs report on Friday, the benchmark S&P 500 powered to a new all-time closing high.

The tech-heavy Nasdaq 100, up 1.3%, and small-cap Russell 2000, up 0.9%, outperformed the broader market S&P 500, which added 0.4% for the week.

At the sector level, last week's advance was led by financial services (2.2%) and technology (1.3%). The traditionally defensive utilities sector was the worst-performing sector, off 2.7%. The common denominator between financials and utilities is that both sectors are heavily influenced by U.S. interest rates. Strengthening financials and weakening utilities are characteristic of a market that's expecting long-term interest rates to rise.

I'll talk about this in more detail later in the report, but before we dig deeper into the interest rate outlook, let's look at what other indicators are saying about likely market movement.

Volatility, Seasonality Still Warn of a Correction

Over the past few weeks, I have stated that near-term downside risk in the stock market exceeds upside potential for a number of reasons, including August and September seasonality (see last week's report) and current extremes in investor complacency as indicated by the Volatility S&P 500 (VIX).

The VIX finished last week at 11.39, while the chart shows that previous forays below 12 have either coincided with or closely led major peaks in the S&P 500 during the past two years.

However, last week provided a couple of positive catalysts that suggest the current advance could potentially extend for another week or two before a pullback takes place.

2 Signs of Strength Could Delay a Pullback

First, on a weekly closing basis, the Nasdaq Composite exceeded its March 2000 tech-bubble high at 5,133 for the first time ever, after spending most of the past year trying to regain last year's highs.  

The more weekly closes above 5,133, the more likely this market-leading index is beginning a new multi-quarter trend higher.

Second, the next chart shows that the CBOE Put/Call Ratio has reached a historic most bearish extreme, indicating relatively few call options are being purchased compared to put options. Similar extremes have previously coincided with most minor bottoms in the S&P 500 during the past year.

Although these two factors could help extend the current rally for a few more weeks, they do not negate the negative implications of the historically low VIX, which I continue to believe will help trigger and fuel a meaningful market pullback later this month.

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More Weakness in Treasury Prices?

In the July 11 Market Outlook, I warned of an emerging market top in long-dated Treasury prices. Though I didn't know it at the time, the iShares 20+ Year Treasury Bond (NYSE: TLT) had actually peaked on July 8 at $143.62. It has since declined by 3.9% to finish last week at $138. Keep in mind that a decline in TLT means a rise in long-term U.S. interest rates.

TLT finished last week right on top of its 50-day moving average, a widely watched minor trend proxy, currently situated at $137.13. A sustained decline below this moving average would signal a bearish change in the minor trend and clear the way for a drop to $132.50, which is 4% below Friday's close.

A bearish trend change fits with the sector-based observation I made at the beginning of this report when I said strength in financials amid weakness in utilities suggested investors are anticipating rising long-term interest rates.

Putting It All Together

Last week's close above the 5,133 tech-bubble high in the market-leading Nasdaq Composite bodes well for more overall strength in the U.S. stock market through the end of the year. In combination with the bearish extreme in the CBOE Put/Call Ratio, it also suggests that the current rally from the late-June lows could potentially extend for another week or two.

However, historic lows in market volatility, especially given bearish August and September seasonality in the S&P 500, continue to suggest that a sustained market advance is unlikely from here without at least a minor pullback first.

Bigger picture, the deeper decline I'm expecting in the iShares 20+ Year Treasury Bond ETF indirectly supports continued strength in stocks through year end, as it suggests an improving U.S. economy and a shift in investor assets out of defensive Treasuries and into more aggressive equities.

Finally, keep a close eye on the VanEck Vectors Steel ETF (NYSE: SLX) this week. It closed Friday up 14% since I first pointed out a buying opportunity in the fund in the July 5 Market Outlook, and just 1.5% away from my $33 target.

[Market Outlook] Why I Can't Stop Talking About The 200-Day Moving Average
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