Why Traders Should be Extra Cautious This Week

The major U.S. stock indices staged a very modest recovery last week. The fact that it was led by the tech-heavy Nasdaq 100, which rose 0.9%, is encouraging. However, historically low volatility, overly bullish investor sentiment and late-October seasonality warn that the market may not be out of the woods yet.

Except for consumer staples (-0.3%) and industrials (-0.4%), all sectors of the S&P 500 finished in positive territory last week, led by materials (+1.6%) and financials (+1.2%).

Bigger picture, Asbury Research's sector ETF-based metric shows that the biggest positive percentage change in investor asset flows in the past one-month and three-month periods went into the energy sector, which is seen by many as a global economic barometer. 

Investors Still Too Complacent

Although I would love to show Market Outlook readers a different set of market metrics each week, my primary objective is to cover what I believe to be the most influential indicators to stock market direction at any given time. Given that criterion, market volatility remains at the top of the list. 

The Volatility S&P 500 (VIX) index has been rising from a complacent extreme of 12 and closed last week at 13.34, slightly below its 50‐day moving average at 13.83. A move above the 50-day would be evidence that investors are shifting from complacency to fear.

As long as the VIX remains near 12, history suggests the S&P 500's upside is limited. So, even if the market gains this week, keep a close eye on this metric. If the VIX starts bumping up against 12 again, it will suggest another near-term market top similar to those highlighted on the chart above.

Beware of Seasonal Weakness

In addition to low volatility, 60 years of seasonality data warns of the stock market's vulnerability to a decline into the end of the month.  

The next chart plots the weekly seasonal pattern for the fourth quarter in the S&P 500 based on data since 1957. The final week of October is historically the second weakest of the entire quarter, after which the index tends to strengthen into year end.

I view this chart as another reason not to chase a rally in stocks, at least not until we see the VIX move off complacent extremes and the calendar roll into the much more market-friendly month of November.

Long-Term Interest Rates at Major Inflection Point

In last week's Market Outlook, I pointed out that the closing yield of the benchmark 10-year Treasury note had edged above its 200-day moving average, a widely watched major trend proxy, for the first time since Jan. 6. I said this suggested an emerging trend change toward rising long-term interest rates.

The yield on the 10-year finished last week at 1.74%, just above its 200-day moving average at 1.73%.

The chart below displays this major decision point with the iShares 20+ Year Treasury Bond (NASDAQ: TLT), whose price moves inversely to yields. TLT is currently negotiating major underlying support at the 200-day moving average at $133.26 to the June 23 low at $132.08.

A sustained breakdown below $132.08 would be necessary to confirm a major bearish trend change, which would clear the way for a deeper decline, perhaps down to the $127.25 April 26 low.  

It's likely such a decline would coincide with or lead a sustained rise in 10-year yields above 1.73%, and potentially a test of the next key level at 1.94% to 1.98%.

Big Reversal Points to Strength in Oil Prices in Q4

In the Oct. 3 Market Outlook, I noted OPEC's announcement that it planned to lower oil production by up to 700,000 barrels per day caused a dramatic bullish reversal in oil prices.

Since then, the breakdown in the PowerShares DB Oil ETF (NYSE: DBO) that I highlighted in the Sept. 19 Market Outlook has evolved into a bullish chart pattern that targets significantly higher prices in the months ahead.

The recent breakout from roughly four months of sideways investor indecision targets a rise to $10.50, which is about 13% above Friday's close. This target will remain valid as long as the approximate midpoint of the indecision area at $8.87 loosely contains prices on the downside as underlying support.

Putting It All Together 

Several factors collectively suggest a rising stock market into early next year. These include November and December seasonality, strengthening oil prices and rising long-term interest rates, plus a bullish chart pattern in the Dow Jones Industrial Average, as shown in the Sept. 6 Market Outlook.

Near term, however, low volatility plus late-October seasonality warn of the market's vulnerability to a minor pullback. If this occurs, I am looking for it to begin near minor overhead resistance at S&P 500 2,155 to 2,165 and potentially provide an even better intermediate-term buying opportunity.

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[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?