The big question facing investors is whether the 10% correction in RUT and NDX will spill over into the large cap indices, SPX and DJIA.
So far, of course, large caps have not only held up, but made new all-time highs as recently as this week. SPY may only be up 1.5% so far in 2014, but it's still in a rising channel. Below 184 is a break of both this channel as well as critical support over the past 5 months.
It's worth stressing how weak participation was at this week's new high: 83% of SPX companies were not even at a 20 day high and only 7% made a one-year high. The large cap indices are masking significant weakness in individual stocks.
NDX and RUT already broke their channels in early April. Since then, they have been trending downward under their declining 50-dma.
RUT is the weakest. It's threatening to break key support at 1090. For reasons explained here, it will likely head lower in the weeks ahead. The likely minimum target is 1050-60.
NDX is only marginally better. Unless it can regain 3620 resistance and its declining 50-dma, a test of its 200-dma 4% lower lies ahead.
The odds favor SPX also heading to its 200-dma.
For one, RUT recently ended a streak of more than 360 days above its 200-dma, its longest ever. Every prior instance when a long streak in RUT ended has led to SPX also breaking its 200-dma in the weeks ahead (bottom panel).
In a post by Michael Batnick (here), he notes that in the 36 prior times since 2000 that RUT has fallen at least 10%, SPX has subsequently fallen by an average of nearly 13%.
SPX has now gone 372 trading days without a test of its 200-dma. In the next two weeks, this could become the longest streak in the past 50 years, surpassing the streak of 385 days from 1995-96 (data via Charlie Bilello).
Similarly, it has been 17 months since SPX touched its weekly Bollinger bottom. This level corresponds with the 200-dma. At the end of May, this will be the longest streak in recent history. It's in the very tail of the probability bell-curve.
The end of the 1995-96 streak in the chart above culminated with an 11% drop in SPX. A similar drop now would bring SPY to 169, a level at which it traded last summer.
While all of this sounds ominous, it need not be. Look again at the chart above. When each of those streaks ended, SPX consolidated and then started a new leg higher. Your risk/reward following the next break is likely to be very attractive, a point we stressed recently here.
One thing that needs to change before a solid low can be made is investors' complacency. To take just one example, retail investor bears actually fell to the lowest level in 3 months this week, despite the weakness in equities. This is not how durable lows are formed.
The macro outlook in the US remains one of positive yet modest growth (read further on this here). Real retail sales reported a 2% yoy growth this week. This is comparable with the nominal growth in Industrial Production of 3.5% also reported this week.
Inflation, as reflected in core CPI and CPI, is inching up to near 2%. Neither has been much above 2% since 2Q 2012 and both are still low relative to prior bull markets.
So, there is growth, but the economy is not booming. Perhaps the biggest concern is the rest of the world, especially Europe. The Eurozone grew just 0.8% yoy in 1Q. About 40% of the sales of SPX companies comes from ex-US markets, the largest of which is Europe.
Investors wondering why US treasuries have been so strong in 2014 should reflect on competing yields. They have been plummeting. US 10 year yields are relatively high in comparison (chart from Yardeni).
The Week Ahead
The big picture presented above is the most important.
That said, on Friday SPY once again touched and bounced off its 50-dma (186.7). It's 13-ema has not inflected downwards since turning positive on April 16. The intermediate trend is weak, but it's still up.
Holding the 187 area is the short term key. Another touch of the 50-dma, and the odds are that it breaks, probably initiating a move to re-sync with RUT and NDX lower.
The Friday close places SPY right between 189 resistance and 187 support. Its been in this zone for most of the past month. Not a strong short term edge.
RUT is more interesting. The trend is unmistakably down. In the past 8 days, it has touched the 1090 area 5 times. Another touch and it likely breaks. But there is a positive RSI divergence forming, and it's still possible that a back test of the 50-dma (1150) is ahead. Risk (20 points)/reward (50 points) is more than 2:1 positive.
There are two potentially countervailing considerations.
First, volatility has been falling. But what is notable now is (1) the tight Bollinger bands (bottom panel), (2) its proximity to 12, where it has previously moved higher (blue line) and (3) the strong call buying which has in the past marked a low in volatility (second chart, via Chris Prybal). Under similar circumstances (in yellow), SPX has struggled to move higher, and has usually fallen.
On the other hand, a potential positive could come from bonds. On Thursday, TLT closed above its upper Bollinger band. The prior 10 examples are shown in yellow. The next few days (but sometimes more) were generally soft. 115 area is likely to be strong resistance.
30-year yields have now completely unwound the ramp that transpired a year ago. This is an area where yields should find support. Stabilizing bond yields (let alone a reversal) would likely support equities.
The week before the Memorial Day weekend holiday normally starts weak the first 3 days but ends strong. The last week of May continues to be stronger than the rest of the month (chart from Sentimentrader).
Our weekly market summary table follows: