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Friday, August 16, 2013 - 15:11

Market Outlook: Indicator Warns Risk Suddenly Became Very High

Interest rates could be the factor that finally triggers a sell-off in the stock market, and that sell-off could be closer than most traders think.

Interest Rates Can Impact Stocks
In studying the recent market plunge in Japan, I had a feeling that I was missing an indicator that should have warned of the risk. The Nikkei 225 benchmark index fell as much as 14.97% from its high in a week.

I think I found that indicator and was shocked to discover the exact same setup exists in the United States right now. As a trader, it is important to change positions when the facts change, and after months of bullishness, I am moving to a cautious position in the stock market.

In Japan, officials attributed the sell-off to disappointing economic news from China. But news rarely causes an immediate change in the trend of a market. Sell-offs related to news events usually occur when the market is already weak, and Japanese stocks were strong up until that point.

Quantitative easing (QE) is also a popular scapegoat for market action. QE has been used to explain why markets go up even when the fundamentals seem to point toward lower prices. When markets do fall, the decline is often blamed on fear that QE will end.

In Japan, the concern seemed to have been that we might finally be seeing too much QE after a vow from the Bank of Japan to double the money supply in two years. Yet it seems unlikely that QE could be the cause of the decline because, by the time the Japanese stock market sold off, this was old news.

The problem in Japan seems to have been the rapid run-up in interest rates on the 10-year Treasury note. That rate climbed more than 50% in the month before the stock market plunged. Large moves like that in interest rates are unusual. When they do occur, they have been associated with stock market declines in the United States.

In the United States, the interest rate on the 10-year Treasury has risen at an annual rate of 30% or more only four times in the past. Right now, we are seeing the fifth time.

Within weeks of the earlier occurrences, stocks sold off. While the rise in the price of stocks can continue, its days appear to be numbered.

Last week's decline of 1.13% in SPDR S&P 500 (NYSE: SPY) may have been the start of a sell-off.

This indicator points toward a sell-off, not necessarily a bear market. Longer term, we should still see higher prices in SPY, but the rareness of the 10-year interest rate indicator makes it important to consider.

Now does not seem to be a good time to add to stock market positions. It does appear to be a good time to tighten stops.

Action to Take -->
-- Maintain long position in SPY
-- Raise stop-loss to $159.80, below the psychologically important $160 level
-- Maintain price target of $176 by year-end

Gold May Have Found a Short-Term Bottom
SPDR Gold Shares (NYSE: GLD)
ended the week with a 0.12% gain despite a 2.03% decline on Friday. The chart below highlights the changes in sentiment that have occurred in the gold market since the beginning of the year.

In the center of the chart, the black line shows the number of gold futures contracts that hedge funds own. This number has been steadily declining while the commercials (the green line) have been increasing their positions.

At the bottom of the chart, the number of contracts held has been converted to an index that makes it easier to interpret. This index shows what each group of investors is doing with their money. High values show that a group is bullish and increasing their positions in the market. Low values are bearish because the group is decreasing their exposure to the markets.

Commercials, the miners and industrial buyers of gold, are as bullish as they have been at any time in the past six months. Hedge funds (the black line) and small speculators (the red line) have become bearish as prices have fallen.

The extremes in sentiment seen in gold futures are similar to the conditions seen at previous short-term bottoms in gold. For now, this appears to be only a short-term bottom with limited upside potential. Traders should wait for a breakout before taking positions in GLD.

This article originally appeared on
Market Outlook: Indicator Warns Risk Suddenly Became Very High

P.S. -- Worried about another market crash? They appear to be more common than ever during the past 15 years. Here's how to know when the next one could strike...

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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