For the past couple of weeks, I’ve cautioned readers about the strong possibility of a pullback in the market.

At the end of last week, we saw that pullback I’ve been expecting.

Now, the question is whether that pullback was the beginning of an extended decline or part of a small retracement.

To answer that question, let’s start by looking at the price of the SPDR S&P 500 ETF (NYSE: SPY) with Fibonacci targets.

Source: Symbolik

Last week’s high was right at the Fibonacci projection from the low. The chart also shows that the advance stalled at other projected levels. This is notable because many traders watch Fibonacci levels. I’ve noted before that these numbers are important solely because they are easy to draw on charts and are widely followed by technical traders.

Because they are widely followed, we could see support near $327.50 on SPY, the 1.50 line that served as resistance during the advance. That’s about 4.4% below Friday’s close.

The next chart looks at momentum and shows that SPY is likely to hit that downside target. Momentum is shown at the bottom of the chart with an indicator that displays the relative strength index (RSI) in a MACD style.

The advantage of this version of RSI is that it provides tradable information with few whipsaw trades.

RSI is a popular indicator, but it rarely provides trade signals. Because of that, traders look for divergence patterns, trendline breaks, and other subjective signals that tend to be unreliable. Using the conversion above provides useful and objective information. Rapid reversals in the indicator are possible, but rare.

It All Goes Back To The Fed

This all tells me we should expect additional weakness in the index. That opinion is reinforced by the actions of the Federal Reserve.

Much of the rally that started in March was fueled by Fed policy. Fed policy, like the RSI, is often interpreted in a subjective manner. For example, analysts listen to speeches and assess how bullish or bearish the statements are. The chart below provides an objective evaluation of Fed policy.

Source: Optuma

The indicator at the bottom of the chart is the 13-week rate of change (ROC) of M2, a broad measure of money supply. Thirteen weeks is about three months and is used to identify the short-term effects of Fed policy.

The dashed line is set at 2%. The green bars in the upper part of the chart highlight periods when the ROC exceeds 2%. The black line is the price of SPY.

The Fed rarely increases M2 by more than 2% a quarter. When it does, the purpose is to combat economic weakness. When we saw ROC exceed 2% in the second half of 2019, there was a growing concern that the risk of recession was rising, and the Fed was responding to that risk with easy monetary policy.

Last week, for the first time since March, the ROC of M2 dropped below 2%. Unless the Fed reverses course, monetary policy is not extremely bullish.

The Takeaway

We started this week with nervous investors, bearish momentum, and a neutral Fed policy. That’s much different than the bullish conditions traders enjoyed in the past few months. Additional downside is likely even if we see a brief rally as inexperienced investors rush to buy the dip.

For the rest of us, it’s still okay to trade in this market, but caution is warranted. And it helps to have someone like my colleague Jim Fink in your corner to help you navigate the landscape…

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