Stocks Shift To Strength, But Could Quickly Crumble If This Happens

All major U.S. indices finished last week in positive territory, led by the Russell 2000 and Nasdaq 100. As I said in last week’s report, this is always a near-term positive sign for the overall market as small-cap and technology stocks typically lead the S&P 500 both higher and lower.

#-ad_banner-#​Outperformance by these areas of the market indicates that investors are in a “risk on” mode and are willing to buy riskier, more volatile stocks to capture a better return. Last week’s strong performance by the Russell 2000 puts it back into positive territory year to date for the first time since April 4. There, it joins the other major U.S. indexes, led by the Nasdaq 100, which is up 5.6% in 2014. 

From a sector standpoint, last week’s broad market advance was led by industrials (+2.3%), financials (+2.3%) and consumer discretionary (+1.9%). Meanwhile, defensive sectors like health care and consumer staples were relatively weak. 

Recent Breakouts Point to More Near-Term Strength
In the May 27 Market Outlook, I said the rise above 3,617 in the Nasdaq 100 “clears the way for more near-term strength and a potential 2% rise to retest the 3,738 early March high.” The chart below shows that 3,738 was tested and exceeded last week. The index closed on Friday at 3,795 for a 3% gain in the two weeks since that report. 

Former overhead resistance at 3,738 now becomes important support that should contain the index on the downside if its current advance is still intact. 

Just about a month ago, in the May 12 Market Outlook, I pointed out an emerging bullish pattern in the SPDR Dow Jones Industrial Average (NYSE: DIA) and said that “a sustained rise above $165.51 would confirm a breakout from four months of sideways indecision in DIA that would target a 7% advance to $177.” As you can see in the next chart, an updated version of the one from that report, DIA has risen 2%, and the breakout I was expecting has indeed taken place. 

The bullish implications of this pattern remain valid and continue to target an additional 5% rise to $177. That target will remain valid as long as support at $165.50 contains this ETF on the downside. 

…But Keep an Eye on VIX This Week, Just in Case
Recent investor complacency, or little to no fear of an immediate market decline, has helped to propel most major U.S. indexes to fresh 2014 highs this past week. However, too much complacency isn’t good, either, because it leaves investors vulnerable to becoming collectively terrified in a hurry if something bad happens, whether it is economic, geopolitical, or just an unexplained adverse price move. 

You can see this in detail in the next chart, which shows the CBOE Volatility Index, better known as the VIX or the fear gauge. The past four times VIX touched or declined below 12% closely preceded the past four significant declines in the S&P 500. 

It’s important to note that a sub-12% VIX is not a sell signal by itself, but rather an indication that investors are particularly vulnerable to being spooked. Therefore, we would view a sustained rise in the VIX above its 50-day moving average, currently situated at 13.22, as an indication that the marketplace is collectively afraid enough to trigger another minor decline similar to those highlighted on the chart. 

However, as long as VIX stays low, it should help support higher prices over the near term as investors throw caution to the wind.

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Stocks Shift to Strength, But Could Quickly Crumble if This Happens