In The Week Ahead: This Sell-Off May Be Just The Tip Of The Iceberg

In mid-December, I warned that although my intermediate-term outlook (one to two quarters) for the U.S. stock market was bullish, Market Outlook readers should consider adopting defensive strategies to protect assets in the short term.

Following an ill-fated attempt at a Santa Claus rally, the weakness I was afraid of emerged with a vengeance last week. In fact, this year’s nasty stock market decline has already done so much technical damage that it calls my positive intermediate-term bias into question.

‚Äč#-ad_banner-#The S&P 500 collapsed by 122 points, or 6%, to its lowest level since early October, exceeding my initial downside target of 1,965. The market-leading Nasdaq 100 and Russell 2000, which represent the technology and small-cap spaces, fared even worse, declining 7% and 7.9%, respectively.  

From a sector standpoint, last week’s broader market decline was led by financial services, which lost 8.7%. This was driven by a strong shift in investor assets back into the relative safety of U.S. Treasuries, which pushed long-term interest rates lower. Declining long-term interest rates eat into the profits of lending institutions. 

The best-performing sector was utilities, which only lost 0.4%. The decline in long-term rates encouraged investors to take on more credit risk in exchange for the higher yield that these stocks offer.

Retail Sector Breaks Seven-Year Uptrend
In last week’s report, I presented four charts that represent major areas of the U.S. economy — retail, housing, energy and transportation — which are coincident if not leading indications of where the broader market is headed in 2016.

Last week, SPDR S&P Retail ETF (NYSE: XRT) declined below its November 2008 uptrend line, indicating the seven-year bullish trend in the sector is over. This clears the way for a fall to my $40 downside target, derived from XRT’s November breakdown, which is 2.4% below Friday’s close.

XRT Chart

More importantly, given XRT’s positive correlation to the S&P 500, this suggests more near-term weakness in the broader market.

Furthermore, major underlying support levels in the PHLX Housing Sector Index (HGX) and Norfolk Southern (NYSE: NSC), a proxy for the transportation sector, were also broken last week. None of this is good news for equity prices in the first quarter.

Breakdown Spills Over Into Defensive Blue Chips
The problem with major technical breakdowns in key sectors is that they tend to have a domino effect, often triggering similar breakdowns in other sectors. 

The next chart is a great example of this. It shows the blue-chip  collapsed below its March 2009 uptrend line last week.

Dow Jones Industrial Average Chart

This is especially noteworthy because the Dow has been a refuge of sorts for investors since the August collapse. Since stocks bottomed in late August, it significantly outperformed the S&P 500 through year end as investors piled into “safer” stocks to try to stay invested while weathering the correction.  

Last week’s breakdown in the industrials calls the viability of that strategy into question. In an environment where most financial asset prices are going down, investors should go in search of a better alternative.

Will Investor Fear Present An Opportunity?
There is one potential silver lining to last week’s wreckage. The Volatility S&P 500 (VIX) spiked above 20, indicating an extreme in investor fear that has previously coincided with almost every near- to intermediate-term bottom in the S&P 500 since the start of 2014.

VIX Chart

While this could turn out to be positive, I am in no way recommending investors try to catch a falling knife. That’s especially true since the period displayed on the chart above was during a quantitative easing-fueled bull market in U.S. stocks. 

If we are still in a bull market, the VIX says we should see a meaningful bottom emerge in the S&P 500 over the next few weeks. My fear, however, is that based on recent breakdowns in some key ETFs and indices, the market may be beginning a sustainable downtrend.

Investor Assets Fuel Rebound In Gold
In the Dec. 28 Market Outlook, I said it was time to start paying attention to gold because of expanding investor assets in the SPDR Gold Shares (NYSE: GLD). Since then, GLD advanced 2.6% to close at $105.68 on Friday on a continued expansion in these assets.

Last week’s rally took GLD above near-term overhead resistance at the $104.21 Dec. 4 high. This clears the way for more near-term strength and a test of major resistance at the 200-day moving average, currently at $109.27, which sits 3.4% above Friday’s close. 

GLD has been in the midst of a major downtrend, as defined by its 200-day moving average, since 2013. Until it can make a sustainable move above this trendline, the recent strength should be viewed as just another of the many corrective rebounds within its three-year downtrend. 

But in an environment where there is a dearth of asset prices of any kind rising, I see this as a near-term buying opportunity that could potentially evolve into a more intermediate-term advance — especially if global equity prices continue to collapse.

Putting It All Together
In the previous Market Outlook, I said risk averse readers should wait for retail, housing, energy and transportation “to ‘show us’ their resilience before getting too aggressive.”

Last week, we witnessed those four sectors, along with defensive blue chips, break down through major support levels. This confirms the market’s vulnerability to a bigger, more sustainable and, frankly, long overdue decline. In other words, last week may be just the tip of the iceberg.

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This article was originally published on Caution: This Sell-off May be Just the Tip of the Iceberg