In The Week Ahead: This Market Needs a Good Scare

John Kosar's picture

Monday, October 10, 2016 - 3:00pm

by John Kosar

The S&P 500 continues to trade within a relatively narrow four-month range, as investors await indication of when the Federal Reserve's next interest rate hike will be and who will win the presidential election in November.

The major U.S. stock indices closed only slightly lower last week, led down by the small-cap Russell 2000, which lost 1.2%. But a sector breakdown looks much worse, with every sector of the S&P 500 finishing the week in negative territory except for financials and energy.

The strength in financials was directly attributable to a big jump in long-term interest rates. The yield of the benchmark 10-year Treasury note jumped from 1.56% on Sept. 27 to 1.75% on Oct. 6 -- a 19-basis-point rise in just seven trading days. This move was apparently triggered by Fed Chair Janet Yellen's semiannual testimony to the House Financial Services Committee, in which she said she expects the unemployment rate to move even lower but will not hold interest rates low for much longer. 

Fear Continues to Act as an Invisible Lid on the Market
I try to bring different charts and metrics into Market Outlook each week so it can be a learning tool as well as a good source of market analysis. But sometimes the importance of one particular metric overrides everything else. That has been the case lately with the Volatility S&P 500 (VIX). 

The VIX finished last week at 13.48 after trading as low as 12.21 intraday on Friday. The chart below shows that a VIX near 12 has closely coincided with every near-term peak in the S&P 500 this year. This was especially evident in August when the VIX's Aug. 9 low of 11.02 preceded the S&P 500's Aug. 15 all-time high.

 

History continues to suggest that a sustainable move to new all-time highs in the S&P 500 is very unlikely without at least a near-term decline first. Ideally, this pullback will take the VIX far enough above 12 to provide a little room to run for the bull market's next leg higher.

Fedspeak Triggers a Jump in Long-Term Rates
I mentioned earlier that some perceived "hawkishness" (i.e., talk of raising interest rates) by Yellen on Sept. 28 resulted in a quick about-face in long-term interest rates.

 
 

This has positioned the yield of the 10-year Treasury note just below its 200-day moving average at 1.76%. This major trend proxy has closely defined the major trend in benchmark interest rates for the past decade. So, what the 10-year does from here will be seen as a key indication of whether the 2016 trend of declining long-term rates is still intact, or if a new major trend toward rising rates is emerging.

My personal view is that higher rates are coming between now and year end, but it would take a sustained rise above 1.76% to clear the way for a move to the next key level at 1.94% to 1.98%, which represents the March and April closing highs.

Rising Rates Bad for Utilities
The rise in long-term interest rates has had an immediate and tangible effect on utility stocks. 

When long-term rates are low, as they have been for most of this year, the utilities sector typically outperforms the S&P 500 because yield-seeking investors are willing to tolerate the additional risk for a better yield. Conversely, when long-term rates rise, those same investors jump back into less risky Treasuries.

This appeared to be the catalyst for the recent collapse in Duke Energy (NYSE: DUK), which I mentioned in the Sept. 26 Market Outlook as a potential opportunity in a dull stock market that was accompanied by low interest rates.

 

 
After testing and holding underlying support at its 200-day moving average on Sept. 9, DUK aggressively rebounded before collapsing back below that average as long-term interest rates spiked higher.

DUK is likely to rebound again if the 1.76% level contains 10-year yields on the upside. But last week's breakdown below the 200-day moving average warns of an emerging bearish trend change in the stock and lends more weight to my expectations for even higher interest rates into year end.

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Gold Meets Initial Downside Target
In the Aug. 15 Market Outlook, I said gold prices appeared to be topping and targeted a 3.7% decline to $122.75 in the SPDR Gold Shares (NYSE: GLD). That target was met on Oct. 4, and GLD continued lower to finish the week at $119.74 -- just below its 200-day moving average.

I view this test of the 200-day moving average as a major decision point for gold prices, from which their 2016 advance must resume if still valid. It also looks like a potential new buying opportunity, so stay tuned.
Also note that my $17.70 downside target for silver futures, which I discussed in the Aug. 22 report, was also met last week, representing a more than 8% decline in about six weeks. 

Putting It All Together 
History suggests that the low VIX is likely to put a near-term ceiling on the stock market. The only way to remedy this is with a market scare of some kind that temporarily pushes volatility higher. In this environment, that could be anything from rising interest rates to a surprise in the upcoming presidential election to some saber rattling in any number of hot spots around the world. 

In the bigger picture, however, I will view the next meaningful market pullback as a potential intermediate-term buying opportunity that could carry us into 2017.

This article was originally published on Profitable Trading: This Market Needs a Good Scare.

 

John Kosar 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.