June 2, 2015
This Obstacle Must be
Overcome to Avoid a Correction
By John Kosar
All major U.S. indices finished lower last week, reversing the previous week's advance (minus the Dow), as the market continues the unusual one week up, one week down pattern that has dominated most of 2015. As a result, the broader market S&P 500 is only up 2.4% almost halfway through the year despite a lot of day-to-day volatility that has frightened investors.
All sectors of the S&P 500 gave up some ground last week, led lower by energy, down 2.3%, and industrials, which lost 1.9%.
My own ETF asset flow-based metric shows that the biggest outflow of investor assets over the past one-week and one-month periods came from energy. This reversed the strong inflows I pointed out earlier this year, which fueled the sector's strength and relative outperformance in March and April. Recent outflows warn of more weakness in energy, at least over the near term.
Bigger picture, however, my metric also shows that the energy sector currently comprises just 14% of all ETF-related sector bets, compared to 20% historically. This indicates that, despite recent weakness, energy is still historically very under-invested amid favorable conditions for more relative outperformance later this year.
Nasdaq Must Exceed 2000 High to Avoid a Correction
In last week's Market Outlook, I said that bullish chart patterns in the market-leading Nasdaq 100 and Russell 2000 indices continued to target an additional 2% to 5% advance. These patterns remain valid heading into this week.
However, standing in the way is formidable overhead resistance at 5,133 in the broader Nasdaq Composite index, which represents it March 2000 tech bubble high. Historic benchmark highs like this one are seldom appreciably and sustainably broken without at least a multiweek decline first, driven by profit-taking. So I am closely watching the market's reaction to 5,133 as a potential trigger for an overdue broader market correction.
The Nasdaq Composite reversed lower from a test of 5,133 last week, trading as high as 5,112 on May 27 before finishing the week at 5,070. The previous failed test of this resistance, on April 27, immediately preceded a 4.5% decline in the index into the May 6 low. The S&P 500 lost 2.7% during that time.
As long as 5,133 is not broken, it has the potential to trigger a broader market decline.
Weakness in Germany Remains a Red Flag
While the Nasdaq Composite continues to negotiate 5,133, the German DAX index -- which has been positively correlated to the S&P 500 for the past 20 years and has outperformed the U.S. broader market index by almost 14 percentage points thus far in 2015 -- continues to look vulnerable.
The DAX declined below its 50-day moving average, a widely watched minor trend proxy, on April 29, confirming a bearish head-and-shoulders chart pattern. It then rebounded to retest the 50-day as resistance on May 26. It failed there and now appears to be headed for the pattern's 11,000 target, which is nearly 4% below Friday's close.
As long as this pattern remains valid by staying below the May 26 high, it warns of the vulnerability to a corresponding pullback in the U.S. markets.
Putting It All Together
With unmet price targets in two key indices (Nasdaq 100 4,600 and Russell 2000 1,320) now 2% to 6% above the market, it is too early for investors to give up on stocks. However, with formidable overhead resistance at 5,133 in the Nasdaq Composite index, amid recent relative weakness in the German DAX, keep an especially close eye on the stock market between now and the end of the second quarter.
Traders should have a defensive plan already in place in case the market significantly reverses direction between now and then.
Editor's note: Profitable Trading's Jared Levy started his career during the dot-com bubble. But unlike the millions of investors who lost their shirts when it burst, he walked away with more than he started.
When the next correction hits, Jared plans to not only survive but make huge profits. If you're interested in putting a plan in place before a correction starts, you should see this.
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