Tuesday, March 18, 2014

A Warning Signal From Dow Theory

By John Kosar

All major U.S. stock indices closed lower for the week of March 10, basically giving back all of the previous week's gains. The market was led lower last week by the blue-chip Dow industrials, which lost 2.4%, leaving the Nasdaq and Russell 2000 as the only two major indices that are still in positive territory for 2014, up 1.7% and 1.5%, respectively, year to date. 

U.S. stocks were particularly weak on Thursday, with the S&P 500 suffering its worst day since early February on rising tensions between Ukraine and Russia and concerns about a slowdown in China. Regarding the latter, I am expecting at least an additional 2.2% decline in China's Hang Seng Index to 21,000.

Dow Theory Non-Confirmation Persists

In last week's Market Outlook, I said, "The deeper that we go into 2014 without a confirming new high in the Dow, the more problematic it can eventually become from a Dow Theory standpoint."

As you can see in our first chart, the new 2014 closing high in the Dow transports set on March 7 of 7,592 versus the Jan. 23 high of 7,570 still has not been corroborated by a new high in the Dow industrials -- and last week both indices turned lower.

The longer this non-confirmation between these indices persists, the more likely that it will lead to a broad market correction.

Broader Market Testing Support

Also in last week's report, I pointed out that the S&P 500 was closing in on a quarterly overbought extreme that had previously coincided with or led most of the near-term broad market peaks in recent history. That overbought extreme helped to trigger a 2% decline last week, positioning it just above minor underlying support at 1,829 to 1,814, which is 3% to 4% off the 2014 highs.

The next chart shows that this support represents the S&P 500's 50-day moving average, a widely watched minor trend proxy, and Nov. 29 benchmark high.

If the S&P 500's 2013 advance is still healthy and intact, the 1,829 to 1,814 area should attract enough dip buyers to fuel a new advance to fresh 2014 highs. Conversely, a breakdown below this support would indicate that a correction is under way and would clear the way for a potential decline into major support 7% to 8% off the highs at 1,746 to 1,737, which represents the November and February lows and the 200-day moving average (major trend proxy).

One way to try to anticipate whether or not minor support at 1,829 to 1,814 will hold this week is by continuing to keep a close eye on investor fear via the CBOE Volatility Index (VIX). As I've been saying, a sustained rise above 14.6 could potentially trigger a market decline.

The "fear gauge" subsequently spent Thursday and Friday above 14.6, while the S&P 500 coincidentally collapsed by 27 points, or 1.5%. If VIX stays above 14.9 this week, look for the broader market to remain under near-term pressure.

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