If there’s any negative side to a sharply rising market, it’s that it doesn’t take much of a downturn to bring the major indices close to breaking beneath their lower trendlines. That’s exactly what’s occurring right now, as the recent selloff has the U.S. market in jeopardy of violating key technical levels.
The S&P 500 Index, while down only less than 5% from its most recent high, closed Wednesday at 1608.90, just above the 1600 level that would signal a break of its current uptrend.
Midcap stocks and global equities are in a similar location as the S&P, while small-caps have slightly further to go. With so many indices at critical chart positions, investors need to consider three key questions regarding the near- and intermediate-term outlook.
First is whether or not the markets will break through these trendlines, and if so, whether that will lead to even worse downside.
In the very short-term, a sharp downturn appears unlikely even though any technical violation would receive plenty of attention as the week draws to a close. The reason stocks might hold here is that the market has come so far, so fast, that it hasn’t taken much of a downturn for it to become technically oversold.
The S&P 500, for instance, traded beneath its lower Bollinger band on Wednesday — a sign of unusually high selling pressure that has precipitated meaningful rebounds every time it has occurred throughout the current rally. As long as the indices remain below their bands, be careful not to overplay your hand betting on additional downside.
The second question is how far the markets can fall if a breakdown does in fact occur. The short answer: quite a bit.
The next stop, based on the trendline formed by the lows of 2011 and 2011, is 1477 on the S&P — about 7.7% from here. Below that is the longer-term trendline that goes back to the low of March 2009, which currently terminates at 1344 — about 16% below current levels. Declines of this magnitude would represent fairly standard corrections from a historical standpoint, but after the one-way market of the past year, they would certainly feel much worse.
Still, these levels serve as clear reference points if stocks continue to weaken from here.
Finally, many investors will want to know whether any other markets are in a position to provide an early warning of whether stocks will hold or break down. The answer, most likely, lies in the yen. The run-up in stocks coincided with the weakening of the yen in the first four-plus months of the year — and their subsequent weakness — has occurred as the yen has regained its footing.
The chart below shows that the yen is on the verge of breaking out of its downtrend. How the Japanese currency performs in relation to this resistance line is likely to tell us quite a bit about what’s in store for U.S. equities in the days and weeks ahead.
One last note: Keep an eye on investment-grade and high-yield corporate bonds in the days ahead. These groups have fallen hard in recent weeks, and both markets are seen as being driven by “smarter” money than equities. If stocks do indeed bounce, watch for a confirmation from these two asset classes. If credit remains under pressure, any bounce in equities is likely to prove short-lived.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.