Beware of an Overdue Correction Unless This Happens

All major U.S. indices posted gains last week, led by the tech-heavy Nasdaq 100, up 1.5%, and the small-cap Russell 2000, up 0.5%.

For the year, things don’t look quite as rosy, however, as the broad market S&P 500 is the only major index in positive territory for 2014. Moreover, last week’s outperformance by technology and small-cap stocks must continue to help fuel another leg higher in the broader market’s 2013 advance. If this doesn’t happen, the market is likely to begin an overdue corrective decline.

From a sector standpoint, last week’s advance was led by technology and consumer discretionary, the latter of which has been the weakest sector of 2014 thus far. My own asset flow-based metric shows the largest inflows of investor assets last week went into utilities. Surprisingly, the largest outflows came from technology. If this continues, it should eventually trigger relative sector underperformance in tech as investors reallocate assets into more profitable areas.

Nasdaq 100 Remains Critical to Market Direction

For the third consecutive week, a key area of my focus has been on the Nasdaq 100 as it continues to negotiate important overhead resistance at 3,617. This level was tested and held on Thursday and Friday, and prior to that on April 24, indicating that the market thinks it’s as important as I do. The index finished Friday’s session at 3,588.

This Nasdaq 100 is particularly important to the overall market direction because technology issues tend to lead the S&P 500 both higher and lower.

The 3,617 area is a critical one. It represents the 61.8% Fibonacci retracement of the March 7 to April 15 decline and the 50-day moving average (minor trend proxy). A sustained rise above it is necessary to indicate that the index’s current major uptrend, as defined by its 200-day moving average, has resumed following a correction.

Dow Theory Leaning Toward a Bullish Resolution

In the March 10 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.” Since then, the bellwether S&P 500 is unchanged, which shows how important it is for the Dow Jones Industrial Average and Dow Jones Transportation Average to confirm one another.

Our next chart shows that the Dow industrials finally confirmed the transports’ March 7 new closing high on April 30, by posting a new 2014 high of its own, although just barely. The industrials’ 16,581 close was just 4 points higher than its 16,577 high close on Dec. 31.

Although this technically meets the criteria for bullish confirmation according to Dow Theory, and thus portends more near-term strength in both indices and in the broader U.S. market, it’s a tenuous confirmation at best. I’m looking for a sustained move above 16,577 over the next week or so to support last week’s “signal,” which, should this occur, would clear the way for an additional 6% rise in the Dow industrials to 17,500.

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