Is the Correction Almost Here? 2 Things to Watch For

All major U.S. indices closed lower last week, led by the Russell 2000, which collapsed 4%. This pushed the small-cap index back into negative territory for the year, although all other major indices are still positive for 2014.

Defensive utilities and consumer staples were the only sectors that posted gains last week. This, combined with the collapse in the Russell 2000 — which along with the tech-heavy Nasdaq typically leads the broader market both higher and lower — suggests that investor assets are making a subtle shift into safer places, perhaps in anticipation of an upcoming correction.

Russell 2000 Fails to Make New 2014 Highs

In the June 30 Market Outlook, I pointed out that the Russell 2000 had broken overhead resistance at 1,137, clearing the way for a retest of the 1,213 March 4 high.

The index tested 1,213 resistance as expected on July 1, but immediately failed there and has since collapsed back into underlying support at 1,150 to 1,139, which represents the index’s 50-day (minor trend proxy) and 200-day (major trend proxy) moving averages.

This sets up a near-term decision point for the Russell, from which its November 2012 uptrend should aggressively resume if still valid and intact. Conversely, a collapse below this support could lead to a 7% decline to test the next important support level at 1,083 to 1,079.

Since small caps tend to lead the broader market, I would view a decline below 1,150 to 1,139 this week as a potential early warning of a similar decline in the rest of the U.S. market.

Seasonality: Q3 Only Gets Worse From Here

Last week, I shared an annual seasonality chart for the S&P 500 based on data since 1957. It showed that July is the seventh seasonally strongest month of the year for the index and represents a modest one-month seasonal rebound from June, the second weakest month.

The next chart breaks down seasonality in the S&P 500 into a 13-week quarterly time frame.

The first two weeks of the third quarter, which are the weeks of July 1 and 7 this year, are the two strongest of the quarter, after which the index declines into the end of September. I view this chart as another reason to pay special attention to the Russell 2000′s reaction to 1,150 to 1,139 support this week, as a breakdown below it would corroborate the 57-year seasonal pattern for the broader U.S. market and warn that a deeper and more sustained market decline may be emerging.

Traders Are Starting To Get Nervous

The next chart, which compares the S&P 500 to the CBOE Volatility Index (VIX), is another reason for bulls to consider being a little more defensive-minded this week. In the June 23Market Outlook, I said: “As long as the VIX remains below its 50-day moving average… I expect the current broader market advance to continue.”

The VIX rose completely above its 50-day moving average on Thursday and Friday.

This metric, also known as the fear gauge, indicates that the market is now worried enough about a potential market decline to fuel at least a near-term move lower. The red highlight shows that the most recent incidence of this occurred during early to mid-April. This meaningful move higher by the VIX is especially significant considering the period of weak seasonality the market is heading into.

Last week’s collapse back into major support near 1,140 by the Russell 2000 may be especially significant this week considering that a bearish period of third-quarter seasonality begins in the S&P 500, amid a significant rise in the VIX that indicates investors are starting to get nervous.

If we get a sustained decline below the 1,140 area in the Russell this week with a move above 11.93 in the VIX, investors should consider more aggressively protecting 2014 profits against an overdue stock market correction.

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