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Is a Bigger Selloff in Stocks Ahead?

Jul 23, 2012
Ron DeLegge

Compared to global markets, U.S. stocks have been resilient and are still holding onto yearly gains. Many of Wall Street's strategist now recommend overweighting U.S. stocks. But is a bigger selloff coming?

A decline in global stocks triggered a brief selloff in the U.S. stock market, but stocks came roaring back. The S&P 500 recovered from intraday losses of1.8% and the Dow Jones Industrial Average and Nasaq (Nasdaq: ^IXIC) followed suit.  

How much longer can U.S. stocks defy gravity? Is a larger selloff still looming?

When the VIX talks… 
The VIX is the stock market’s main fear indicator. High readings indicate fear, whereas low readings indicate complacency. Over the past week, the VIX (^VIX) has spiked from under 16 to a 7/23 intraday high above 20. And although the VIX is still not at extreme levels, it’s not necessarily good news for the stock market.

In 2008 and 2012 a peaking VIX did not coincide with a bottom in the S&P 500 (SNP: ^GSPC). The S&P bottom actually happened against a lower VIX reading. 

The ETF Profit Strategy Newsletter, recognized this phenomenon, but still warned:

“Everytime the VIX has fallen below the $16 level, market tops (some significant) were usually right around the corner.  There was one early signal in late 2010 that took a little bit longer to confirm a top than others, but there were 8 other occurrences that have all marked some sort of short term or intermediate top.”

Sector Fatigue
A gander at the performance of stock industry sectors often gives clues about where the broader market is heading. The Financial Select Sector SPDR (NYSEArca: XLF) and KBW Bank ETF (NYSEArca: KBE) are among top performing sectors year-to-date, but have recently begun to trend down.

In early May, the Financial Sector SPDR (XLF) broke down from its uptrend, but still showed relative strength on par with the market. Then in mid-May when XLF’s relative strength broke down and the XLF was underperforming the S&P 500, the market also broke down from its sideways consolidation confirming a trend change and a sell signal.

Since early June, the financials are still barely in an uptrend and their relative strength has broken down hard. The breakdown in relative strength has bigger implications for the broader market. The ETF Strategy updated noted, when leading industry sectors start to waver, watch out below.


Beware of Hidden Erosion
In geographic regions with fault lines, hidden erosion can cause irreparable damage to structures built on or near them. In financial markets, when an investor or trader isn’t aware of the market’s hidden erosion, it can cost them dearly.

On the day the Dow Industrial (NYSEArca: DIA) peaked in January 2000, 55% of NYSE-listed stocks were already down more than 20%. The day the Dow peaked in October 2007, 27% of NYSE-listed stocks were already down more than 20%.

On May 1, 2012, when the Dow hit 13,339, 30% of NYSE-listed stocks were already down more than 20%. In other words, the market may erode unrecognized in plain sight.

The "tipping point" (the point where stocks start falling hard) almost always coincides with a break below key support. The May 2 ETF Profit Strategy update identified key support at 1,387 - 1,393 and warned that a: "Move below 1,386 will be a sell (as in go short) signal." The S&P closed down 10 of 12 days once the sell signal triggered.

The ETF Profit Strategy Newsletter identifies important support/resistance levels and combines them with common sense technical analysis to provide a short, mid and long-term forecast along with actionable buy/sell recommendations. This helps investors to avoid the hidden erosion within the market by capitalizing on the trend.

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