Stocks Get Burned by Bond Meltdown

Last week's rout caused some short-term technical damage to the S&P 500 chart, and there could be some limited downside for the index

Stocks got smacked for the first time since late February last week, as long-term Treasury yields jumped over 5%, surging to their highest level since July, 2006. After finally posting an all-time high, the S&P 500 apparently didn't like the rarefied air above 1527.46, and had its worst three-day drop since late February.

We did see some short-term technical damage to the S&P 500 chart, as the pullback gathered momentum late in the week. The "500" sliced through trendline support off the lows since May 1, and also broke below its 20-day exponential moving average for the first time since late-February.

On Thursday, June 7, the index finished right on its 50-day exponential moving average, and so far, has bounced off this important piece of support. The 50-day simple average comes in at 1488, right near the intraday low for the index on Friday. Additional support may be garnered from the 65-day exponential at 1482.

The S&P 500 has already given back over 23.6% of the rally since March after breaking through the 1499 level. The next Fibonacci retracement level of 38.2% targets the 1473 level but there are not a lot of other pieces of support in that general zone. When using Fibonacci retracement levels, we like to see additional pieces of technical support near the Fibo targets. We think the more pieces of support in a general area, the more likely the market will bottom out in that zone.

With the bearish activity being seen in the bond market, we think there may be some more downside for stocks, but not too much. There is a plethora of support in the 1450 to 1460 area, and at this point, we think that represents maximum downside. A move near the 1460 level equates to a 5% drop from the recent highs near 1540. The high from back in February sits in the 1460 area, and this represents strong chart support in our view. The 80-day simple average is at 1462, and represents potential support. A 50% retracement of the rally comes in at 1452 and there is a high level of put open interest at 1450 for the month of June, and both represent good pieces of support during a long-term uptrend.

If this pullback continues into the end of June or early July, a very important trendline, off the closing lows since July 2006, will also come in around the 1450 area. So needless to say, there is a host of technical supports in the 1450 to 1460 zone.

On a very short-term basis, the market is pretty oversold so we could see a counter trend rally for a day or two. The 3-day relative strength index (RSI) fell to 8 on Thursday, June 1, the lowest since early March. The 6-day RSI has dipped to 23, also the lowest since early March. However, for the market to get oversold on an intermediate-term basis, we would like to see the 14-day RSI move under the 30 level from the current 41 area. Many times, when the 14-day RSI gets oversold in a bull market, it provides a springboard for the market to move to new highs.

There have also been some extreme oversold readings from the NYSE internal data that indicate to us that we may have already seen some capitulation-type selling. The NYSE down/up volume ratio hit 17.3 on Thursday, the highest since February's mini crash ratio of 100.6. Thursday's down/up ratio was the second highest since March 2003. In addition, Thursday's NYSE decliners/advancers ratio soared to 11, the highest since May 2004 and was the second highest since the mini-meltdown in October, 1997.

There is still a mixture of good and bad from the sentiment indicators we monitor. On the negative side, we are still seeing high levels of OEX put/call ratios while equity-only put/call ratios are fairly low. This divergence, between what the professionals (smart money) are doing versus what the individuals are doing will probably have to be unwound before a firm market low is in. The market sentiment polls, that measure what the professionals are doing, are still showing very high levels of bullishness, and while we prefer to bet on the smart money, we would also like to see a bit less optimism from these polls.

On the positive side, the American Association of Individual Investor poll is still showing extreme caution by the individual. In addition, the NYSE Short Interest ratio remains near record highs. In addition the ISE Sentiment Index fell to 74 yesterday, the lowest and most oversold since the last market bottom in March.

Bond yields broke out with a vengeance last week and the 10-year Treasury yield jumped 16 basis points to 5.12%. This is the highest yield for the 10-year note since July, 2006. Since May 11, yields have surged 45 basis points in just 19 trade days. This is the biggest jump in 19 days since March, 2005.

Yields have completed a fairly large inverse head-and-shoulders pattern, which suggests to us that the intermediate-term trend is now firmly higher. The next piece of important chart support is up at 5.25%, and that is from last summer's high. Once yields get up to this area, we think there will be a counter trend move in yields to the downside. Sentiment is getting fairly bearish, and the market is extremely overbought with respect to yields, and oversold with respect to prices.

However, from a very long-term perspective, the great bull market in bonds appears to be over. Yields broke out of a very definable downward channel this week, and that is significant. This channel goes all the way back to 1987, so it is our belief that the bull market in bonds that started in 1981 is finally over.

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