Are Markets Ready to Catch a Cold?

More fear filled the air on Wednesday as U.S. stocks dropped across the board, along with oil, while VIX, the “fear index,” spiked higher. Volatility across various asset classes and the recent sharp spike in interest rates has spooked markets, at least temporarily, even generating whispers that, perhaps, the U.S. Federal Reserve is losing control of the bond market as happened recently in Japan.

The world continues to slow down, even as the Federal Reserve considers tapering its quantitative easing programs, and the real economic weakness can be seen in economic bellwethers such as copper, lumber, and home builder stocks. Of course, much of the recent rally has been driven by momentum and the “buy the dip” mentality, and should that mood change, the results could be quite dramatic, indeed.

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For the day, the Dow Jones Industrial Average went on a roller coaster ride but managed to finish off its lows for a drop of 106 points. The S&P 500 fell 0.7 percent, the Nasdaq Composite dropped 0.6 percent, and the Russell 2000 was the big loser for the day with a decline of 1.04 percent. Oil closed at a monthly low, while gold posted a 0.73 percent gain.

Weak economic reports in Europe added to the gloom, along with a lowered forecast for Chinese growth issued by the IMF. The Organization for Economic Development issued its economic outlook, which warned about the challenges of exiting quantitative easing without potential disruptions to the bond markets in the form of higher interest rates and global growth. This theme has been recurring all week and has already caused havoc in Japanese stock and bond markets.

The OECD forecast calls for slowing global growth in 2013 and 2014 compared to earlier estimates and forecasts an ongoing recession in Europe with a 0.6-percent decline in GDP.

On a technical basis, Wednesday’s action further weakens the technical picture and sets up a challenge of strong support levels. The action followed Tuesday’s late day reversal and brought the S&P 500 down to significant support at 1650. A break below here would issue a “sell” signal in point and figure charting methodology for the S&P 500.

Thursday’s GDP report will be closely watched, along with weekly jobless claims and pending home sales.

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Over the past several weeks, we have been discussing how stock market action has been diverging from the “real” economy, and this fact now seems to be dawning on market participants as enthusiasm seems to be on the wane. The next few days will be decisive for the recent rally to continue. Wall Street Sector Selector remains positioned on the “short” side with bearish ETF, bond and put option positions, expecting lower prices ahead for many asset classes.

John Nyaradi is the author of The ETF Investing Premium Newsletter.

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