RISING RATES COULD LEAD TO STOCK MARKET CORRECTION -- DROP IN SMALL CAPS AND EMERGING MARKETS IS ANOTHER SHORT-TERM WARNING -- DOLLAR STRENGTHENS -- STOCK MARKET INDICATORS WEAKEN

RISING RATES POSE A THREAT TO STOCKS ... On December 28, Arthur Hill showed an earlier version of Chart 1 which demonstrated that the stock market advance since mid-year had coincided with a drop in bond yields. As Mr. Hill pointed out, however, the TNX had already broken its six-month down trendline (green circle) by the end of December. The upturn in bond yields continued on Friday in reaction to the big jump in December jobs and wages, and probably contributed to heavy stock selling. The reasoning is simple. If falling bond yields helped the stock market rally, rising yields could start to hurt it. Friday's stock selloff pushed the S&P 500 dangerously close to breaking its six-month uptrend line as well. Another side-effect of rising U.S. bond yields is the stronger dollar.

Chart 1

RISING BOND YIELDS BOOST DOLLAR ... The daily bars in Chart 2 show the U.S. Dollar Index closing back over its 50-day moving average (blue line) for the first time in two months. That's not enough to reverse its major downtrend. The USD is still well below its 200-day moving average; but it is enough to turn its short-term trend higher. The green line is the yield on the 10-year T-note. The purpose of the chart is demonstate the linkage between the two markets during the second half of 2006. Falling bond yields since July helped weaken the dollar. Rising bond yields since mid-December are helping boost the dollar. The rise in the dollar had a bearish impact on commodity markets (and their related stocks) and took a heavy toll on emerging markets.

Chart 2

EMERGING MARKETS SUFFER WEEKLY REVERSAL ... The MSCI Emerging Markets iShares (EEM) suffered a downside weekly reversal on heavy volume as shown in Chart 3. In fact, the EEM had its biggest weekly fall in more than three months. At the very least, that suggests that a pullback of some type is probably in store. That cautious view is supported by the 14-week RSI line (blue line) which had been trading in overbought territory over 70 for the first time since last May. The RSI line has fallen below 70 for the first time since the last EEM peak eight months ago. Since emerging markets had been leading the global rally during the second half of 2006, any serious pullback in that group would most likely weaken most other global stock markets -- including the US.

Chart 3

SMALL CAPS BREAKS 50-DAY AVERAGE ... On Friday, I showed the S&P 600 Small Cap Index (SML) breaking its 50-day moving average. Chart 4 shows that's the first close below that support line since late August. That consitutes a short-term sell signal for the SML. The bigger question is what that means -- if anything -- for the S&P 500 Large Cap Index shown in Chart 5. It's no secret that large caps have done better than small caps during the second half of the old year. Having said that, however, it's also true that they've been rising together -- at least until now. I made the point yesterday that the SML had failed to clear its May high and thereby created a "negative divergence" from the SPX. That negative divergence got even worse with Friday's downturn in the SML. Chart 5 shows that the SPX is still trading over its 50-day line which now sits at 1400. The SPX has been trading over that support line since late July (blue circle). It would have to close below that line to signal a short-term top. But I think the odds of that happening increased over the past week. That view is supported by weakening in short-term technical indicators.

Chart 4

Chart 5

MACD LINE IS FALLING ... Normally, the daily MACD lines rise with the market's price action. That was the case from July to the end of October. Since October, however, the MACD has diverged from the rising S&P 500. As of Friday, the daily MACD lines had fallen to the lowest level in five months. That's a strong hint that the S&P is in need of some downside correcting. Chart 7 shows some lower support levels to watch if and when the 50-day line is broken. The next two levels of support would be at 1377 and 1360. The latter number coincides with the 100-day moving average (green line). A pullback to 1360 would also constitute a one-third retracement of the July/December advance which is a reasonable downside expectation after such an uninterrupted rally.

Chart 6

Chart 7

WEEKLY INDICATORS ARE STARTING TO SLIP ... I promised a look at some long-term market indicators and here they are. Chart 8 applies two of my favorite technical indicators to weekly bars for the S&P 500. Both show some weakening in the market's major uptrend. The 14-week RSI line along the top of the chart is starting to pull back after climbing into overbought territory over 70 for the first time nearly three years. The weekly MACD lines, which turned positive over the summer, are still positive. However, the two lines have started to converge. That can be seen by the falling histogram bars. That's not an actual sell signal. Short-term traders, however, often take that as a sign to take some profits. That's because converging weekly MACD lines usually signal a short-term correction within an ongoing uptrend.

Chart 8

MONTHLY TREND IS STILL UP, BUT OVERBOUGHT ... Chart 9 applies the same two technical indicators to S&P 500 monthly bars. The good news is that the monthly MACD lines that turned positive nearly four years ago are still positive. That means that the market's major trend is still up. The bad news is that the 14-month RSI line has reached overbought territory over 70 for the first time since the bull market began. At the very least, that's another caution sign that the bull market is in need of some kind of rest. Over the short-run, of course, the daily charts are the most important. That's where most of the weakness is being seen. But the fact that the weekly and monthly charts are in overbought territory increases the odds for some type of market correction. I'd keep a close eye on the 50-day moving average for further confirmation of any short-term market downturn.

Chart 9