STOCKS DECLINE WITH BROAD SELLING GAPS REMAIN UNFILLED SMALL AND MID CAPS LEAD LOWER DEFENSIVE SECTORS OUTPERFORM IN MAY DOLLAR HITS SUPPORT AREA BONDS GET OVERSOLD BOUNCE 10-YEAR NOTE YIELD HITS RESISTANCE

BROAD SELLING HITS WALL STREET ... The market declined sharply on Wednesday with broad selling pressure. All of the major indices were sharply lower. All nine sectors were lower with five declining over 3%. Chart 1 shows the S&P 500 hitting resistance at its January high last week and declining below 90 over the last three days. It all started with an outside reversal last Thursday. Despite a rebound on Friday, selling pressure returned on Monday and continued the last two days. We have been talking about overbought conditions for a while and it looks like a correction is underway. With that in mind, I am showing the Fibonacci retracements tool to estimate a correction target. Using the upper range of the 38-62% zone, a 38-50% retracement would extend to the low 80s. The bottom indicator window shows 14-period RSI, which was featured last week. In an uptrend, the 40-50 zone sometimes offers support and this area is highlighted in yellow. RSI is likely to reach this zone before SPY reaches the low 80s. We could see a short-term oversold bounce when RSI hits its support zone, but this may not signal the end of the correction. After a 35% advance in two months, I would expect a corrective phase to last a few weeks.

Chart 1

MIND THE GAPS... This week's price action reveals a sudden change of heart. Chart 2 shows 15 minute candlesticks for the S&P 500 ETF (SPY). As with last week's 15-minute QQQQ chart, this chart is to illustrate a pattern of increased selling pressure, not a short-term pattern or setup. After a sharp decline last Thursday, SPY gapped up on Friday and closed strong. However, this gap was countered with a gap down on Monday AND a weak close. In other words, Monday's gap held. After a late rebound on Tuesday, SPY gapped down again on Wednesday's open and this gap also held. Two unfilled gaps and a 4% decline in just three days indicate a shift in investor outlook.

Chart 2

SMALL AND MID CAPS LEAD DECLINE... The Russell 2000 ETF (IWM) and the S&P 400 Midcap ETF (MDY) were two of the biggest losers on Wednesday. If we must blame something, then it would be today's decline in retail sales. Small and medium size companies are more vulnerable to changes in the economy. They have less international exposure, less diversification and fewer available resources. However, it is not just today's retail sales report. IWM and MDY are both down over 6% in the last three days. The real blame goes to overbought conditions and resistance. Chart 3 shows IWM meeting resistance from its January high. Chart 4 shows MDY briefly exceeding resistance last week, but failing to hold above and declining below 100 today. Both charts are shown with the Fibonacci Retracements Tool and RSI. Even though 14-day RSI is nearing 50 and a potential support zone, the Fibonacci Retracements Tool indicates that a correction could extend another 10% lower. Therefore, we could see a short-term oversold bounce in the coming days, but not necessarily the end of the correction. A one week correction would not befit an enormous two month advance.

Chart 3

Chart 4

CHANGE OF SECTOR LEADERSHIP... Sector changes point to a more defensive market. The S&P Sector PerfChart is a great tool to identify the sector leaders and laggards. Moreover, the slider at the bottom can be used to identify changes in leadership over specific timeframes. PerfChart 5 shows relative performance for the nine sector SPDRs. Note that these percentage changes do not measure absolute performance. If a sector SPDR is up more than the S&P 500, its relative change will be positive. If a sector is down more than the S&P 500, its relative change will be negative. The S&P 500 was up 21.95% from March 10th to May 1st, while the Consumer Discretionary SPDR (XLY) was up 36.29% and the Healthcare SPDR (XLV) was up 7.15%. On a relative basis, XLY was outperforming by +14.34% (36.29% - 21.95% = +14.34%) and XLV was underperforming by -14.80% (7.15% - 21.95% = -14.80%).

Moving back to Perfchart 5, we can see that the offensive sectors led the market higher from March 10th until May 1st. For now I am ignoring the Financials SPDR (XLF) because it is a special case. In particular, the consumer discretionary, industrials and materials sectors were clear leaders. The technology sector also outperformed, but not by as large a margin. These are the sectors we want to see leading a broad advance and the advance was healthy when these sectors led the way.

Chart 5

Chart 6

Using the slider at the bottom of the PerfChart tool, I changed the date range to focus on more recent price action. PerfChart 6 covers the period from May 4th until May 12th. Even though the S&P 500 is flat over this timeframe, there has been a clear change in sector leadership. The offensive sectors are now underperforming. In particular, the Consumer Discretionary SPDR (XLY) and the Technology SPDR (XLK) are leading the way in relative weakness. In contrast, the defensive sectors are outperforming with healthcare, utilities and consumer staples showing relative strength. Energy is also outperforming the broader market. Even though this change is relatively new, it does show a change in risk appetite. Investors and traders are turning more cautious on the market overall.

DOLLAR FIRMS AS STOCKS FALL... Bloomberg reports that today's surprise decline in retail sales re-ignited the flight-to-safety trade. In short, the flight-to-safety trade is bullish for the Dollar and bonds, but bearish for the Euro and stocks. Chart 7 shows the US Dollar Index ($USD) over the last eight months. The yellow areas show two periods when the U.S. Dollar Index advanced sharply and stocks declined in a flight-to-safety. The other areas show the Dollar falling and the stock market rising, which has been the case since early March. Based on this inverse relationship of the past eight months, a decline in stocks could give way to a bounce in the Dollar. The technical situations also support such a scenario. First, stocks became overbought in early May and the Dollar became oversold. The S&P 500 became overbought after a 35% advance in just two months, while the US Dollar Index became oversold after a decline from 89 to 82. Second, the US Dollar Index ($USD) is trading near potential support from the 62% retracement mark and the rising 200-day moving average.

Chart 7

BONDS GET OVERSOLD BOUNCE... Bonds found reason to rally after retail sales declined for the second straight month. Retail sales drive some two thirds of GDP. Except for January and February, retail sales declined six of the last eight months. Renewed recession concerns pushed interest rates lower and bonds higher on Wednesday. Chart 8 shows the 20+ Year T-Bond ETF (TLT) becoming oversold when RSI moved below 30 last week. In addition, TLT was down over 25 points from its late December high. So far this looks like an oversold bounce. Broken support around 100-101 turns into resistance that is confirmed by the down trendline. A breakout is needed to fully reverse the four month downtrend.

Chart 8

Chart 9

Chart 9 shows the 10-Year Note Yield ($TNX) with a rather interesting picture. With the 200-day moving average falling and TNX trading well below the October high, an argument can be made for a long-term downtrend in interest rates. With this assumption, the Jan-May advance would be considered a counter-trend move and a resumption of the downtrend could happen soon. Let's look at the details. After a sharp decline from October to December, TNX retraced 62% with a rising wedge advance to around 34 (3.4%). Also notice that broken supports around 32-34 turned into resistance. In addition, the falling 200-day moving average marks resistance just below 32. All told, there is a heap of resistance around 32-34, which is equivalent to 3.2-3.4%. If the long-term downtrend in rates is set to resume, then bonds are set to rise and this could be bearish for stocks.