CHINA LEADS GLOBAL RETREAT -- INTERMARKET REVERSALS RAISE WARNING FLAGS -- MARKET IS OVERSOLD SHORT-TERM -- BUT WEEKLY MACD LINES HAVE TURNED NEGATIVE -- THAT INCREASES ODDS FOR A 10% CORRECTION

CHINA ISHARES LEAD GLOBAL RETREAT... I wrote a message on January 12 about Chinese central bankers starting to tighten credit, and the fact that Chinese stocks were no longer showing relative strength. In fact, China had lagged the global rally for several months. The biggest negative divergence took place in early January when the Dow Jones World Stock Index (solid line) hit a new recovery high while China iShares (price bars) didn't even come close to doing so. I warned that the loss of Chinese leadership could spell trouble for global stocks and commodities. Last week's plunge in stocks and commodities was partially the result of events in China. Chart 1 also shows the FXI dropping below its 200-day average for the first time since last spring. That's not a definitive sign of a major downturn, but it is enough to justify a more cautious stance on global stocks.

Chart 1

INTERMARKET REVERSALS... The FXI isn't the only market that's broken its 200-day moving average. Chart 2 shows that the Euro has done so as well. That's another warning sign of a weakening global picture because the Euro has the biggest influence on the direction of the U.S. Dollar Index which has been rallying since December. A rising dollar has a negative influence on commodity markets as well as stocks, currencies, and countries with commodity exposure. For example, the Brazilian Real has been one of the biggest currency losers this month and has fallen below its fourth quarter lows (Chart 3). [The Aussie and Canadian Dollars have also been hit relatively hard]. Brazilian stocks have also fallen harder than most global stocks as shown in Chart 4. That's true of emerging stocks in general, but especially those tied to commodities. Intermarket trends over the last month have seen a rising dollar, falling foreign currencies, falling commodities, falling global stocks, falling basic material stocks, and rising Treasury bond prices. That's a change from what we saw most of last year. China has played a big role in those reversals. The big question now is whether those trend reversals are just short-term interruptions in the global uptrend or something more serious.

Chart 2

Chart 3

Chart 4

DOW AND NASDAQ REACH INITIAL SUPPORT LEVELS... Charts 5 and 6 show the Dow Industrials and Nasdaq Composite bouncing off initial chart support along their October/November highs. [Broken resistance acts as support on pullbacks]. Daily stochastic lines are in oversold territory below 20. That's helping to stabilize the market. Unfortunately, the big red volume bars over the last week show urgent selling taking place. That usually signals that this is more than just a short-term pullback and that there may be more selling to come. The market is certainly entitled to a bounce after a 5% drop in such a short period of time. If the October highs aren't able to contain any subsequent selling, however, a further drop toward the October lows may be in the offing.

Chart 5

Chart 6

WEEKLY MACD LINES TURN NEGATIVE. ... There's good and bad news on the next two charts. The daily bars in Chart 7 show the S&P 500 to be bouncing from chart support along its November/December lows after losing 5% of its value. It also shows the SPX to be bouncing from its lower Bollinger band which has acted as support throughout the market's uptrend. That would seem to suggest that the recent selling has been overdone and the market entitled to a bounce. The weak condition of the daily MACD lines, however, warn against complacency. Their weak condition suggests that damage has been done to the market's short-term trend, and suggests that the market correction may have more to go (after a short-term bounce). Another downturn would most likely head toward the early November low near 1030 which also happens to be a 10% correction. The odds of the market reaching that lower level are increased by the downturn in weekly MACD bars as shown in Chart 8. That chart shows the weekly MACD histogram having turned negative for the first time since last March when the market upturn started. Chart 8 also shows that the 20-week m.a. (dotted line) has acted as support since last spring. A close below that level would signal a likely drop to the lower band (blue arrow) which would approximate a 10% drop as well. The stock market hasn't had a 10% correction since it bottomed last spring. It looks due for one.

Chart 7

Chart 8