VOLUME PATTERN SUGGESTS DEEPER CORRECTION FOR STOCKS -- JANUARY BAROMETER IS A NEGATIVE SIGN FOR STOCKS DURING 2014 -- SO IS THE FACT THAT THIS IS A MIDTERM ELECTION YEAR -- UTILITIES, REITS AND HOMEBUILDERS FOLLOW BOND PRICES HIGHER

HEAVY DOWNSIDE VOLUME ISN'T A GOOD SIGN... The stock market ended the week as it began -- on the downside. Two low-volume bounces on Tuesday and Thursday were followed by higher volume declines on Wednesday and Friday. Charts 1 and 2 show the Dow Industrials and S&P 500 still in the process of testing initial support levels at their December lows. Some nibbling by "buy the dippers" this week helped the market stabilize at those levels. However, the negative volume pattern suggests that there's more to come on the downside. My last two messages talked about the possibility for a decline of at least 10%, which would take both stock indexes back to major support near their October lows. Between now and then, there should also be a test of their 200-day moving averages which could also provide some support. [Both indexes ended January with losses which turned the January Barometer negative. More on that later]. The flight from emerging market currencies and stocks has been the main catalyst in the flight from risk assets. With global stocks on the defensive, money has flowed into U.S. Treasuries as well as British, German, and Japanese government bonds. [A flight into the perceived safety of the Japanese yen pushed Japanese stocks 8% lower during the month]. An attempt by central bankers to stem their currency declines in India, South Africa, and Turkey by raising interest rates has had minor impact. Currency weakness has spread to emerging currencies in Europe (like Hungary). Commodity currencies in Australia and Canada also weakened. One winner in all of this turmoil has been the U.S. dollar.

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Chart 1

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Chart 2

DOLLAR NEARS UPSIDE BREAKOUT AS EURO WEAKENS... With emerging currencies in freefall, and currencies tied to commodity exporters weakening, the U.S. dollar has become the logical currency of choice. [Although the Japanese yen has recovered during January, central bank policy in that country is determined to push it lower]. European currencies had also help up reasonably well. This week's announcement, however, that January inflation for the eurozone dropped to 0.7% raised more concerns about the threat of deflation. That raises the possibility for more aggressive easing by the ECB, which might eventually involve quantitative easing (at the same time that Fed is phasing out its QE bond buying program). The net result should be a weaker Euro and a stronger dollar, which is what we saw this week. Chart 3 shows the U.S. Dollar Index ($USD) closing the week just shy of its November high and its 200-day moving average. A close above those two barriers would turn its trend higher. Chart 4 shows the Euro (which accounts for 57% of the USD), tumbling to the lowest level since November, after completing a "double top" pattern at its October/December highs. The Euro has also broken a rising trendline drawn under its July/November lows. My January 20 message explained that some of the intermarket effects of a stronger dollar would be weaker commodities and weaker performance by foreign stocks relative to the U.S. A rising dollar would hit stocks and currencies of commodity exporters especially hard, which include several emerging markets.

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Chart 3

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Chart 4

UTILITIES AND REITS SHOW RELATIVE STRENGTH ... An early January message (January 11) talked about the need to do some rotating out of over-extended stock market groups that did especially well during 2013 into more defensive (and dividend-paying) groups that had been market laggards. The two I mentioned were utilities and REITs. I mentioned those two groups for two reasons. One was that they are defensive in nature, and usually hold up better when stocks weaken. The other is because both groups are closely tied to the direction of bond prices. With bond prices rising throughout the month (as stocks fell), those two groups have done especially well. Chart 5 shows the Utilities Sector SPDR (XLU) moving up to challenge its November high. Its relative strength ratio (gray area) has surged as well. [Dividend-paying stocks also do better when bond yields decline, as they did during January]. Chart 6 shows the Dow Jones Wilshire REIT ETF (RWR) also climbing during the month. Its relative strength line has risen as well. The RWR is nearing a test of its 200-day moving average. Homebuilders also had a strong week and a strong January.

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Chart 5

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Chart 6

HOMEBUILDERS ARE ALSO MARKET LEADERS... In that same January message, I identified homebuilders as my favorite rate-sensitive group. That was mainly due to their stronger chart pattern. I also pointed out that any pullback in stocks would result in lower bond yields, which is a plus for rate-sensitive homerbuilders. [Falling bond yields lower mortgage rates which encourage homebuying]. I also suggested that homebuilders would likely benefit by a strong economy later in the year, even if bond yields turned higher again. I suggested that "those investors who are optimistic on the longer range trend for stocks and the economy (as am I), but who are concerned that 2014 may see a correction in stocks (which I am), homebuilders appear to offer a good middle ground." Chart 7 shows the Dow Jones Home Contruction iShares (ITB) hitting a new eight-month high this week after bouncing off a "neckline" drawn over its July/September/November highs. [A broken resistance line should act as a support line on a subsequent pullback]. Upside volume was also positive. The homebuilder bottom started during August when bond prices bottomed (green line), and have benefited from the bond rally during January -- both on an absolute and a relative basis. The homebuilders relative strength ratio (below chart) has also broken out to the upside.

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Chart 7

COMBINING THE JANUARY BAROMETER AND MIDTERM ELECTION YEARS ... My December 14 message included the headline: 'The Four-Year Presidential Cycle Suggests that 2014 Could Suffer A Major Downside Correction". That message also suggested that two of the best months to take some profits were during January and April. [I further suggested that a major correction was more likely to take place between May and October, which could lead to a major buying opportunity during the fourth quarter of the year]. The fact that January turned out to be a down month makes that warning for a volatile year more likely. With the Dow down -5.3% for the month, and the S&P 500 losing -3.6%, the January Barometer has issued a negative warning. The January Barometer is based on the belief that "as January goes, so goes the year". The January Barometer is backed up by market history. Credit for its discovery goes to Yale Hirsch who first wrote about it in the Stock Traders Almanac in 1972. According to the Almanac, the January Barometer has predicted the year's stock market direction 76% of the time since 1950. It goes on further to state that "every down January in the S&P since 1950, without exception, preceded a new or extended bear market, a flat market, or a 10% correction" (Stock Traders Almanac 2014, p. 12). It goes on further to state that 10 of the last 16 midterm elections years followed January's direction. The fact that the Barometer turned negative during 2014 (a midterm election year) raises the odds for a more volatile year for stocks. The good news is that midterm election years usually finish the year stronger than they start.

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Chart 8

COMPARISON TO 1997 ASIAN CURRENCY CRISIS ... The current currency crisis in emerging markets has caused comparisons to be made with the 1997 Asian currency crisis. While I wouldn't carry that analysis too far, there are similarities worth studying. [I'm drawing from my last two books on Intermarket Analysis which covered that earlier period]. The crisis began in the summer of 1997 when Thailand's currency (the baht) collapsed, which caused a panic in other Asian currencies. That in turn caused heavy selling in Asian stock markets which spread throughout the globe. During the crisis, the dollar became the currency of choice and Treasury bonds became the world's strongest market. Commodities weakened as the dollar rose. Asian central bankers raised interest rates to support their currencies, which only made matters worse. [Some of them tried that this week]. The crisis started in the summer of 1997 and ended in October of 1998. Chart 8 shows what happened to the Dow Industrials during those two years. It lost 15% between July and October 1997 before turning back up in October. A bigger correction of 20% took place between July and October 1998 (caused mainly fears of Russian debt default and the failure of a major hedge firm, Long Term Capital Management). The Dow resumed its major uptrend which lasted until 2000. Some possible take-aways from that earlier crisis: Bond prices and the dollar should benefit as long as the crisis continues, while commodities weaken. U.S. stocks should correct, but not as much as foreign markets. Dow losses between 15% and 20% are possible. And, lastly, major buying opportunities took place during October of both years. And one more thing. 1998 was a midterm election year.