NASDAQ AND SMALL CAP INDEXES FALL BELOW 50-DAY AVERAGES ON BIG VOLUME -- SECTOR ROTATIONS TURN DEFENSIVE -- DOW AND S&P 500 SUFFER DOWNSIDE REVERSAL DAYS -- VOLUME PATTERNS ARE NEGATIVE -- WEEKLY MACD LINES REMAIN NEGATIVE FOR S&P

NASDAQ AND SMALL CAPS LEAD MARKET LOWER... Stocks suffered a bad chart day on Friday. Stock indexes lost more than 1% in heavy trading. Small cap stocks and the Nasdaq market lost more than 2%. Chart 1 shows the Nasdaq Composite Index losing -2.6% on the day in very heavy trading. The $COMPQ also ended back below its 50-day moving average. Nasdaq losses were caused mainly by big drops in biotech and technology stocks. It now appears that the Nasdaq is headed toward its early February low and a test of its 200-day moving average. Chart 2 shows the Russell Small Cap Index ($RUT) losing -2.3% and also ending below its 50-day line. It's not a good sign when those two indexes are falling faster than the rest of the market.

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Chart 1

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Chart 2

DEFENSIVE ROTATIONS... Beneath the surface, recent sector rotations also show a market that is turning more defensive. Chart 3 shows four market sector ETFs plotted relative to the S&P 500 (black zero line). The blue line on top shows the relative strength line for the Consumer Discretionary (XLY) falling sharply over the last month to the lowest level since last August. That's a sign of waning confidence. The rising relative strength lines near the bottom of the chart show three groups that have shown rising relative strength. Two of them (consumer staples and utilities) are defensive in nature. Utilities have been the market's strongest sector throughout the first quarter. [Utilities were also the only sector to gain during Friday's market selloff]. Rising utilities are usually a bet on a stronger bond market, which is negative for stocks. New leadership by energy stocks over the last couple of weeks is often a prelude to a market correction.

Chart 3

DOW INDUSTRIALS SUFFER DOWNSIDE REVERSAL AT OLD HIGH... Chart 4 shows the Dow Industrials suffering a downside reversal on Friday right at its old high. The fact that it did so on heavier volume adds to the day's bearish look. The Dow actually fell less than the other major averages on Friday. It lost -.96% versus a drop of -1.25% in the S&P 500 (while the Nasdaq lost more than 2%). That's not necessarily a good thing. The Dow is composed of large blue chips that pay dividends. It's considered to be the safest of the major market indexes. During a market rally, the Dow usually lags behind the rest of the market. It usually does better during a market correction. The line on top of Chart 4 shows the Dow/S&P 500 relative strength ratio turning up over the last two weeks. That's usually a sign that investors are turning more cautious on the market.

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Chart 4

S&P 500 SHOWS NEGATIVE VOLUME DIVERGENCE... Chart 5 shows the S&P 500 also suffering a downside reversal from a record high on Friday. It also fell in heavy trading. The price rectangles show an "equivolume" chart (invented by Richard Arms). [Click on equivolume under Chart Type to get the chart]. The height of each day's equivolume rectangle shows the day's price range. The width of the rectangle, however, is adjusted for volume. A heavier trading day results in a wider price rectangle. If you look at the equivolume rectangles over the last month, you'll see that weaker price days (red) have been wider than up days (black). That shows that volume has been heavier on down days than on up days, which is a sign of weakness. Recent volume weakness shows up in another indicator. The black line on top of Chart 5 is the On Balance Volume (OBV) for the S&P 500. The OBV line (invented by the late Joe Granville) is a running cumulative total of up and down volume. Volume is added on up days and subtracted on down days. The OBV line should trend in the same direction as the S&P 500. A negative divergence is present when the OBV fails to confirm higher prices. That happened twice this year. The first time was in mid-January (first red arrow) which was followed shortly by a market downturn. The second divergence occurred this past week (second red arrow). That increases the odds for another downturn. For that to happen, however, the SPX needs to drop below initial chart support (and its 50-day line) near 1840 (blue arrow).

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Chart 5

WEEKLY MACD LINES ARE STILL NEGATIVE... My February 12 message showed weekly MACD lines turning negative for the S&P 500. I wrote that those lines needed to turn positive to confirm the February/March rally in the SPX. So far, that hasn't happened. Chart 6 overlays the weekly MACD lines on the S&P 500. The two lines turned negative during January and remain so (red box). That "negative divergence" between the MACD lines and the SPX increases the odds for more selling. The fact that the MACD lines also stopped at last spring's high is worrisome. [The histogram bars beneath Chart 6 plot the difference between the two weekly MACD lines and have been below their zero line (negative) since January]. To quote from the February message: "That makes me suspicious of the staying power of the stock market rally from here. It also reinforces my view that the market may run into bigger trouble as we approach the spring months."

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Chart 6

WATCHING FOR A SPRING TOP ... Last December 14 I wrote a message warning of the likelihood of a market correction during 2014. Midterm election years are the most dangerous of the four-year presidential cycle. ["The Four Year Presidential Cycle Suggests That 2014 Could Suffer a Major Downside Correction...The Strongest Six Month Period Ends in April"]. The message points out that midterm year peaks usually start in the spring. Since April ends the "strongest six month period" that starts in November, that makes April a good time to take some money off the table. It may also make the "sell in May" maxim more meaningful this year. The good news is that a major bottom usually takes place during the second half of the year (usually in October). Calendar-wise, we've now entered the dangerous spring season. That makes warning signs of a possible market top more meaningful. The monthly bars in Chart 7 show the S&P 500 rising above its 2007/2000 highs last spring to register a major bullish breakout. Those two prior peaks should act as major support below the market. Measuring from this week's intra-day high to the 2007 intra-day peak at 1576, an S&P 500 drop of 17% would bring it back to that major support level. That's probably the maximum correction we can expect. The red line shows the last two 17% corrections taking place during 2010 and 2011 (the 2011 correction of 19% lasted from May to October). The moral of the chart is that a correction as big as 17% would not disturb the market's major uptrend, and would most likely represent a major buying opportunity later this year.

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Chart 7

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Chart 8

A LOOK AT RECENT S&P 500 CORRECTIONS... Chart 8 shows the last 10% correction in the S&P 500 (using intra-day prices) taking place in the spring of 2012 (during April and May). Two years without a 10% correction is unusual. A correction of 8% took place in the autumn of 2012, and a smaller 7% drop in the spring of 2013 (during May and June). An even smaller pullback of 6% took place this January. An S&P 500 drop to its early 2014 February low near 1740 would represent an 8% correction (see first support line). That's probably the minimum correction we can expect this year.