SMALL CAPS TEST NECKLINE OF POSSIBLE H&S TOP -- MIDCAP INDEX IS IN DANGER OF BREAKING AUGUST LOW -- SO IS THE NYSE COMPOSITE INDEX -- THE U.S. IS BEING LED LOWER BY FOREIGN SHARES -- THE DOLLAR RALLY MAY BE JUST STARTING

SMALL CAP HEAD AND SHOULDERS TOP?... A debate is going on within the technical community as to whether or not the Russell 2000 Small Cap Index is in danger of completing a "head and shoulders top". A case can certainly made for it, although it would be an unusual one. The daily bars in Chart 1 show Russell 2000 iShares forming two smaller peaks (shoulders) during January and late August. In between those two lower "shoulders" a "double top" was formed between March and early July. While it might not qualify as a textbook "H&S" top, the bearish warning is still valid. At the moment, the Russell 2000 iShares (IWM) are testing a "neckline" drawn under its February/May lows (red line). A downside violation would complete the topping pattern that's been forming for months. The negative volume pattern confirms that bearish warning. The volume bars along the bottom of the chart show heavier trading during selloffs and lighter volume on rallies. This week's downside volume has been particularly heavy. The red line on top of Chart 1 is On Balance Volume (OBV) which is a running cumulative total of upside versus downside volume. It's also in danger of breaking its own support line. [A 1% bounce today kept the IWM above neckline support].

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Chart 1

MIDCAP INDEX MAY BE FORMING DOUBLE TOP... One bearish pattern that isn't in doubt is the potential "double top" in midcaps. Chart 2 shows the S&P 400 Mid Cap Index trading below its August low for most of the day (after breaking its 200-day average yesterday). The two tops were formed in late June and late August (black circles). A decisive close below the August low would complete that bearish pattern. A serious break of support by small and midcap stocks would weigh heavily on large caps. [An afternoon bounce kept the MID near its August low].

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Chart 2

NYSE COMPOSITE INDEX TESTS AUGUST LOW... Chart 3 shows the NYSE Composite Index in danger of falling below its August low as well. The early July, early September peaks also form a potentially bearish "double top". A decisive close below the August low would complete that bearish pattern. The NYSE has already lost 5% of its value. A measurement taken from its highs to its August low suggests the potential for another drop of at least 5% -- if the August low is decisevly broken. The NYSE includes all common stocks traded on the big board which numbers more than 2000 (of which 1600 are U.S. stocks). The fact that it includes many more stocks than the narrower indexes like the Dow (30 stocks) and S&P 500 (500) probably explains why it's the first of the major stock indexes to break support. The Dow and SPX include only the largest stocks on the NYSE which are holding up better than smaller stocks. But they're all in danger of trending lower. [A late bounce today prevented a breakdown in the NYA on a closing basis].

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Chart 3

FOREIGN SHARES ARE PULLING U.S. LOWER... Although U.S. stocks are the strongest in the world (on a relative basis), they're not immune from sharp selloffs in foreign markets. Global stocks are positively correlated. That's even more so during market downturns. Chart 4 shows the Vanguard FTSE All-World ex-US ETF (VEU) having fallen to the lowest level in more than six months. It has also fallen well below its 200-day moving average (red line), and a support line drawn under its 2013/2014 lows. [The VEU includes all foreign developed markets (including Canada), and has a 25% weight in emerging markets]. It has lost nearly 9% from its July peak. At the same time, the S&P 500 has lost about 4%. Since the global bull market began in 2009, downside corrections in foreign shares have been larger than in the U.S. (-15% versus -9% on average). So it's not unusual for foreign shares to fall further during downside corrections. But previous upturns in U.S. stocks have coincided with upturns in foreign stocks as well. So the direction of U.S. stocks is strongly tied to what foreign shares do from here. So far, action overseas is not encouraging. Another reason why U.S. large caps in particular are vulnerable to overseas weakness is because 46% of earnings among S&P 500 stocks come from foreign markets. Weakness there usually leads to weakness here.

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Chart 4

VIX IS STILL TESTING AUGUST HIGH ... As shown above, a number of stocks indexes (mid and small stock indexes and the NYSE Index) in the U.S. are in the process of testing important support levels. That puts the market at a critical spot. The same is true of the CBOE Volatility (VIX) Index. Yesterday I showed the VIX testing its August high on a closing basis. Chart 5 shows the more traditional bar chart, but the message is the same. An upside breakout in the VIX usually coincides with a market downturn. So far that hasn't happened. Today's action shows the VIX backing off from its August intra-day high at 17.57 (while stocks experienced an afternoon bounce). A pullback in the VIX would be supportive to stocks. An upside breakout through its August high wouldn't be. A lot may depend on whether or not foreign shares are able to recover from their current tailspin.

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Chart 5

US DOLLAR RALLY MAY JUST BE STARTING... Although the U.S. Dollar has recently hit a four-year high (and become the strongest currency in world), I believe the dollar upturn is just starting. For one thing, the dollar appears to be emerging from a major bottom. Secondly, its bull run may last for several years. The monthly bars in Chart 7 show all major moves in the $USD since 1985. Over those thirty years, the USD has experienced two major bear markets and one major bull market. What they have in common is that each of them lasted approximately six years. The first bear market lasted from 1985 to 1991 (6 years). The first bull market lasted from 1996 to 2002 (6 years). In between those two trends, the USD went through basing pattern between 1991 and 1997 (also six years). The dollar drop starting in 2002 also lasted six years until it bottomed in 2008. Here's where it gets interesting. The potential bottoming formation that started in 2008 is now in it sixth year (2014). That by itself doesn't guarantee a major upturn. But the fact that the USD has rallied to a four-year high increases the odds. A correlation exists between the width of a bottom and upside price potential once a new uptrend starts. A six year bottom is certainly capable of supporting much higher dollar values -- maybe even for six years. Currency markets also have a long history of staying in major trends once they're established. One of the side-effects of that would be weaker commodity prices.

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Chart 6

CRB INDEX NEARS MAJOR SUPPORT... The dollar rally has contributed to a major selloff in commodity markets. While the dollar has rallied 8% since May, the CRB Index has lost -10%. That could get even worse if the dollar keeps rallying. Chart 7 shows the CRB Index nearing a test of a support line drawn under its 2012, 2013 lows. Even if a short-term bounce does materialize, the overall trend doesn't look promising. One positive effect of lower commodity prices is that it will discourage global bankers (especially the Fed) from raising rates too soon or too fast, and will likely prevent a major upturn in bond yields. But it may be bad news for countries battling deflation.

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Chart 7

GERMAN BUND YIELD BATTLES DEFLATION... One of the regions of the world fighting deflation is Europe. The latest eurozone headline inflation figure showed a drop to 0.03% which is the lowest in five years. That's putting more pressure on the ECB central bank to adapt a more aggressive easing policy. Its attempts so far have pushed the Euro to a two-year low against the dollar. And is pushing eurozone interest rates to record lows. The green line in Chart 8 shows the 10-year German Treasury Yield ($DET10Y) falling all year to below 1%, which is the lowest level in history. The two-year German yield is negative. The solid area shows the plunge in commodity prices since June contributing to those lower bond yields. Lower eurozone (and Japanese bond yields) are also weighing on U.S. bond yields, and should prevent them from rising too fast. Ironically, the plunging Euro is one of the contributing factors to the dollar rally and the commodity selloff.

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Chart 8

HEADING TO LONDON ... I'm travelling to London this weekend to attend and speak at the 27th Annual Conference held by the International Federation of Technical Analysts (IFTA). It's a rare opportunity to listen to what foreign chartists are looking at, and what they're thinking. Plus a chance to see a lot of old friends again. As a result, I won't be writing any messages over the next week. Hopefully, I'll be back writing again the week after. Cheerio.