Troubling technical signals appear to be confirmed by recent movements in key sectors, driving up the possibility of a deeper correction ahead. As MoneyShow's Tom Aspray suggests, this is a time for patience.

Last Thursday’s rally interrupted the five-day slide, but the relief was short-lived as stocks were hit hard again on Friday. Most of the major averages closed lower, but above the worst levels.

The Euro crisis again returned to the front burner for the first time since the ECB decision in early September. Stocks dropped sharply early Friday over concerns about Spanish banks' stress tests. The report was within expectations, so stocks did manage to rebound from the early-morning lows...but could not make it back into positive territory.

The poor economic data on Friday did not help stocks, as the Chicago Purchasing Managers Index dropped sharply to 49.7 from 53 in August. A drop below 50 is consistent with contracting activity. Consumer sentiment from the University of Michigan was also revised downward.

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There has been extensive work by many analysts to identify stages of the business cycle and which sectors do the best in each stage. An old friend and excellent analyst, Martin Pring, has done quite a bit of work in this area. The chart above shows the six stages of the economy and which sectors do best in each stage.

In March, the Dow Jones Pring US Business Cycle Index was launched. It is a gauge designed in collaboration with Pring Research to reflect its proprietary investment strategy, which tactically allocates among stock, bond, commodity, and cash segments based on the phase of the economic business cycle.

According to Martin, since 1955 the index has had an annualized monthly average gain of 10.05%, vs. 6.85% for the S&P. Currently, Martin says, “we are in Stage II (bullish for stocks and bonds), but headed very soon to Stage III, when commodities will go positive.”

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As the chart indicates, in Stage II the best sectors are banks, technology, and consumer discretionary. The Performance chart reveals how the SPDR S&P Bank ETF (KBE), Select Sector SPDR Technology (XLK), Select Sector SPDR Consumer Discretionary (XLY), and Spyder Trust (SPY) have done since the June lows.

The performance of all four was quite similar, with KBE leading up 14%, followed by XLK rising 13.7% and the other two just slightly above 12%. In the Sector Focus section, I will take a look at technology, transports, and oil drillers, which typically lead in Stage III.

This week’s economic news may shed more light on the economy. The PMI Manufacturing Index and ISM Manufacturing Index are both out on Monday, along with construction spending.

Wednesday we get a preliminary reading on the jobs outlook with the ADP Employment report, as well as the ISM Non-Manufacturing report. Thursday brings jobless claims and factory orders, followed Friday by the monthly jobs report.

An update on intrade.com, as discussed last week in Traders Dump Romney: Obama shares are at $7.92 (79.2% change of Obama winning), while Romney has dropped to $2.07.

NEXT: What to Watch

What to Watch

As expected last week, the selling continued early last week. By Wednesday, many of the major averages reached more important support. The sharp rally took the major averages well off the lows, and despite the heavy selling early Friday, Wednesday’s lows did hold in all except the Dow Industrials.

It is still clearly a mixed market, as while the technical studies on the NYSE Composite and Russell 2000 still suggest that this is just a correction, the S&P 500 and Nasdaq 100 look much weaker.

The sentiment picture is also mixed, as individual investors are still not enthusiastic about the stock market—only 36.4% are bullish. The financial newsletter writers became slightly less bullish last week, at 51% (down from 54.2%), which is still closer to bullish extremes than bearish ones.

Interest rates are still holding well above the July lows. The iShares Barclays 20+ Yr Treasury Bond (TLT) rallied further last week. It needs to move above the late August highs or below the mid-September lows to signal a change in trend.

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The NYSE Composite has pulled back to the support from the May highs (line a) and closed Friday just barely above its flat 20-day EMA. A drop below last week’s lows will signal a deeper correction. The daily uptrend (line b) is at 7,950, about 3.7% below current levels.

The NYSE Advance/Decline lines tested its uptrend (line d) and its WMA average last week. A drop below last week will be a short-term negative.

S&P 500

The Spyder Trust (SPY) had a low last week of $142.95, just above the recommended stop of $142.92. SPY did close below the 20-day EMA, which has flattened out.

The daily uptrend (line f) is at $141.50, with more important support in the $140.40 to $140 area.

The S&P 500 Advance/Decline line dropped more last week than the NYSE, as it is well below its WMA. It turned lower again Friday after Thursday’s bounce. A drop below last week’s lows will signal an increase in selling pressure.

Minor resistance now stands at $145, with stronger levels at $146.24. A close above this level will signal a resumption of the uptrend.

NEXT: More Stocks

Dow Industrials

The SPDR Diamond Trust (DIA) has continued to act weaker, as the prior week’s lows at $135 were broken, reaching a low of$134.48 on Friday. The next support is at $133, which was the August high, with additional support at $130-$131.

The Dow Industrials A/D line (not shown) broke its longer-term downtrend, but has still not been able to move above either the August or July highs.

The daily chart has first resistance at $135, with more important levels now in the $136 area.

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Nasdaq-100

The PowerShares QQQ Trust (QQQ) was hit pretty hard last week, as its low at $67.85 was not far above the late August high of $67.47, which is an important level of support. If it is broken, the next downside target is in the $65.50 to $66.50 area.

Apple (AAPL) contributed to the decline in the QQQ, as it lost almost $30. The next good support for AAPL is in the $650 area.

After breaking its downtrend, the Nasdaq-100 A/D line (line b) reversed sharply, dropping back below its WMA. The more important support (line c) was tested last week. A decisive drop below this level would be a sign of weakness.

Russell 2000

The iShares Russell 2000 Index (IWM) pulled back to retest the breakout level (line d), which is characteristic of a normal pullback. There is additional support at $80 with the uptrend (line e) in the $79.40 area.

The Russell 2000 A/D line also dropped back to test its WMA, but is still well above the August highs and further support. The former downtrend and the key uptrend (lines f and g) provide more important support.

Sector Focus

As I discussed earlier, in Stage III of the business cycle, technology, transports, and oil drillers are typically the best sectors. Since June, Market Vectors Oil Service (OIH) has done the best, up just over 17%. It has corrected rather sharply from its highs, as it was up over 25% in the middle of September.

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The Select Sector SPDR Technology (XLK) and Spyder Trust (SPY) are about even since the June lows, while the iShares Dow Jones Transportation (IYT) is flat for the same time period.

As I noted on September 7, in “One Sector Sends a Strong Warning,” the action of the transports had me concerned. It looks as though I was not alone, as last Tuesday, The Wall Street Journal ran a long story, “Transportation Stocks Flash Hazards.”

All the key sectors except the Select Sector SPDR Utilities (XLU) are lower for the week. The Select Sector SPDR Materials (XLB), Select Sector SPDR Energy (XLE), and Select Sector SPDR Technology (XLK) were all down close to 2%.

The Select Sector SPDR Health Care (XLV) and the Select Sector SPDR Consumer Staples (XLP) were down 0.4% and 0.7% respectively.

NEXT: Commodities and Tom's Outlook

Crude Oil

The December crude-oil contract dropped just below the 50% Fibonacci retracement support from the June lows, as it hit $88.95 before rebounding, Crude closed the week $2 a barrel above the lows, but was still down slightly.

A move back above the $94 level should be enough to the reverse the downside momentum. While crude oil prices have been dropped, gasoline prices continue to move sharply higher, which will not help consumer sentiment.

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Precious Metals

The SPDR Gold Trust (GLD) closed the week just a bit lower, trading in about a $7 range since September 13. As I noted in Friday’s column, “Buying Gold When Bulls Are Charging,” the sharp increase in bullish sentiment makes the risk on new long positions uncomfortably high.

If we get a further correction, it should set the stage for another new rally high that could mark a short-term top. The way analysts are raising their price forecasts for gold reminds me of the stock market last spring, when the S&P targets kept moving higher a month before stocks topped out.

The best risk-reward buy point for those who are not long will come after a more sustained correction where the risk can be better controlled.

The Week Ahead

As I suspected last week, we did get another bit of Eurozone news this week that clearly did concern the markets. It does not appear to be over, as if stocks fail to rally above last Thursday’s highs early this week, a deeper correction looks more likely.

Clearly, the short-term outlook favors a cautious approach for now, and be sure you have your stops in place.

Several of our positions were stopped out last week, and I will concentrate on doing new buying only on a test of more important support. October is a seasonally strong period, which suggests a better buying opportunity is likely in the coming weeks.

And don’t forget to read Tom's latest Trading Lesson, Are May's Top Groups Still Leading?

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