Get Set for a Wild Ride Into the Third Quarter

Supply chain disruptions, rate cut mania, and a shrinking job market practically ensure a volatile end to the second quarter. Next week may offer a preview of coming attractions, with Thursday's rollover of the June index futures contract into the September forward month, which signals the start of triple witching options expiration. There's no guarantee that bulls or bears will make much headway into the quarter's end, so trend followers may want to take a break while the short-term trading crowd gets sliced and diced.

Headline risk continues to grow at a rapid pace, despite Wall Street and investor complacency. For starters, no one seems concerned about talks with Mexico, which have the power to upend the bull train in next week's price action. At the same time, optimism about an eventual reconciliation with China seems misplaced because the country's government-controlled press is setting an aggressive and contrary tone that is being ignored by many Western news outlets.

The SPDR S&P 500 ETF (SPY) rallied just one point above the 2018 high in May and turned tail, dropping into a test of the 50-day exponential moving average (EMA) last week, and it is set to post a bullish outside week that opens the door to a second test at 2018 resistance. The Invesco QQQ Trust (QQQ) failed a stronger breakout in May but has also bounced at support. This mixed action raises the odds for a range-bound market into the summer months rather than breakouts to new highs.

Small caps continue to underperform blue chips as we head into mid-year, keeping a lid on market breadth. The iShares Russell 2000 ETF (IWM) just bounced off a five-month low after breaking down from a four-month trading range. More importantly, it's now trading closer to the 2018 low than 2018 high, signaling a bearish divergence compared to stronger SPY and QQQ price action.

Bond Yields at Support

Chart showing the performance of 10-year Treasury yields (TNX) 

Bond yields have collapsed, lifting the iShares 20+ Year Treasury Bond Fund (TLT) to the highest high since the 2016 election. (See also: Long Bond Reversal Could Underpin Stocks.) Meanwhile, Fed Chair Jerome Powell has raised hopes for interest rate cuts if political forces trigger an economic slowdown. However, rate cuts are no substitute for corporate profits in the tenth year of a bull market, suggesting that selling pressure will pick up in the coming weeks.

Even so, there are signs that bond yields will rise in coming weeks. The 10-Year Treasury Yield is nearing strong support at the 2.00% level, while the long bond fund reversed at resistance above $130 after posting a new high at $132.58. These forces suggest that China and Mexico will generate fewer headwinds than expected, at least in the short term, allowing the growth crowd to come out of their caves.

Transports Waving a Red Flag

Chart showing the performance of the The iShares DJ Transportation Average Index Fund ETF (IYT) 

The iShares DJ Transportation Average Index Fund ETF (IYT) posted an all-time high at $206.73 in January 2018 and tested that level in September. It turned sharply lower into year end, dropping to the lowest low since November 2016, ahead of a 2019 bounce that stalled at $200. Bearish price action has been waving a red flag in the past six weeks, dropping the venerable average to a four-month low.

Dow theory warns this price behavior could presage a broad-based downturn, but less ominous forces may be at work. For example, former sector leaders FedEx Corporation (FDX) and United Parcel Service, Inc. (UPS) are now underperforming other transportation components, raising fears of an economic slowdown, but both companies are set to lose market share as, Inc. (AMZN) rolls out its in-house transportation system.

The Bottom Line

The market faces major cross-currents as it heads into the summer months, making a sustained bull run unlikely.

Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.

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