Major indices have bounced strongly since Feb. 9, ending a steep decline generated by rising interest rates, but the market could retest lows in the coming weeks and punish recent dip buyers. More importantly, those support levels could break and set off the next leg of an intermediate correction that exposes a significant portion of 2017 upside. Given the threat, market players should take defensive steps to protect returns and adapt to a more adverse market environment.
The dismissal of Chief Economic Advisor Gary Cohn removes a major obstacle to metals tariffs and other measures that are likely to target Chinese imports. These policy decisions could trigger a trade war that has a strongly negative impact on U.S. growth. Unfortunately, inflation is likely to escalate at the same time, raising the specter of stagflation as Americans are forced to pay more for everything from canned goods to their favorite Amazon.com, Inc. (AMZN) Prime purchases. (For more, see: Which Stocks Will Win or Lose From Steel, Aluminum Tariffs?)
The SPDR S&P 500 ETF (SPY) took off like a rocket at the start of 2018, adding to a historic rally that began following Donald Trump's 2016 election. The uptick hit an all-time high at $286.63 on Jan. 26 and rolled over, entering a major decline that posted an 11.5% loss into the Feb. 9 low. Buyers emerged into month's end, lifting the stock back through the decline's midpoint before it stalled out on Feb. 27.
Price action has settled near the 50-day exponential moving average (EMA), carving a ragged pattern that favors neither bulls nor bears. A Fibonacci grid stretched across the sell-off wave places the bounce's peak near the .786 retracement, which is notorious for printing lower highs in developing downtrends. First news of the tariffs last week dropped the fund into the .386 retracement near $265, which bulls need to defend to avoid a trip back to the low.
The fund could be playing a game of 50-200 pinball, caught between the 50-day EMA at $271 and 200-day EMA at $258. If so, a retest of the February low becomes likely, allowing market players to decide if price action has entered a broad trading range or an intermediate downtrend that targets the 200-week EMA, currently rising from $218. Odds for a trade war will be the deciding factor, with China policy having a greater negative impact than broad-based metals tariffs. (See also: Stocks Plummet Amid Fears of a Trade War.)
The Powershares QQQ Trust (QQQ) broke out above the 2000 internet bubble high in January 2017 and entered a powerful trend advance that posted shallow pullbacks into January 2018, when the fund topped out at $170.95. It fell more than 20 points and 12% in the next two weeks, coming to rest just two points above the 200-day EMA. The subsequent bounce posted stronger upside than SPY into late February, recouping nearly 100% of the decline.
A pullback into Friday's close reached the .618 Fibonacci retracement level near $163, yielding a strong uptick that stalled less than two points under the two-week high. Overnight price action into Wednesday morning probed the $167 level, but the fund is holding up well into the opening bell. A breakout above $171 would negate further sell signals, possibly supporting another trend advance.
While QQQ is holding up better than SPY, it is unlikely to rally or break out without blue-chip participation. Meanwhile, continued selling pressure will target last week's low, with a breakdown opening the door to $158. Curiously, SPY's on-balance volume (OBV) has shown stronger buying interest than its big tech twin in the past month, suggesting that QQQ's relative strength will fade quickly if blue chips head for lower ground. (See also: 4 Red Flags for Technology Stocks.)
The Bottom Line
Major indices are now vulnerable to a rapid decline that tests last month's corrective lows. The .382 retracement levels at SPY $265 and QQQ $158 mark lines in the sand that must hold to avoid that test and risk breakdowns to new 2018 lows. (For additional reading, check out: 6 Reasons for Another $6 Trillion Stock Market Correction.)
<Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.>