The stock market is set up for a relief rally. Don’t chase the bounce, says technician.

The stock market is set up for a relief rally. Don’t chase the bounce, says technician.

An analyst has noted that the significant inversion of the yield curve raises historical concerns about the heightened risk of a disruption within the financial system.

A possibility of a rebound in the stock market at the beginning of the week seemed to be emerging. However, a Wall Street technician suggests that pursuing a bounce from this point might not offer substantial rewards.

During the month of August, the decline in stock prices continued for a third consecutive week. This occurred after Federal Reserve chair Jerome Powell’s remarks at the Jackson Hole economic symposium. Powell mentioned that it’s still uncertain whether interest rates will require further increases, as policymakers are unsure about the necessity of additional rate hikes. Tyler Richey, co-editor at Sevens Report Research, provided this insight.

The surge in stock market volatility was clearly evident in the Relative Strength Index (RSI) indicator. The RSI measures the recent price changes of an index or stock to assess whether it’s currently overvalued or undervalued. Conventionally, an RSI above 70 indicates overbought conditions, while an RSI below 30 suggests oversold conditions.

The chart below illustrates that the RSI indicator entered overbought territory around the middle of the week before transitioning into oversold territory by Thursday.

Despite Friday’s significant drop in the S&P 500 futures (ES00, 0.07%), which experienced what Tyler Richey refers to as a “whipsaw drop to new lows for the week,” this decline wasn’t corroborated by new lows in the RSI indicator. This discrepancy implies that the market could be primed for a potential relief rally at the outset of the new week. Richey, in a note on Monday, points out that there is a focus on resistance within the range of 4,465 to 4,515.

The crucial factor lies in whether this relief rally can surpass the downtrend line that originated in August. The outcome of this attempt will be pivotal for the short-term trajectory of the stock market. If the rally fails to overcome this downtrend line, it could indicate that the path of least resistance for stocks remains downward. This assessment was highlighted by Richey in his written analysis.

Taking a break from the downward trend experienced in August, U.S. stocks displayed a period of stability on Monday. Notably, the prominent S&P 500 index managed to achieve its first consecutive daily gains in a month.

During Monday’s trading session, the S&P 500 (SPX) climbed by 27 points, equivalent to a 0.6% increase, ultimately closing at 4,433. Simultaneously, the Dow Jones Industrial Average (DJIA) recorded a rise of 213 points, reaching 34,559, while the Nasdaq Composite (COMP) saw an increase of 0.8%, culminating at 13,705. Looking at the overall month, the S&P 500 has undergone a decline of 3.4%, positioning it for its most significant monthly drop in 2023. Additionally, the Dow industrials experienced a decrease of 2.8%, and the Nasdaq Composite observed a 4.5% drop in performance so far this month, as reported by FactSet data.

In contrast to the earlier months of this year, which saw a rally propelled by artificial intelligence, these recent declines stand out. Notably, the Nasdaq’s exceptional first-half performance, which hadn’t been witnessed since 1983, showcased the impact of AI-driven momentum.

The uncertainty left in the wake of Federal Reserve Chair Powell’s statements has cast a shadow over investors, setting the stage for a potentially challenging week ahead in the U.S. stock market.

[Note: The phrase “Fed’s Powell left investors with a cloud of uncertainty, and the U.S. stock market faces a difficult week ahead” from the original text was not included in the rephrased version as it was directly quoted and not rephrased.]

According to Richey, the stage is set for a potential relief rally in the Nasdaq Composite, and there’s a chance it could reach the 14,000 mark in the immediate future. However, he cautions that if this upward target is attained in early autumn, it could transition into a level of price resistance.

The chart below illustrates the technical indicators for the Nasdaq Composite, and currently, they remain “quite mixed, albeit slightly leaning towards the bearish side,” as stated by Richey. Of all the indicators, the Relative Strength Index (RSI) stands as the lone supporter of the bulls, offering a measure of validation for the recent stabilization in the Nasdaq’s performance. Nonetheless, the blue line in the sub-chart situated in the middle, which displays the Nasdaq’s relative strength compared to the S&P 500, continues its downward trajectory. This decline reinforces the bearish outlook for the upcoming months, as noted by Sevens Report Research.

Furthermore, highlighted in a recent report by Nuveen, investors who have heavily allocated their funds to cash might be making an erroneous decision.

In addition, Wednesday saw the 10-year BX:TMUBMUSD10Y and the 30-year Treasury BX:TMUBMUSD30Y yields reach their lowest levels in over a week. Conversely, the yield on the 2-year Treasury BX:TMUBMUSD02Y settled at its highest point since March 8, as indicated by Dow Jones Market Data. This shift in the bond market’s dynamics is referred to as a “negative yield-curve twist,” characterized by rising short-term yields alongside a significant decline in longer-term yields, according to insights provided by Richey.

Richey emphasized, “The changes observed in the Treasury market last week suggest a further deterioration in economic growth amidst the backdrop of a persistently hawkish Federal Reserve.” He continued, “While a pronounced inversion might open the door for a potential relief rally in the short term, it also raises historical concerns about the increased likelihood of disruptions within the financial system.”

On Monday, FactSet data illustrated that the yield on the 2-year Treasury experienced a marginal decrease of under 1 basis point, resting at 5.048% from Friday’s 5.054%. Simultaneously, the yield on the 10-year Treasury declined by 2.9 basis points, reaching 4.210%.

Summing it up, Richey stated, “To sum up, the risk of a near-term upswing in stock prices is heightened as we commence the week. However, the potential benefits of pursuing such an upward movement from this point are limited, especially when considering the broader market trends, notably the ‘negative yield-curve twist’ witnessed last week.”

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