In The Week Ahead: Risk/Reward Favors The Bears

All major U.S. stock indices except the small-cap Russell 2000 posted a slight weekly gain. Despite last week's poor showing, the Russell 2000 is actually leading the market higher this year, up 8.3% versus 6.9% for the benchmark S&P 500.

The week's best-performing sectors were financials, which have benefitted from the recent rebound in long-term interest rates, and energy, thanks to oil's rally from major underlying support near $41.

While I remain positive on the stock market between now and early next year, my research continues to warn that near-term downside risk exceeds upside potential.

Another Major Obstacle For Market-Leading Technology

In last week's Market Outlook, I pointed out that the Nasdaq Composite had just posted its first weekly close above its 5,133 tech-bubble high. I said this boded well for a significant advance in the index over the next one to several quarters.

While the Composite managed another close above this important level on Friday, the chart below shows that its large-cap cousin, the Nasdaq 100, finished last week at 4,807, just below its corresponding high from March 2000 at 4,816.

How To Tell When A Correction Is Beginning

Last week, I also pointed out that the Volatility S&P 500 Index (VIX) was hovering near 12. I said this indicated an extreme in investor complacency that has historically coincided with or closely led near-term broader market declines. However, now that this complacent extreme has been reached, the market needs a good scare to trigger the next sell-off.

When that happens, the VIX should shoot above its 50-day moving average, currently situated at 14.95, as my research shows that a sustained rise above this moving average has coincided with every broader market decline over the past several years.

In the meantime, as long as the VIX remains near 12, the market is likely to continue drifting sideways to higher.

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Once the VIX does move above its 50-day moving average -- and it eventually will -- the next step will be to determine if the increase in investor fear is having a tangible effect on near-term market direction. One way to determine this is by watching the S&P 500's one-month rate of change (ROC).

The next chart shows that the S&P 500's one-month ROC has been positive -- i.e., above its zero line -- since July 11. But we also see that this metric has been declining lately even as the index has been setting new all-time highs.

This "negative divergence" indicates that the broader market index is losing upward momentum and is therefore vulnerable to more weakness later this month. Additionally, if one-month ROC moves into negative territory -- especially if accompanied by a move above 14.95 in the VIX -- it will be evidence that the near-term pullback I'm expecting is actually getting under way.