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All major U.S. indices except for the blue-chip Dow Jones Industrial Average closed higher last week, led by the tech-heavy Nasdaq 100 and small-cap Russell 2000, which both gained 0.7%. These two indices are also leading year to date, up 6.9% and 3.9%, respectively, compared to a tepid 3.3% advance for the broader market S&P 500.

As I have been saying all year, as long as technology and small-cap issues continue to lead, my overall outlook for the stock market remains cautiously positive.

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The sectors of the S&P 500 were essentially split down the middle last week in terms of winners and losers. On the plus side, health care gained 1% and technology was up 0.7%. Consumer staples lost 1% and materials were down 0.8%. 

My own ETF asset flow-based metric shows that the biggest contraction in investor assets over the past one-week and three-month periods came from consumer staples, which warns that more near-term weakness is in store for this typically defensive sector.

Weakening Transports a Canary in the Coal Mine?

For months, I have been discussing the bullish implications of chart patterns in the Nasdaq 100 and Russell 2000. They continue to target an additional 2% to 5% advance in these indices provided they remain above key support levels at 4,347 and 1,213, respectively.  

I consider these to be primary indices that typically have the most immediate cause-and-effect relationship with the broader market. One secondary index is becoming troubling, however, at least according to Dow Theory, which states that the Dow industrials and transports must confirm each other’s strength during a healthy uptrend.

The Dow Jones Transportation Average declined below its 200-day moving average, a widely watched major trend proxy, in early April. The transports then tried to regain the moving average as underlying support by late April, failed to do so, and collapsed to fresh lows by the end of last week.  

This is problematic because, as the next chart shows, the Dow Jones Industrial Average set a new all-time closing high last week as the transports are making seven-month lows. This classic divergence between the two indices, which have been positively correlated for the past 20 years, suggests that one of them is temporarily mispriced.

With the industrials setting new all-time highs amid generally anemic economic data, especially considering that the Federal Reserve is expected to begin raising interest rates later this year, I believe it is the industrials that are mispriced. Therefore, they should eventually fail and fall back into sync with the steadily weakening transports.  

Although this divergence is not a signal to immediately exit the stock market, with technology and small caps still in the midst of healthy uptrends with unmet upside targets, I view it as a strong indication that there may now be more downside risk in this market than there is upside potential.  

The Most Important Chart This Quarter

While the 2015 crosscurrents continue in the stock market, the yield of the 10-year Treasury note is negotiating a major inflection point — one that is likely to become the springboard for the next significant trend in benchmark U.S. interest rates. Moreover, this emerging move in rates is likely to have a strong effect, at least initially, on stocks’ direction.

The yield on the 10-year has been hovering between the December 2013 downtrend line at 2.25% and the 200-day moving average and 2.18%, both major trend proxies, for weeks. This is proof that the market recognizes their importance to upcoming direction.

A sustained move above 2.25% would indicate that a major trend of rising long-term U.S. interest rates is beginning and would clear the way for a test of the next two overhead obstacles at 2.34% and 2.44%. Conversely, a sustained move below 2.18% would suggest that the 2014 trend of declining rates is still intact and would clear the way for an initial move down to 1.9%. 

My own analysis, which is based on price and yield activity in a number of additional interest rate-related assets, as well as investor asset flows, suggests the former is more likely, as investors slowly and grudgingly acknowledge that the Federal Reserve will begin an interest rate hiking cycle later this year. Should this happen, it could be the catalyst for the long-awaited stock market correction that Dow Theory is warning of.

Copper Meets Initial Upside Target

In the March 23 Market Outlook, I discussed a positive near-term trend change in the iPath DJ-UBS Copper Sub Total Return ETN (NYSE: JJC). I said it cleared the way for a move to the 200-day moving average, which at that time was situated at $35.69.

JJC traded as high as $35.60 on May 5, slightly clearing the 200-day moving average as expected, before recently backing off to retest the 50-day moving average at $33.49, a minor trend proxy, as underlying support.

This sets up an important near-term decision point for JJC, and for copper prices, which it represents. The ETN should attract new buyers that fuel a retest of the 200-day moving average from below if the bullish trend from its late-January lows is still valid and intact.  

On the other hand, a sustained breakdown below $33.49 would suggest that JJC’s larger bearish trend, as defined by the 200-day moving average, is resuming. This would be a sign for copper bulls to protect any open trade profits in expectation of a deeper decline.

Putting It All Together

My near-term outlook for the U.S. stock market remains cautiously bullish due to unmet upside targets 2% to 5% above the market in the Nasdaq 100 and Russell 2000. However, there are three strong reasons why investors should keep a particularly close eye on their portfolios this summer:

1. New seven-month lows set last week in the economically sensitive Dow transports.

2. An upcoming rate hike by the Federal Reserve.

3. Weak summer seasonality of “sell in May and go away” fame.

Traders should already have a defensive plan in place and ready to be executed, as the chances are very good that a long-overdue corrective decline could begin sometime this quarter.

This article was originally published on ProfitableTrading.com: Caution: Downside Risk Outweighs Upside Potential​