All major U.S. indices closed higher last week, logging the second week of strength following choppy trading since late August. 

Last week’s rally was led by the small-cap Russell 2000, which is another positive sign. The index gained 4.6% through Friday’s close but is still down 3.3% for the year and lagging the other major averages. Broad market advances are typically led by the Russell 2000 and tech-heavy Nasdaq 100, the latter of which is the only major index still in positive territory for 2015.

Recent strength in the energy sector is more good news, as it suggests a pickup in expectations for global economic growth. In last week’s Market Outlook, I pointed out that the biggest expansion in sector bet-related investor assets over the previous one-week and one-month periods was in energy, according to Asbury Research’s own ETF-based metric.

These positive asset flows have already fueled an 8.4% rise in the energy sector in the past month, making it by far the strongest sector of the S&P 500. It has outperformed the broader market index by 4.7 percentage points during that time. As long as these positive asset flows continue, so should strength in energy-related stocks.

Resilient European Market A Good Sign For The U.S.

Last week, I noted we were at an important inflection point for the market from which a fourth-quarter recovery should begin unless we were entering a global bear market. I mentioned the Japanese and German stock markets as two ways to determine whether the worst was materializing. Specifically, I pointed out that the German DAX was testing major support at its 2011 uptrend line.

The DAX rose 5.7% last week and has rebounded 8.3% from its Sept. 29 test of this line.

I view this chart as evidence that fears of a global contagion due to weakness in China have not materialized — at least not yet. This is another encouraging sign for the positively correlated S&P 500 heading into this week.

Dow Reclaims Its 2009 Uptrend

The recent recovery in a number of global equity markets is also apparent here in the United States. In the Sept. 14 Market Outlook, I discussed the breakdown in the Dow Jones Industrial Average below its March 2009 uptrend line. I said a sustained rise back above it would be viewed as evidence the market recovery I’d been expecting was getting under way. 

The Dow closed significantly above that trendline on Friday. In the process, it established a series of higher highs and higher lows, which, by definition, is an uptrend.

As long as the Dow remains above this major support level, currently situated at 16,587, it will suggest the larger bullish trend has resumed.

Abating Volatility Points To Sustainable Rally

Elevated volatility was another red flag for the market during August and September, but that too appears to be clearing up.  

On the chart below, we can see the direct relationship between the Volatility S&P 500’s (VIX) move above its 50-day moving average on Aug. 20 and the S&P 500’s collapse from near its all-time highs.

The VIX traded below its 50-day all of last week, which indicates recent investor fear has abated and investors are now collectively confident enough to buy stocks again. As long as the VIX remains below this moving average, currently at 21.35, history suggests the stock market rally will continue.

Waiting For The Bond Market’s Blessing

Despite all of the positive market signs last week, there is still one potential indication of trouble ahead: The bond market remains nervous.  

Two weeks ago, the yield of the 10-year Treasury note collapsed below its 200-day moving average, then at 2.12%. This suggested the bond market saw economic risks ahead.

Another way to determine what the bond market is “thinking” is via the 2-year/10-year yield curve.

The chart shows that, after steepening (widening) since April, the curve peaked in early July before flattening (narrowing) below its 200-day moving average, a widely watched major trend proxy, on July 31.  

A steepening yield curve indicates the forward-looking bond market is pricing in improving economic conditions, while a flattening curve warns of economic trouble ahead. Accordingly, the April to early July steepening period was a relatively strong one for the U.S. stock market, but once the yield curve began to flatten later in July, the market stopped moving higher. Within weeks of the curve flattening below its 200-day moving average, the market collapsed into the late-August lows.

The yield curve clearly stabilized through the end of last week but is still slightly below its moving average, which is currently situated at 148 basis points. I would view a sustained steepening back above that moving average as evidence the bond market is giving the economy its blessing. This would be the final piece of the puzzle for a sustainable Q4 stock market rally.

Putting It All Together

Relative outperformance by the economically sensitive energy sector, recent strength in European and Japanese markets and declining volatility here in the United States set the stage for a sustainable U.S. market rally heading into year end. All that’s missing is a steepening U.S. yield curve to indicate the more prescient and forward-looking bond market is giving global economic conditions the all clear.

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This article was originally published on ProfitableTrading.com: There’s One Problem With This Market Rally…