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Global Macro: Volatility Lurks; Correction Is Likely

Stocks in this article: RSP SPY XLU QQEW QQQ AAPL VXX GLD DBC

NEW YORK ( TheStreet) -- U.S. equity markets have extended their winning streak to four months, but low volumes and lack of a catalyst could add more volatility this week. The chart below shows Guggenheim S&P Equal Weight ETF (RSP) over SPDR S&P 500 (SPY). This chart represents market breadth, or in simpler terms, how many stocks are participating in the rally. As the indicator rises, it signals that a large number of stocks are taking part in the move higher.

The indicator has recently broken out of a multi-month consolidation and looks to be pushing upward. Although contrarians will point to an overvalued market as reason for a large pullback, the strength of the rally indicates that it has the steam to continue rising. If the market does see a pullback in the next few days or weeks, due to something said by Ben Bernanke at his congressional testimony or poor economic data, the downside is limited by the strong support line below. In essence, a pullback is possible, especially due to the overbought nature of the market, but any pullback should be limited to a minor correction, not a trend reversal.

Volatility has been gradually declining as markets have experienced their four-week run. The S&P 500 VIX Short-Term Futures ETN (VXX) is a good options measure for equity market volatility, but another useful indicator comes by way of the Utilities Select Sector SPDR (XLU) over the S&P Equal Weight ETF. The pair moves in a strong inverse to U.S. equity market, similar to the VIX.

The price action has approached lows that, until earlier this year, hadn't been breached since 2011. With volatility hitting a bottom and markets falling on the side of overbought, it would not be unreasonable to see a pickup in near-term volatility, and a pullback in U.S. markets.

Waning strength in the Nasdaq gives further evidence to an equity market pullback. The pair below compares Nasdaq-100 Equal Weighted Index Fund (QQEW) to Nasdaq-100 Index Fund (QQQ). The Nasdaq is a market-cap weighted index, so it naturally is dominated by Apple (AAPL). However, when you look at the equal weight index over the normal-weighted index, it shows the true market strength.

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