Why the rout could continue in the week ahead

After another volatile Friday, analysts say they would not be surprised to see stocks take aim at January's lows in the week ahead as investors await two days of testimony from Fed Chair Janet Yellen.

Yellen's two days of testimony on the economy before congressional committees Wednesday and Thursday is the highlight of what promises to be another volatile week in markets. One catalyst that has been temporarily removed is China, where markets are closed for the Lunar New Year, and little data is expected.

The Fed chair's testimony comes as markets are anxious about the health of the economy and the Fed's stated intention to continue on a rate hiking path. But the markets have also priced out the possibility of a rate hike for this year, over concerns that the weakening economy and faltering financial conditions could give way to a recession. New York Fed President William Dudley this past week highlighted the Fed's concerns about financial conditions.

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Traders on the floor of the New York Stock Exchange
Brendan McDermid | Reuters
Traders on the floor of the New York Stock Exchange

"She has to do what Dudley did. She'll say the economy seems to be weathering the storm well, but it's premature yet, and there's still a storm, and as long as there's still a storm, they're not going to raise rates," said Mark Zandi, chief economist at Moody's Analytics.

There are several economic reports of importance in the week ahead. The JOLTs report on job openings and turnover Tuesday will be important, after the January employment report showed a big decline in hiring — just 151,000 payrolls — but a surprise pickup in wages and a decline in unemployment to 4.9 percent, due to more workers finding jobs.

Those positives in the employment data also diverge from the stream of disappointing economic reports that have some worried that the current soft patch could turn into a bigger slowdown or recession. There is also retail sales data on Friday, a key read on the consumer.

"There's a lot of pressure on the Fed chair. It's definitely a tricky situation for the Fed. The economy doesn't look too bad but it certainly has weakened. They finally got liftoff, and now the market is clamoring for at least a reversal — to stay on hold, if not some outright action," said Gina Martin Adams, Wells Fargo Securities institutional equities strategist.

Stocks sold off violently Friday, and the S&P 500 was off 3.1 percent for the week to 1,880, after three weeks of gains. LinkedIn's earnings disappointment sent its shares down 43 percent, and momentum names followed. Facebook was down nearly 6 percent Friday, and the IBB, iShares Nasdaq Biotechnology ETF lost 3.2 percent.

"The market certainly has shifted so very defensively that it seems to me the market is trying to price in a very significant slowdown in growth. As much as the economic data has weakened it still shows expansion," said Adams.

Don Townswick, director of equities at Conning, said it's time to take a more defensive tack now but investors shouldn't just dump stocks. "I think the markets are thinking recession. It's a little early to get in, but it's late to get out. Why sell stocks now that have taken most of the beating they're going to take?" Townswick said. He said if there is a recession, he expects it would be relatively mild.

Adams said she will be watching the dollar in the week ahead, especially for its reaction to Yellen's testimony. She said the dollar is repricing lowered expectations for Fed rate hikes, and has floundered against the euro and yen even as the European Central Bank and Bank of Japan take more easing action.

The dollar in the past week lost 2.6 percent, its worst performance since October 2011. But its losses helped stanch some of the selling in oil. Still, West Texas Intermediate crude futures were down more than 8 percent for the week, ending right above $30 per barrel.

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"The technical patterns say we can't dismiss the possibility of going lower. It's a pretty weak little recovery rally, as well. It just seems people are willing to take a wait-and-see attitude rather than 'buy on dips' mentality. About 40 percent of the gains from the low has been from energy's bounce back," she said. "We haven't seen anything in earnings that generates a lot of optimism. The numbers are OK but exhibit a slowdown from where we were a few months ago. There's not a lot of reason to stick your neck out and take a risk."

Adams said that if the market breaks its January lows, she is looking for the S&P 500 to test an important area right below 1,800. "The challenge would be to test that line before we give up the ghost and say this is a bigger financial market correction than we've had. … That's about as bearish as I'm willing to get right now. That support line is pretty critical for support of the long-term bull trend," she said.

Scott Redler, who follows short-term technical at T3Live.com said it would not be surprising to see the S&P 500 test the 1,812 low from late January early in the week. He said tech was the heart of the market, and has now lost its beat.

"High beta tech has now lost full momentum and is in collapsing mode, and why wouldn't the S&P at least test the low sometime before Yellen?" he said. "We're not at the lows, and there's no real catalyst to buy. … The market is not even as oversold. Why would someone step in at a level that's still 5 percent off the low of the year when there's even more technical damage than we had the last time stocks were at that level?"

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Redler said if the 1,812 level is broken, the next level to watch is 1,770, and if the selling continues, 1,660 on the S&P.

China's mainland stock markets will be closed all week, and the People's Bank of China should also be quiet.

"There's only a couple of data releases from the PBOC and it's money supply growth, so we're not expecting any earth-shattering data release when the celebrations are going on," said Peter Donisanu, global strategist at Wells Fargo.

"I think it's going to give us a breather. I think one hopeful note, a silver lining out of this holiday season, is the consumer spending that's expected to occur inside of China and outside, as well," he said.

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