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Breakout or head fake? Here’s what the bulls need to watch for

Bull run
Pablo Blazquez Dominguez | Getty Images

The stock market's recent strength is nice to see. But the bulls shouldn't celebrate just yet.

On the second-to-last day of the month, the S&P 500 stands slightly above the top end of its very tight four-month range. That's a good thing, but we have to see more upside follow-through to confirm the breakout. We have to make sure this is not a "head fake" — like the one we got in the other direction a week and a half ago, when the S&P broke below the bottom end of its range by more than it has broken above it this time. That one only lasted a couple of days. At this point, we need to examine whether this latest breakout of the range is built to last.

The first place to look is in the bond market. The yield curve continues to flatten, as the spread between the two-year Treasury note yield and 10-year Treasury note yield has fallen to 0.94 percentage point, and now stands at its lowest level since October. The yield curve is considered an indicator of economic strength, so this isn't a great sign in and of itself. But the more immediate concern is that this falling spread continues to weigh on the bank stocks.

Both the KBE bank ETF and the KRE regional bank ETF have moved back into correction territory again (as they are each down about 12 percent from their early March highs) and both sit in negative territory for the year. Heck, even JPMorgan Chase is down 2 percent on the year, after being up by more than 8 percent in March.

On a longer-term basis, these declines are not the worst thing in the world. Both of these bank ETFs had rallied more than 75 percent from the February 2016 lows to the early March highs of this year, so declines of 10 to 12 percent are not that significant. However, given how long they've been underperforming — and how the yield curve continues to flatten on almost a daily basis — we're surprised that the vast majority of pundits out there continue to be so adamant in defending the group. We may need a least a few people to throw in the towel before the group finally sees a decent bounce.

Having said all this about the banks, the tech stocks obviously continue to be the key group to keep an eye on. They are overbought on a near-term and intermediate-term (and frankly, even long-term) basis — but that has been true every day for the past few weeks. Yet except for that one-day drop a week and a half ago, the group has not shown any signs of rolling over. Even if it does decline this week, the XLK tech ETF is going to have at least break below its 50-day moving average (which is still 4 percent below Friday's close) before it would raise any yellow flags on the group.

We get some key data this week, like the ISM manufacturing data Thursday and the employment number on Friday. But the most important factor that will answer the question of whether the S&P can indeed break "meaningfully" above the 2,400 level will be the performance of those tech stocks.

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Brian Sullivan

Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

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