The following article is adapted from the August 2014 Elliott Wave Financial Forecast, published Aug. 1. For the latest from the Financial Forecast Service, click here.

Weak Secondary Stocks and Declining Junk-to-Treasury Bond Ratio Indicate the Stock Market is Ripe for Reversal

The Dow Jones Industrial Average is in the terminal stages of its advance from March 2009.

Its rise to a July 16 closing high of 17,138.20 met the long-term price targets discussed in detail in the July-August double issue of The Elliott Wave Theorist. The market continued to narrow into the high, as less-liquid, more-volatile assets lagged the Dow.

In May, when The Elliott Wave Financial Forecast first showed the plunging prices in shares of small-cap stocks relative to large-cap stocks, we said the transition from "risk on" to "risk off" was fully underway. Since then, the small-cap/big-cap ratio has declined to its lowest level in 19 months, since November 2012.

While the DJIA chopped higher, the Russell 2000 Index of small-cap shares remained essentially flat. The Russell's closing high remains 1208.65 on March 4, while its intraday high is 1213.55 on July 1.

The broader Value Line indexes also made highs on July 1 and have declined in five waves since then.

The chart below -- the ratio of junk debt prices-to-U.S. Treasury debt prices -- shows another telltale sign of a crippling return to risk aversion.

Junk bonds are issued by companies with the weakest balance sheets. In the event of bankruptcy, holders of these bonds risk getting back only dimes on the dollar, or nothing at all.

The junk/Treasury price ratio is currently down more than 11% since Dec. 31, 2013, the date of its most recent peak. The last time this ratio was down more than 11% while the S&P 500 was at a new all-time high was in July 2007, at the forefront of the greatest credit contraction since the Great Depression.

Weak secondary stocks and a declining junk-to-Treasury bond ratio indicate an environment that is ripe for a stock market reversal.

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