When portfolio managers come back from vacation next week, they have the busiest two months of the year ahead of them.

If they are running behind their benchmark index for the year they will be forced to dump underperformers and try to buy some winners in hopes of increasing their gains before the fiscal year end on October 31st. If they are ahead of their benchmarks they will concentrate on holding their gains and possibly locking in some of those gains by closing positions. Either way the next two months are spent on restructuring portfolios for maximum performance and to put a positive spin on their 2017 marketing materials.

If a manager wants to add performance in this market, he must buy small cap stocks. That suggests he will have to sell large cap stocks since they are the current laggards. Obviously, this can change at any time but small caps are typically the favorites in Q4. Since the market is not showing any volatility, managers may not feel the need to hide out in the high liquidity large caps.

I showed charts for the S&P-400 and S&P-600 in the market commentary so I will not list them again here. If we look at the larger version of the large cap indexes, the Russell 1000, we see a similar picture to the S&P-500. The R1K has been stuck in a tight range for the last 45 days. The new historic high was set at 1,213 back on August 15th and until Friday's short squeeze the index had been fading. This chart is almost identical to the Dow and S&P.

One way to play the breakout on the small caps is the Russell 2000 ETF (IWM). However, the Russell is not breaking out because there are hundreds of low quality stocks in the index. It did make a new 52-week high but it is lagging the S&P 400/600. You can play the Midcap SPDR ETF (MDY). The ETF closed at a new high on Friday and has a positive trend. The options are relatively expensive but you get what you pay for. I would recommend a call spread to reduce the cost.

The Semiconductor Index broke out to a new high on Thursday but was fractionally lower on Friday because of a disappointment in the Broadcom (AVGO) earnings. The $SOX is currently overextended but could move higher. Ideally you would want to wait for a pullback to that breakout point at 792 and see if that becomes support. You can play the $SOX using the ETF (SMH).

The Nasdaq and the $SOX are locked together at the recent highs and a continued rise in the $SOX should pull the Nasdaq higher.

Another problem for the Dow is the Dow Transports. The index is stuck below downtrend resistance at 7,950 and horizontal resistance at 8,000. Even with oil prices sagging the transports are struggling. The airlines are trapped in a major battle for market share and they have put themselves into an over capacity position that is impacting fares and load levels. Add in the decline in travel to Europe because of terror fears and their guidance has been weak.

The railroads are still struggling because of the decline in the energy sector. There are thousands of car parked on sidings that were previously hauling oil, drill pipe and frac sand when active rigs were four times higher in 2014 than they are today. That problem is not going to be resolved in the near future.

The Dow Industrials normally fail to rally when the Dow Transports are lagging.

The sentiment charts are not showing the bullishness you would expect given the breakout on the small caps. That is because the sentiment charts are based on the big cap indexes. The S&P Bullish Percent Index has plateaued at the 75% level and a level where it has stalled several times over the last three years. I would be surprised to see this chart rise significantly.

The S&P-100 is the 100 largest stocks in the S&P-500. The percentage of those stocks over their 200-day average had risen to almost 90% and the highs from 2014 but the two months of consolidation has allowed the averages to catch up and the number should continue to decline from here.

The S&P-500 chart is similar with 80% of the stocks over their 200-day average but fading.

You can really see the fall off from the sideways consolidation pattern in the percentage of stocks over their 50-day average. That has fallen from 90% in July to 61% as of Friday. The two months of consolidation allowed the shorter-term 50-day average to rise to meet the price on any minor pullback in the stock. This does not mean the market is rolling over but there have been a lot of major declines in individual stocks as the result of earnings misses. That all adds up in the percentages.

The fluctuation in interest rates and expectations for the Fed actually raised the correlation between the High Yield ETF and the S&P to 90%. In theory as long as they remain locked to each other the market should continue to rise. The high yield ETF has stalled at $86.50 as the S&P stalled at 2,175. Eventually one of these will break loose and lead the other up or down. I would bet on th ehigh yield ETF to push higher.

The dollar rose ahead of the Fed meeting in Jackson Hole then began to weaken as the prospects for a hike began to dwindle. The weak ISM report on Thursday pushed it lower and the conflicting jobs analysis on Friday caused volatility with a minor gain. The relationship between the dollar and commodities caused the dollar to push oil lower last week.

The broadest indicator for the market is the Russell 3000 and it is still locked in a consolidation pattern. This is the tug of war between the big cap stocks of the Russell 1000 and the small cap stocks in the Russell 2000. They have battled to a stalemate and until one side capitulates to the other, the R3K could remain in the consolidation pattern. This is the true picture of the broad market.

Volume should increase this week but probably not on Tuesday. Managers will want to catch up on their email, meet with their teams and plan some strategy. It could be several days before the volume accelerates but we should see the markets go directional before the end of the week. The direction may only be temporary so don't bet the farm on any initial move.

Enter passively and exit aggressively!

Jim Brown

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