Have you ever played that kids game where each player removes piece after piece of the puzzle until the tower comes crashing down?

Do you feel like the minor market gains every day are the equivalent of stacking another layer on our Jenga market? In the game Jenga there is no way out of the game without a collapse. In the current market, we may actually escape for several more weeks before the bricks come tumbling down.

We all know the market cannot continue to rally every day to another new high. The market has to rest and retrace some gains so investors on the sidelines feel better about entering positions. The market needs to "ebb and flow" in order to remain healthy. Too many days in one direction eventually produces an opposite reaction.

In our current environment, we have several factors working for us. The investing paradigm appears to have changed. This means a lot of money has to be repositioned.

Mutual funds are currently managing more than $31.38 trillion dollars worth of stocks and bonds. There are 79,669 mutual funds worldwide and 9,260 funds in the USA. If they are an actively managed fund they are scrambling to rotate funds from various sectors expected to do poorly into sectors expected to do well in the new environment. Energy, industrials, financials, healthcare, biotechs, defense and transportation stocks should be the winners.

Funds are rotating out of bonds as their value comes crashing down. More than $2 trillion in value has been lost in the global bond market since the election. There are trillions more to be lost if the current rotation continues. The yield on the ten-year treasury has risen from 1.33% in July to 2.37% in November. That is a 78% increase in yields in four months due to selling in treasuries and the drop in prices.

Only the very long-term institutional holders will stick with bonds in this environment. In order to recover their existing losses they need to hold to maturity. Investors not willing to take the paper losses are dumping bonds and treasuries to rotate into equities in hopes of catching a momentum wave into 2017.

The correlation between the High Yield ETF (HYG) and the S&P is breaking down. The S&P has taken the lead and the ETF is faltering. Historically they run in tandem and the breakdown is proof investors are rotating out of bonds.

Equities are being favored with the exception of the big cap techs. The Nasdaq 100 ($NDX) has yet to make a new high as investors cash out of large positions to raise cash to invest in the sectors that should win in 2017. The defense sector has exploded higher with Trump promising to rebuild the military and end the sequester that has crippled defense spending. Each daily gain is the equivalent of adding another layer of blocks on a Jenga tower.

The Biotech sector is an example of what happened when the tower became unsteady. Somebody dumped the wrong stock and the index crashed back from 3,500 to 3,200 in a very short period of time. The index was up 22% since November 3rd in a knee jerk reaction to the events. Therein lies the problem.

The Russell 2000 Small Cap Index has posted gains for 15 consecutive days. That is the best performance since 1996. This Jenga tower is growing to the sky. Since that is impossible we know a critical event will eventually remove the last support piece and the index will decline. In the case of the Russell, it may decline sharply because the small caps lack liquidity and once a bunch of stop losses are triggered, the avalanche can be dramatic.

Another index where the gains are unsupported is the Dow Transports. The transport index is up 12% compared to the 6% gain in the S&P. The transports are nearing critical resistance at 9,200 and the odds are slim they will make it through in the near future. Declining transports tend to drag the Dow lower. Conversely, a breakout over 9,200 would be very bullish for the Dow and the market.

The big cap tech stocks are recovering from their post election dip but the progress is slow compared to the other indexes. Facebook, Google and Netflix have been laggards holding the index back. Amazon has recovered somewhat over the last six days but Apple is still struggling. Until those tech generals decide to lead the charge higher, that new high may be elusive.

The broadest major index is the Russell 3000. That index broke out to a new high on the 17th and has not looked back. Although the market breadth has been shrinking, the decline amounts on individual stocks has been minimal while the gainers are adding points at a fast clip. The Russell 3000 represents the broader market and it is showing no weakness.

I could be very wrong but I believe we are going to see some profit taking soon. However, I also believe any retracement will be shallow and brief. There are far too many investors waiting on the sidelines for a chance to join the party.

The oscillators suggest we could have a continued rally because we have not yet reached the levels seen back in July. The percentage of S&P stocks over their 50-day average reached 69.6% but that is well below the 87% from July when the indexes were a lot lower. This means quite a few stocks have not taken part in the rally and are lagging the market. Investors will be hunting these out as underappreciated opportunities.

Likewise the Bullish Percent Index has only returned to 63.4% compared to the 76% or higher we have seen twice in 2016. This percentage of S&P stocks with a current buy signal. This suggests the market has room to run.

I would be a dip buyer in the week ahead. I am afraid that buying the market momentum after a three-week rally is asking for trouble. If you have a long time horizon and can stand a $3 to $5 temporary decline then you could buy the breakouts but I would rather buy the dips. Let somebody else take that hit and we can profit from our patience.

Keep those stops in place because it is always better to look back and say "I am glad I got out" instead of "I wish I had gotten out." There is always another day to trade as long as you have capital to invest.

Enter passively and exit aggressively!

Jim Brown

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