This is turning into a "hold your nose and buy it rally." The minor dips continue to be bought and the market is immune to every headline. Analyst tell us that hedge funds and institutional traders were underweight equities going into the election and even with the massive post election rally they are still underweight. The initial November rally was met with a lot of skepticism and many hedge funds attempted to short it when the initial bounce faded. After two months of sideways trading, the outlook by professional traders was still negative.

When the current surge broke over 2,300 on the S&P and 5,800 on the Nasdaq, those traders stared in disbelief.

You may remember me saying multiple times that a breakout over 2,300 would trigger serious short covering and price chasing by portfolio managers. That is exactly what happened and they are not done yet. Everyone is racing to get into the market because they cannot afford to be left behind and beaten on gains by their competitors. Portfolio managers live and die on their market benchmarks and on their comparison to gains achieved by other funds. Those gains become a marketing tool and lagging the market and competitors is a way to lose your bonus and your job.

Today we have a very overbought market and it may become even more overbought before the inevitable profit taking appears. The Nasdaq 100 is at overbought levels not seen since January 3rd, 2000 when the Nasdaq bubble market was in full swing. That should be a scary thought.

However, while the market is overbought, I looked at more than 500 individual stock charts this weekend and the majority were strongly bullish. Unfortunately, quite a few looked like the chart of the Nasdaq and I would not buy them on a bet.

There is a funny thing about the market. Stocks making new highs tend to continue making new highs regardless of how overbought they become, until the bubble finally bursts.

The internals did give us a clue to the market health. The major indexes closed at new highs on Friday. However, the new 52-week highs on individual stocks peaked on Monday at 1,017 and declined each day of the week to only 454 on Friday. In other words a fewer number of stocks were supporting the market as the week progressed.

Some internal weakness should be expected ahead of a three-day weekend. Traders will lock in profits and some will leave early to stretch a three-day weekend into 4 or 5 days. That means volume shrinks, which it did with Friday the second lowest day of the week at 6.5 billion shares. Monday had 6.35 billion and Wednesday was the highest at 7.1 billion.

Advancing stocks peaked the prior Friday at 5,022 to 2,012 decliners and the ratio on Friday was 3,563 to 3,421 decliners.

It is hard to say too much negative about the market when the Russell 3000 Index, the largest 3,000 stocks in the market, closed at a new high and is poised to move over 1,400. The initial breakout was textbook with the minor retracement that used prior resistance as support to launch the next leg higher. Unlike the post election rally from a low spot, the new leg higher rally is overbought and needs to rest.

The Russell 1000, the largest 1,000 stocks in the market, has an identical pattern to the broader index. It closed at a new high on Friday and could stand a dip to the blue line to equalize the overbought conditions.

The Achilles heel for the market remains the small cap sector. The Russell 2000 did breakout to a new high but only barely. The small caps are still struggling. The 1,400 level has become new high resistance and the index is consistently the worst daily performer in the market.

Small caps normally lead the market up and down. This time the big caps are leading because it is easier to throw a lot of cash into stocks like Apple, Boeing and Microsoft because of their high liquidity. If the market decides to pause that cash can be extracted just as easily without a major impact to the stock price. Portfolio managers are looking for safety rather than bang for the buck that they would normally get with small caps.

The Russell 2000 has a wide range of stocks and not all are truly small caps stocks. Russell sorts all the available stocks by market cap and the top 1000 go into the Russell 1000 and the next 2,000 become the Russell 2000. So, the stocks with the market cap just below what would qualify for the Russell 1000 index are still in the Russell 2000. There are a lot of big fish left in that pool of minnows.

The S&P-600 is a carefully selected group of "quality" small cap stocks. This is unlike the Russell 2000 where everybody gets in if your market cap qualifies. The S&P-600 stocks are picked by a team of analysts just like the S&P-400 Midcap Index and the S&P-500.

With the S&P-600 we have a true representation of the small cap sector and this index has not yet broken out and has stalled just under that 860 level.

I would watch this index next week for the health of the market. If the S&P-600 begins to fade, I would be very cautious with large cap long positions. A decline under 850 would be a warning sign. Conversely, a break over 860 would be very bullish and could trigger price chasing in the small cap sector.

The Volatility Index is still showing total complacency in the market. However, there were several days early last week when the VIX actually rose in a strongly bullish market. Somebody was buying a massive amount of puts to protect their positions.

The average period of low volatility in the market is 55 days according to S&P. The VIX has closed under 14 since November 16th and has easily exceeded that 55-day average. We are due for a volatility event.

With the market so completely complacent and severely overbought, any unexpected headline could cause a rush to the exits. I theorized in the Option Investor commentary this weekend that it could be a confirmed delay in the announcement of a tax plan that appears to indicate it will be significantly less than promised. There could be other factors. I am still waiting for some other country like Iran or North Korea to challenge President Trump with some event that requires a response. It happens with every new president. The market could react badly to that event.

Washington DC is in a chaotic condition and I would not be surprised to see a shocking headline at any time. All these things could spike the VIX and cause a pullback in the market. We are approaching a new debt ceiling deadline and the first real test of how the divided houses are going to conduct business. A government shutdown would definitely tank the market.

When the market appears the least concerned about outside events, is when we should be extra cautious. We could look back at this period three months from now and think, "Wow what a rally" or we could look back and think, "Wow that was a really fast drop." While hindsight is 20:20, foresight is very limited.

If the market is up, hold your nose and buy something but keep a tight stop just in case somebody hits the panic button. Personally, I would prefer to wait for a buying opportunity. We know it is coming, we just do not know when.

Enter passively and exit aggressively!

Jim Brown

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