August and September are normally the two weakest months of the year.

Will history repeat itself or should we expect a late summer rally? The correct answer to that question would be worth a lot of money. However, historically, the average S&P decline for each month is only about 1.2% to 1.5%. That is hardly worth getting excited about. Unfortunately, averages have a way of distorting the facts. There are some years where the markets dipped 15% over that period and others where they gained sharply. If you average anything over 30 to 50 years, it is hard to see the potential damage.

If this August turns into a repeat of 2015, it would be very painful. There is no reason to expect that kind of decline but there was no reason to expect it then either.

October is called the "bear killer" month because more bear markets end in October than any other month. Those bearish markets typically decline in Aug/Sep to reach a low in early October. That has happened so much in the past that investors became accustomed to buying the October lows in advance of the best six months of the year strategy that starts on November 1st.

This year we have no specific reason for a sell off other than just being long term overbought. The forward PE on the S&P is 17.9 and 16 is considered a reasonable PE. The number is higher for high growth stocks but that is the average. The 17.9 is not high but it is elevated.

The analysts and fund gurus warning about a correction sometimes mention the Cyclically Adjusted PE or CAPE, which is currently 30.23 and the second highest in history. This was made famous by Robert Shiller and is also called the Shiller PE. The CAPE is the price to earnings ratio based on average inflation-adjusted earnings from the prior 10 years. That takes into account multiple market cycles over a trailing 10-year period.

Using the CAPE as a measuring stick, stocks are very overvalued. However, we know from experience there is no maximum number. Stocks can remain overvalued for sometime but there will eventually be a rapid devaluation.

There is no tape across the finish line for the market and no guarantee of an immediate decline once that line is crossed. Think of it as long distance race. Some runners cross the finish line and collapse while others slow down gradually to cool off. How the market reacts depends on the sentiment at the time and any headlines that trigger the peak.

I apologize for the small chart but we have a width restriction in email. For the larger chart click here

As I wrote in the Option Investor commentary this weekend, there are no specific reasons for an immediate decline. Earnings are strong, the Fed is on hold, the economy is healthy and Washington is gridlocked. We could go months or even a year before a material decline appears, BUT, that is not likely. The S&P is up 36.5% or 661 points since the last material sell off that ended in February 2016 at 1,810. That is a long time without a material decline and a lot of uncaptured profits are at risk.

On a shorter-term basis, the S&P punched through uptrend resistance over the last two weeks but could not hold the gains. There was a lot of choppy movement at the top. Thursday's decline was an outside day and the addition of Friday's decline makes it a bearish engulfing candle, which typically signifies a change in direction.

Despite that bearish comment, the S&P chart is still overall bullish. The MACD is about to turn negative again but a positive day on Monday could reverse that indicator.

The most bullish chart for the last several weeks was the advance/decline line for S&P stocks. That sharp uptrend stalled last week and we could be seeing the first signs of market weakness.

The correlation between the High Yield ETF and the S&P remains very high at 94%. Yield junkies are still sucking up high yield debt at almost the same rate as equities in the S&P. There is no market weakness in this chart.

The Dow had a great week with a gain of 250 points but note the A/D line also stalled. The Dow gains were only due to a small number of stocks that posted outsized gains. Boeing was up 29 points and added 198 points to the Dow. That is only one stock out of 30 so it is hard to call it a Dow rally. It was a Boeing rally. Note the MACD on the A/D chart is on the verge of a negative cross despite the strong gains.

The Dow chart is strongly bullish on the surface but suffers from the same lack of breadth impacting the A/D chart. The Dow soared through uptrend resistance but it was only driven by 5-6 stocks. The potential for 5-6 stocks to make the same enormous gains again this week is close to zero.

The Nasdaq has been the market leader over the last 20 days with a monster rebound from the early July lows. This looks very similar to the rebound out of the April lows and we would be very fortunate if the pattern repeated. The Nasdaq did suffer some extended profit taking from early June through early July. Despite the gains over the last 20 days, the index is not that overbought. It still needs to rest again in order to give traders the confidence to buy the dip. Nobody likes to buy new highs, especially after the volatility event we had on Thursday.

The Nasdaq could see additional weakness if the semiconductor sector continues to decline. If Apple disappoints and/or warns about production delays on the iPhone Pro/8, we could see chip stocks take another dip and that would lead the Nasdaq lower.

The Russell 2000 is now the weakest index. After a nice rally and new high, the index failed at 1,452 on three out of four days and then rolled over to retest support at 1,425. If that level breaks, the next target would be 1,400 and that would be negative for market sentiment. The MACD turned bearish on Friday.

While there is no specific reason for a market decline in August other than the historical trend, the market does not need a reason to rest. A sudden decline can come at any time. Because of the historical trend, I would suggest not being overly long over the next few weeks. Keep your stop losses in place and I would not buy any initial dips. Look for a rebound first and then pick an entry point. There is always another day to trade if you have money in your account.

Enter passively and exit aggressively!

Jim Brown

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