Who would have thought after the prior week's volatility we would have been at record highs again this week?

The week started slow with the major indexes posting minor declines but sentiment improved as the week progressed and the Dow and S&P closed at new highs on Friday. With two major events in the near future that could tank the market, investors have decided to ignore the headlines and stick with the historical December trend.

The market internals are acting as though there were only rainbows ahead with a pot of gold around every corner. Bullishness is breaking out all over but it is somewhat hidden behind the lackluster gains on the indexes. The Dow only gained 97 points for the week but overcame profit taking to close at a new high. The S&P only gained 9 points but closed at a new high. The Nasdaq actually lost 7 points and the Russell 2000 lost 15 points. It is this index divergence that is hiding the bullish sentiment.

As I said in my market commentary, investors are buying the tax cuts because they expect them to produce more dividends, stock buybacks and higher earnings. I cannot blame them as long as that actually happens. Making new laws in a divided government is a tough task and it is not over until the president signs it. That could be in 7-10 days or it could be in late January if the current negotiations blow up.

Maybe I worry too much because I study the market and the external influences every day. I see all the potential pitfalls where a normal investor is only looking at the Dow at a new high and seeing the positive tax cut headlines. It is those investors who are blissfully ignorant that are profiting from the market.

We always tell readers to trade the trend until it ends. The positive trend that has produced a 24% YTD gain on the Dow has not ended. Yes, there is a minor hiccup now and then, but the trend has not ended. We get closer to that train wreck every day but nobody has a crystal ball to tell us the time and date.

I have warned for the last month that January could be rough. That has not changed. If we get past the potential for a sell the news event on tax reform, we could see significant profit taking in January as we enter the new tax year. Periodically, January's can be a challenge. In 2016, the S&P fell -269 points in three weeks after setting highs in early December. I am not saying it is going to happen again but we do need to be prepared after a 24% gain on the Dow, 30% gain on the Nasdaq and 18% gain on the S&P. That is a lot of uncaptured profit.

Our primary market indicator is the A/D line on the S&P and it closed at a new high on Friday. The early December weakness has been erased and based on this chart the market should continue higher. When more stocks advance then the day before and do it routinely, it is a sign of rising investor sentiment. This is a strong motivator.

The S&P dipped exactly to uptrend support and rebounded on Thursday and Friday to close at a new high. There have been two higher intraday highs but Friday was a record close. The indicators are all positive with the RSI back over 70. There were 362 new 52-week highs on the S&P on Friday. That is the most since November 28th and represents 72% of the S&P at new highs. It is hard to argue with that kind of bullishness.

Note the length of the bars over the last two weeks. The intraday volatility has increased significantly and that normally happens in times of investor indecision, which normally signal tops or bottoms in the market. Just because everything is bullish does not mean it will remain bullish. There were a lot of intraday sellers to produce those tall bars. On the bright side, the index recovered from the volatility and is making new highs. The buyers won the battle.

The Dow A/D line also made a new high and the Dow closed at a record high. The blue chip industrial stocks are still being bought because investors believe taxes are going lower, earnings and dividends will rise and buybacks will increase. For the retail investor if we add in a rising global economy this is the perfect investing scenario. The only problem is that the tax cuts are not yet law.

The Dow closed at 24,329 and the prior high was 24,290. The close was right at resistance and the index could be poised for a breakout, headlines permitting. Despite the new high, the index is very unsupported with the 2,050 point gain over the last two months. That is a 9.2% gain in two months. In many years, the Dow does not gain that much in an entire year.

The Nasdaq has rebounded from the two bouts of sector rotation out of techs stocks and into industrials but it has not returned to the highs. The A/D line has only shown a minor uptick.

On the indicator chart the MACD is still bearish and the RSI is just starting to reverse higher. The CCI did turn positive because it reacts faster. Note the length of the bars for the last two weeks. The grouping of strong intraday volatility is the result of indecision and the rotation. The dips were bought but it was a battle. There is solid resistance at 6,900.

The small cap S&P-600 is struggling. The index tried to move higher and was quickly sold. This is a carbon copy of the Russell 2000. Small cap stocks should be bullish in December and they should be bullish ahead of the tax reform. This is a warning sign and we should pay attention if the weakness continues.

To summarize: The big cap indexes are bullish because of the expected tax cuts, which would increase earnings and allow them to bring cash back from overseas to use for dividends and stock buybacks. The tech stocks are weaker because of rotation out of tech growth and into industrial value for the tax benefits. The small caps are weak without any obvious reason other than possibly rotation in to the industrials for the same reasons. Small companies should benefit from the tax cuts but the large companies have billions overseas that could be put to immediate use and therefore a stronger gain in stock prices.

We can never know exactly why a market or sectors move. There are millions of moving parts and conflicting ideas. In the end, it boils down to how many investors believe the shares are going up and how many expect them to go down. It would appear the group thought leading the parade in December is the positive benefits from the proposed tax cuts. The potential government shutdown on December 22nd is not even a consideration for retail investors as is the possibility for a failure of the tax reform bill. Both are real possibilities.

Enter passively and exit aggressively!

Jim Brown

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