After three weeks of gains are we headed for a pause? Over the very long term a string of gains for three weeks typically leads to a bout of profit taking. Even in the most bullish markets, stocks can become overbought and investors decide to take profits. This should not be a surprise.

However, the urge to take profits in January 2019 is more than likely going to come from disappointing earnings rather than simple overbought conditions. The flurry of earnings warnings just before earnings is not unusual. It is just that investors are already concerned about slowing earnings growth and any unexpected dips in that growth could escalate the problem.

On the positive side, Tom Lee of Fundstrat Advisors, pointed out last week that the odds are very good for the market to rise double digits in 2019 with 15-17% his target. He based this on historical patterns. The high yield market was down in 2018. The high yield market has never been down two consecutive years and has only been down a total of five years since it has been tracked. The average market gain the year after a high yield decline has been 21%.

On the equity side the S&P saw a waterfall decline of 18% over 60 days twice in 2018. Whenever that has occurred in the past the average return over the next year is 21%.

Lee said the market has the best chance of a double-digit gain since 2009. Equities are facing a lot of risks, but the waterfall decline in Q4 has discounted all those risks. The equity market now has a discounted wall of worry to climb and plenty of cash available because of the selling.

The High Yield ETF (HYG) typically leads the equity market. In 2018 it was the equity market dragging corporate yields lower late in the year. While the Fed is being "patient and flexible" in 2019, investors are going to favor the higher yielding corporates and that should lead to the HYG having a good year and leading equities higher.

The S&P gained 2.5% last week and you can tell by the A/D chart the advancers were winning by a wide margin. The bulls are back.

We can also see the bullishness in the market from the percentage of S&P stocks that are trading over their 50-day average. At one point less than 5% of the S&P was trading over their 50-day. That has surged to 38.6% as of Friday. Those over their 200-day have rebounded from 10.8% to 30.6%. Most of these long-term averages are still well above the stock prices. All of the major indexes are well below their 50/100 and 200 day averages.

One of the most bullish changes in the market was the surge in buy signals for S&P stocks. Three weeks ago, only 11.8% of S&P stocks had buy signals on a point and figure chart. This is a long-term indicator and one that is followed by portfolio managers on a stock by stock basis. Today more than 40% of the S&P stocks have current buy signals.

The AAII Sentiment Survey saw bullish sentiment rising to a nine-week high. Bearish sentiment declined to 29.4% and the lowest level since October 3rd, and the historic high in the market. The sharp drop in bearish sentiment ended a 13-week streak of above average bearishness.

The Russell 3000 Index is the broadest market index of tradable stocks. Stocks not in this index are very small and considered microcaps or they are not US stocks. This is the market for all practical purposes.

The R3K declined 358 points or -20.6% in the market crash. The index has already rebounded 151 points or 10.9% since December 26th. That is a monster amount of capital flowing into the market and it is not likely over.

The R3K has strong resistance at 1,550 and again at 1,660. However, the R3K is not normally reactive to specific support and resistance levels because the index is so broad. There are not enough portfolio managers following the technicals and then spending enough money to move the index. However, they do follow the S&P, Nasdaq and Dow and all of their components are in the R3K.

I see this index as the most accurate indicator of market direction because the normal intraday peaks and valleys and the stock noise of earnings and acquisitions are not enough to cause even a tiny blip in the R3K.

However, Apple's earnings warning caused enough knew jerk reactions in the tech sector to cause a similar dip in the R3K. This is one of the very few instances where a single stock caused a material move in the index.

The Nasdaq continues to move in lock step with the chip sector and showing no signs of the linkage breaking. The Apple warning has depressed the chip sector even for those companies that are not suppliers to Apple.

The one new trend over the last two weeks is that the FANG trade is breaking up. Netflix has soared well away from the others and the gains in the other three faded last week. Google and Facebook appear to be rolling over as the privacy issue refuses to go away.

Finally, the index chart that will control the markets next week is the Russell 2000. The small caps are the fund manager sentiment indicator for the market. If small caps are rising, fund managers are bullish. They are currently up 12 of the last 13 days and the index is facing major resistance at the 50 day at 1,455 and at the Oct/Nov resistance at 1,463. We need these levels to be broken quickly so they do not become self-reinforcing.

I am positive on the market for next week with my only concern being weak earnings that could sour sentiment. This is bank earnings week and they have not been earnings leaders. Even when they report good news, they tend to retrace their gains. If we are depending on the financials to lift the markets, if may be a battle.

I would continue to buy the dips until proven wrong. I believe it would take a lot of disappointing earnings to push the market significantly lower but that is always possible. We have had positive guidance and negative guidance for Q4 and negative tends to produce the moist headlines.

Enter passively and exit aggressively!

Jim Brown

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