The markets are at key levels where a breakout could be imminent. All of the major indexes except for the Russell 2000 made a new high last week. Even the broader Russell 3000 made a new high on Wednesday. Friday's decline was just a knee jerk reaction to the payroll report as well as some minor profit taking before the weekend. We should not expect too much or worry that a top is taking place.

The internals remain strongly positive and volume was actually about two billion shares more than I anticipated on Friday at 5.2 billion shares. I asked myself why volume was so high for a summer holiday Friday. Was it investors getting out at a potential market top? I am sure there were some of those. Was it investors in panic mode because rate cut expectations suddenly declined from 50 points to 25 points? I am sure there was some of that as well. However, after looking at the charts and the internals, I believe the volume came from investors buying the dip. For a combination of reasons there was a sharp drop at the open. That dip was bought, and the Dow rebounded from -232 to -10 just before the close. That is a huge recovery for a holiday Friday.

Granted, for every buyer there had to be a seller, but the rebound showed that the buyers won the day. I was a little disappointed that we did not finish in the green but there were plenty of reasons why some investors would not have wanted to hold over the weekend.

The A/D line was negative at 8:5 on Friday with decliners over advancers but the rest of the week was strongly positive even on Tuesday when the indexes were choppy. Wednesday was very strong at 5:2 advancers over decliners.

Long term the A/D line is a great indicator of market sentiment and it is telling up the buyers are in control. Note how unbroken the line is for the last 8 days. It is almost vertical. That is due to the calming of China trade fears and Fed expectations but also with the historic highs so close, investors are sucked into the market in hopes of a breakout.

The Nasdaq A/D was strongly positive despite some weakness in the big caps. The A/D closed at a two-month high. Tech stocks were 2:1 advancers over decliners on Wednesday and almost 4:3 on Friday despite the minor Nasdaq loss.

Retail investors like to follow the Nasdaq when it is making new highs. The tech stocks move faster than industrials and when they are hot, they attract a crowd. If the Nasdaq can break out this coming week we could have a strong market.

The Nasdaq is going to be fighting the chip drag this week. The warning by Samsung of a 50% decline in Q2 earnings, the potential crash in Broadcom on acquisition headlines and the antitrust loss by Qualcomm are going to be a drag. Note the reversal in the $SOX last week. That kept the Nasdaq from moving higher.

The FANG stocks all turned higher with FB, NFLX and AAPL nicely correlating. Google is finally rebounding but they have a long way to go to catch up. Fortunately, as long as all four stocks along with Amazon are moving higher the Nasdaq will rise as well. These five stocks plus Microsoft account for more than 30% of the weighting of the Nasdaq.

The small cap A/D line is actually positive, and the Russell 2000 posted a minor gain on Friday. Unfortunately, I do not believe it was an influx of retail buyers. I believe it was the final adjustments on the reconstitution trade.

I am adding a new chart this week and it is the Russell 2000 ETF (IWM) compared to the S&P ETF (SPY). These are more reflective of the actual indexes than the index symbols themselves. Note that the two traded in parallel until the June 3rd rebound. That is where they diverged and have continued to diverge. We need them to converge and the IWM to take the lead to the upside. The IWM is normally the leadership ETF. This suggests the small caps are still weak and i can attest to that with as much trouble as I am having finding small cap long recommendations.

While the other indexes are at new highs, the Russell is stuck below two levels of resistance. This could be the Achilles Heel for the market. Now that the reconstitution is over and we are facing the summer doldrums, we could see small caps weaken again. The only bright side is that they have little exposure to global economic weakness.

Midcaps are also struggling with the MDY facing strong resistance at 260 and again at 375.

On a positive note, the Russell 3000, the 3,000 top stocks by market cap, broke out to a new high and showed no signs of a big retracement on Friday. As I said last week, if this index continues making new highs, the other major indexes are going to follow. This is the market.

The Volatility Index traded down to 12.04 and very close to long term support lows. There is still a lot of uncertainty about a market top so we could see a lot of fluctuation here before it settles down.

I am expecting a short-term rally of 2-3 weeks. Historically, August is the worst month of the year and a flurry of bad earnings and guidance could accentuate that trend. China has not been solved. They are only on the back burner and could boil over at any time. Powell could develop foot in mouth disease at any time and that would be market negative. Until then rate cuts trump bad earnings.

Enter passively and exit aggressively!

Jim Brown

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