The Dow gained for the week and the Russell 2000 lost -1.9%. Confusion abounds.

Market Statistics

With the Dow closing at a new high and the Russell only 4 points above a 10% correction at the morning lows there was a significant divergence of investing opinions. I believe Friday's afternoon rebound was short covering ahead of the weekend but we may be nearing a material change in the markets.

The blue chips are refusing to decline and the drop in the small caps may have found a bottom. If the Russell and the Nasdaq actually had a couple of positive days I think the Dow and S&P would be breaking out to new record highs. Last week the Russell and Nasdaq were the anchors on the big cap indexes and once they begin to rebound the big caps will be set free.

This is the point where analysts expecting a decline in May begin to reevaluate the possibility for a May rally. Obviously, the instant the bears turn bullish it will be the signal for a full fledged market decline.

If you look at the chart of the Russell 2000 there have been five multiple day rebounds since the high at 1,208 on March 5th. That means the +9 point rebound on Friday is not yet a change in trend. However, it did occur at strong support so it does have a better chance of a continued run.

Economics on Friday were minimal. The Job Openings and Labor Turnover Survey (JOLTS) showed hiring ads slowed from 4.1 million to 4.0 million in March. The number of hires also declined from 4.7 million to 4.6 million. This is a lagging report for March and we have already seen the April payroll report so the JOLTS data was ignored.

The Wholesale Trade report for March showed inventories rose +1.1% and in line with expectations. This compares to the upwardly revised +0.7% in February. Sales rose +1.4% compared to +0.9% in February. The inventory to sales ratio declined from 1.19 to 1.18. The upward revisions to February bode well for the future revisions to GDP but it will still be tough to avoid a negative number in the next revision.

We have a full calendar of reports for next week with the Philly Fed Survey on Thursday the biggest report for the week. Expectations are for a decline from 16.6 to 15.4. April retail sales are due out on Tuesday and expectations are for another decline. This could be an upward surprise if April ended the three month bout of cabin fever for consumers.

The CPI and PPI would be of interest to the market if there were any inflation in the economy. These reports are likely to show another month with minimal gains in pricing power.

The Housing Market Index on Thursday and residential construction on Friday should begin to show a rebound now that winter is over.

The earnings cycle will be officially over on Thursday when Walmart (WMT) reports. This is typically considered the end of earnings but Hewlett Packard will drag in late on the following Thursday. The most notable earnings for the week will be Cisco and Walmart followed by Rackspace, Take-Two Interactive and Applied Materials.

So far 451 of the S&P-500 companies have reported. Of those reporters 68% beat estimates, 9% met estimates and 22% missed estimates. The majority of those estimates had previously been lowered, some more than once.

Friday is never a big day for earnings but there were a couple of notable companies that did report. Alcatel Lucent (ALU) posted a loss of 3 cents compared to a loss of 16 cents in the year ago quarter. Expenses declined about 20%. Adjusted earnings of 33 million euros beat estimates for a breakeven quarter. ALU burned through about 398 million euros in the quarter as free cash flow continues to shrink. The company is going through a restructuring that will see 10,000 job cuts and expects to be cash flow positive again in 2015. Shares declined -4% on the news.

Newly public Hilton (HLT) saw profits triple to 12 cents or $123 million. Adjusted earnings were 13 cents compared to estimates of 9 cents. Revenue rose +4.4% to $2.36 billion compared to estimates of $2.37 billion. The company forecast earnings between 18-20 cents for Q2 and analysts were expecting 17 cents. For the full year Hilton projected 64-67 cents and analysts were only expecting 60 cents. Hilton also owns the Double Tree and Waldorf Astoria brands.

Stratasys Systems (SSYS) reported earnings that met estimates at 40 cents and revenue of $151.2 million beat estimates of $143.3 million. The company reiterated the full year forecast and analysts dumped on the stock. Investors fled for greener pastures. The company said operating expenses would increase "materially" this year due to investments in sales and marketing. Operating expenses rose +42% in the quarter. Earnings were also helped by a decline in income tax from $3.1 million to $820,000. The company reiterated full year earnings in the $2.15-$2.25 range and analysts were expecting $2.21. Stratasys said organic sales would grow 25% annually after 2013. Shares fell -5% to $90 on the news but that was about +5% off the reaction lows at $85.

Bloomin Brands (BLMN) reported adjusted earnings of 46 cents that missed estimates of 47 cents by a penny. Revenue of $1.16 billion met estimates. The company guided to full year sales growth of 1% to 2% with adjusted earnings of $1.21 compared to estimates of $1.22. Revenues rose +6% in Q1. However, same store sales declined -1.7% due to weather and the timing of holidays. Shares declined -2.5% today but the outlook is bearish.

Tetra Tech (TTI) reported a loss of 4 cents compared to estimates for a profit of 5 cents. Revenues of $212.9 million missed estimates of $220.9 million. They blamed the weather for delaying field operations. They cautioned that future operations of most segments would be in line with estimates with the exception of their "Production Testing segment where revenue recovery continues to be slower than previously anticipated." Shares fell -8% on the news.

Ubiquiti Networks (UBNT) reported earnings on Thursday after the close. Adjusted earnings of 50 cents beat estimates of 49 cents. Revenue rose +78% to $148.3 million and well over estimates of $142 million. However, the stock was crushed on Friday after they forecast revenue of $150 million and EPS of 50 cents. Analysts were expecting $151.8 million. Inventories rose from $32 million to $66 million. That rise was twice the $16 million rise in the prior quarter. Analysts are worried that new equipment is not selling despite a +78% rise in revenue for the quarter. Shares fell -24%.

Apple (AAPL) is said to be near a deal to buy Beats for $3.2 billion. Apple is close to striking a deal with Dr Dre and Jimmy Lovine to acquire the headphone maker and the online streaming music site. Beats Music service charges a fee of $10 a month and subscribers get unlimited access to all the songs in the music catalog through a smartphone, tablet or web browser. Beats is the leader in high priced headphones with prices in the $170 to $450 range for their best models. This would be the largest acquisition ever for Apple but they have $147 billion in cash left so maybe they are about to go on a shopping spree. Apple has made 24 acquisitions over the last 18 months. With iPhone and iPad sales slowing Apple needs to find some other ways to make money.

It is getting harder to buy a car in China but sales increased +13% in April. Some dealerships saw sales increase more than 40% in April. More cities are putting restrictions on the number of cars that can be sold to combat congestion and air pollution but that is only accelerating the purchases. Customers that have cars on order are accelerating their purchases to avoid being shut out of the market by some new regulation. More than 1.5 million cars, trucks and SUVs were sold in April. Six Chinese cities have imposed quotas in recent months. They are limiting the number of license plates that can be sold and those are doled out in a lottery. Winners then resell the plates in the open market for huge premiums. Sales at an auto show in Nanjing occurred at the rate of one every 3 minutes.

Chinese cars are gasoline sippers compared to U.S. cars but adding them at the rate of 1.5 million a month is still increasing gasoline demand significantly. China is on track to add more than 20 million cars/trucks/SUVs in 2014. This is one more reason oil prices will continue to rise long term.

However, China's economic growth is slowing to 7.3% in 2014 and the lowest level since 1990. It is expected to decline to 7.2% in 2015 and be flat at that level in 2016. The decline in GDP and a lower than expected inflation reading last week will give the government plenty of room to add stimulus without worrying about overheating. The CPI rose only +1.8% from year ago levels in April. That was less than the 2.1% consensus and +2.4% gain in march. The producer price index fell -2% and the 26th consecutive monthly decline after a -2.3% decline in March. The record is a 31-month decline that started in 1997. China is struggling through a credit crisis and businesses are finding it much more difficult to obtain credit for things like equipment and inventory.

So far this has not impacted the demand for commodities like iron ore and copper. Bookings of Capesize vessels, which mostly haul iron ore, surged +47% to 90 a month so far in 2014. The number of available ships have shrunk to the point where freight rates are expected to rise from $12,000 a day currently to $20,000 by next month. The price for ore continues to decline and this is leading to a buying frenzy. China is currently investing in large infrastructure projects like roads, bridges, railroads, ports, etc. All of these take enormous amounts of steel and the projects are not impacted by the slowing economy. China imported 83.4 million tons of iron ore in April. That is the highest since records began in 1990.

Venezuela is having economic problems for different reasons. Ford (F) announced it was shutting down operations in the country because it could not obtain dollars from the government to import parts. Suppliers will not accept the Venezuelan Bolivar currency. The government rations dollars to a privileged few companies that are loyal to the government. Columbia halted natural gas sales to Venezuela using the excuse they were holding back in case El Nino returned this year. However, if you can't get paid there is no reason to export it.

Venezuela said it was going to start rationing water and electricity because of an impending drought. In the Chacao business district, home to office towers, restaurants and shopping malls, water service will not be available on Tuesday's and Saturdays. The other five days it will only be available in the evenings. More than 25% of basic goods were out of stock on grocery shelves and the worst since the central bank began keeping records. The lack of products is so bad the central bank quit publishing the lists of shortages because of the negative sentiment.

The economy is so bad only 1,674 cars were sold in March in a country of 28 million people. Inflation rose to 59% in March, the highest in the world. Of course President Maduro is blaming the shortages and inflation on the United States. According to Maduro, it is our fault because we are squeezing his economy in an effort to overthrow his government.

In the U.S. the labor force participation rate for 25-29 year old workers hit a record low of 79.8% in April. That is the lowest since January 1982 when the data was first collected and the participation rate for that group was 80.7%. The 24-29 year old population is very employable and starting their careers. The peak was 1999 when 84.6% of this demographic were employed. It we were at that level today another 4.7 million people would have jobs.

Zerohedge posted this chart last week showing the breakdown of the entire labor force.

The Russell 2000 dipped to 1,091 and came within 4 points of correction territory at 1,087 on Friday before rebounding +16 points to close at 1,107. Since 2010 there have been nine corrections in the Russell of 10% or more. The average was -15%. In every instance the S&P-500 declined about 10%. Today the S&P is currently only a few points from a new high. According to Josh Brown you have to go back more than decade to find a similar divergence.

According to J.C. O'Hara at FBN Securities, "Often at the end of bull markets, large cap stocks continue to rise and the smaller stocks begin to falter." The S&P-500 is market cap weighted so the bigger blue chips like Exxon, Apple, IBM, etc, have a much bigger impact on the index. "Large cap stocks have a much larger impact and can mask internal weakness" according to O'Hara. He said the average stock in the S&P-1500, the combination of the large cap S&P-500, Midcap 400 and Small cap 600, is down -12% and the average stocks in the Russell and Nasdaq are down about -20%. The higher weighted stocks are disguising this weakness. "Historically, this sort of divergence does not bode well for the longevity of the market's upward inertia." They also went back and studied the average stocks when markets made new highs and comparatively the market breadth today is "very unhealthy." He said new highs were shrinking, new lows increasing and the breadth divergence was a "major concern." Also, "the powerful message of 'there is something wrong' should not go unnoticed."

The Dow closed at a new high on Friday but there were only 104 new individual highs with 219 new lows. When the Dow was near the highs back on March 6th there were 896 new highs and only 81 new lows. At the December 31st Dow high there were 750 new highs and 98 new lows.

Market breadth is terrible and volume was very low at only 5.7 billion shares.

Chart from FBN Securities, Bloomberg, Business Insider

Michael O'Rourke, of Jones Trading, said the current market was a classic zombie scenario. The dead are dead but they don't know they are dead. Stocks today may be the walking dead. He said despite the Dow and S&P closing near record highs there are headwinds building. O'Rourke said the rot may start with the banks with the biggest names piling up new 52-week lows in the weeks ahead. Many are already at six-month lows and the earnings were not good. He said a big problem for the market is that the leadership of the blue chips has been driven by a defensive rotation. Investors are buying relatively safe stocks because they don't want to be left out of the market and dumping higher priced techs, biotechs, Internet and momentum stocks. "That buying does not represent strong hands and as deterioration accelerates, these players will come out of the market."

O'Rourke pointed to the Russell 3000, which represents about 98% of the investable market. The average stock in that index is down -19% from their 52 week highs but the index is only 17 points below its historic high.

Dan Greenhaus at BTIG warned that half of the Russell 2000 components are down -20% or more and 80% are down -10% or more from their 52-week highs. He believes in the dead stock walking analogy. Former Goldman Sachs chief economist Jim O'Neil said he fully believes in the "sell in May" scenario and would not be putting his money in U.S. stocks today.

Apparently the Irish analysts have decided to gang up on the market with O'Neil, O'Rourke and O'Hara all deciding to pick on the Russell index components in the same week. Or, maybe Irish analysts are just smarter.

According to the Investment Company Institute (ICI) U.S. mutual funds saw outflows of $3.9 billion last week for the biggest outflows in a year. The prior high was $4.9 billion in the week ended May 1st, 2013. Are you sensing a pattern here?

The Russell 2000 lost nearly -2% for the week but it is still holding above critical support at 1,096. That level was broken twice intraday on Wednesday and Friday but rebounded into the close. However, the five-week downtrend is still intact with lower highs and lower lows. The support at 1,096 is critical now that support at the 200-day average has failed for four consecutive closes. That is a strong sell signal but the obvious support at 1,096 may be providing hope for those unwilling to close positions.

The S&P-500 tested upper resistance at 1,890 on Thursday and the selling was immediate. Twice in the last two weeks the S&P spiked through to that level and both times was met with heavy selling. Interim support at 1,860 was tested on Wednesday and there was a sharp burst of buying.

The S&P is stuck in a clearly defined range with a solid resistance top. There are two schools of thought on the possible outcome. The first suggests we continue to chip away at the overhead resistance until it weakens and allows a breakout. This is a common event. Every temporary spike through the initial resistance saps the strength of that resistance. If the index remains here long enough eventually the number of sellers will dwindle. Every bout of selling uses up a certain amount of stock and weakens that resistance. Buyers have to exhibit a lot of stubbornness to wear down the sellers.

The second scenario has the buyers giving up. After a number of fruitless attempts to push through that resistance level the buyers give up and cancel their bids. It is the equivalent to banging your head against the wall. Eventually you realize it is painful and the wall is not moving. Buyers decide the resistance is not going to break and they use the next attempt to sell their existing positions and either go to cash or switch sides and short the market.

We have all seen both scenarios many times. We have seen resistance levels attacked repeatedly until they fail. We have also seen unbreakable resistance end rallies and the market reverse to the downside.

The S&P has been fighting this battle since April 22nd when it first tested the 1,885 level. The first test resulted in significant selling that knocked us back to 1,850. The dip last week only took us back to 1,860 and a higher low was made.

With the big caps in the Dow like BA, MMM, MCD, DIS, XOM, PG, AXP, CAT and TRV all holding at multi-week highs the S&P has broad based support in the larger individual stocks. As I mentioned earlier the big caps exert a stronger influence on the indexes than the smaller cap stocks.

What we have had is a defensive rotation from smaller caps into the safety of blue chips. As long as they are deemed to be safe the rotation could continue. Investors don't want to be out of the market during a period of seasonal weakness just in case that weakness does not appear. A market making new highs is a strong incentive for investors to remain invested. Should conditions change and the S&P start making some lower lows that investor sentiment can change very quickly.

I still believe there is going to be massive resistance at 1,900. Back in March when the S&P hit 1,897 intraday there were multiple sell programs triggered and a steep decline lasted two days. I believe that resistance still exists so getting through the 1,885 and 1,890 resistance levels is not the end of the battle.

The Dow closed at a new historic high at 16,583, only 3 points above the old high set the prior Wednesday. I warned everyone two weeks ago that 16,580 was going to be a critical level and that came to pass. Since the Dow is the bluest of the blue chips and a price weighted index the defensive rotation into the blue chips has a direct impact on the Dow. As a narrow 30 stock index only a few bullish stocks can overcome lackluster performance by the rest of the components.

It is entirely possible the Dow could continue to climb while the Russell and Nasdaq weaken further. However, if the Dow does break out from this current resistance level it could bolster market sentiment across the board. For the vast majority of low information investors the Dow is the market. "If the Dow is breaking out then the market must be bullish."

Conversely if the Dow begins to break down the decline in the small caps should accelerate.

Ignoring the ugly market internals and the weak economics the Dow chart looks more bullish than bearish. The constant chipping away at resistance and the pattern of higher lows suggests there may be a breakout soon. That assumes no geopolitical headlines that tank the market. We could be setting up for a decent run if the selling in the Russell were to end. The rebound from the critical support at 1,096 on Friday could have been a bottom forming after two tests in three days. We won't know that until we see what next week brings.

If the Russell just remains positive it would help the Dow break through resistance. The Russell would not have to add a large number of points but simply quit declining.

The Nasdaq rebounded +20 points on Friday. Based on the short term chart below I don't find that encouraging. That 20 point rebound to 4,071 was just a drop in the proverbial bucket and still -38 points below the Thursday high at 4,109. Granted all the big name stocks are on the winning side of the table below but despite all those gainers it was still a lackluster performance considering how oversold the tech sector was.

The key number for next week will be the support at 4,025 which has been tested several times since the April 15th low at 3,946. That 4,025 level is now critical. A lower close means the selling is not over and 4,000 and then 3,946 becomes the next targets.

In summary I would like to think the Dow will breakout next week and create some bullish market sentiment that spreads to the Russell and Nasdaq. However, hope has never been a successful trading strategy. We need to be prepared for a potential breakout but also be mindful of the potential for a continued decline in the Russell and Nasdaq. Neither of those charts have any material bullish patterns. The earnings cycle is basically over and summer is approaching. That means lower volumes and declining interest in the market. Thoughts will soon turn to weekends at the beach and away from the market.

Random Thoughts

This is an interesting article on the fallacies in Janet Yellen's testimony last week. Numerous lawmakers asked her pointed questions about Fed policies, job growth and the economy and the answers appeared to be "Don't worry, be happy, the Fed is in control." Unfortunately we know they are not in control and they don't have a plan for extricating themselves from $4 trillion in treasuries. 6 dubious Yellenisms from the Fed chair's testimony

China's bad debt problem could be a serious problem for global growth. I alluded to this earlier but here is an article with some facts. China Debt Could Spark Global Growth Slump

Home ownership is at a 19 year low. Home mortgage rates are at a 7-month low at 4.21%. New home sales, existing home sales and builder sentiment have been declining. So why are more people not buying homes? One analyst that just bought a home said the qualification process was like a "financial colonoscopy." The average person can't qualify and fears of being turned down are causing many people to not even apply.

The current economic expansion is the 6th longest in history and the current bull market is the 4th longest. Equity valuations are at the highest level since the bubble. The willingness to overlook negative data is the strongest when markets are at their highs. Bull markets are often been called parties and the Fed is slowly withdrawing the punchbowl. Interest rates are not going to stay low forever. It has been 17 months since we have had a meaningful decline. Small caps and momentum stocks typically lead us up and lead us down.

After a six-pack at a party a member of the opposite sex previously rated a 4 on a scale of 1-10 suddenly begins looking like a 7. After two six-packs they move up to a 10. The next morning, when reality returns and you think back on that individual they return to a 4. What was I thinking? The same is true as a bull market peaks. Investors are looking at stocks after a euphoric 2-3 six-pack binge as those stocks rose in price. Bear markets appear when the beer wears off and those same stocks are viewed in the light of day.

The energy sector has been leading the market for the last month. Click the advertisement below for a free trial to the newsletter.

Enter passively and exit aggressively!

Jim Brown

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"Expertise is great, but it has a bad side effect: It tends to create the inability to accept new ideas."
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