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posted on 28 May 2017

This Is One Weak Breakout

Written by , Clarity Financial

In last week's missive, I discussed the confusion of the market:

"In the lead right now are sectors that are both "risk on" (ie Technology, Emerging Market and Discretionary) as well as the "risk off" sectors. (Utilities, Health Care and Staples).

Talk about confused.

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The problem, of course, that both trades are unlikely to be right. Either the market is going to breakout to the upside with a clear participation in the 'risk on' stocks, or money will begin a rotation into the 'risk off' trade of bonds and defensive equities. "

Well, the market did break out of the trading range that began back in March as noted below.

However, it did so without there being a rotation from the "risk off" trade back into equities, or, "risk on."

The failure of the market to rotate to the "risk on" trade should not be lightly dismissed. A healthy breakout of the market should have been accompanied by both an increase in trading volume and leadership from the "smaller and riskier" stocks in the market.

The chart below is the Russell 2000 Index as compared to the S&P 500 Index.

As shown by the red highlights, such divergences in the index tend not to last long and either a correction in the S&P 500 occurs OR the "risk trade" returns with a vengeance.

However, currently it is only the large cap stocks, and primarily the #FANMAG mega caps of Facebook, Amazon, Netflix, Microsoft, Apple, and Google, which have been propelling the major market to new highs while the Russell 2000 remains within its downtrend. Which has continued to create the divergence in internals discussed last Tuesday:

"The 10-year chart below, while a bit cluttered, shows several very important things worth considering currently. First, the top part of the weekly chart is essentially a buy/sell indicator. Each sell signal previously, has been indicative of a correction. The middle of the chart is a combination of internal strength indicators from the number of stocks on bullish buy signals, advancing vs declining issues and volume, and the percent of stocks above their 200-day moving average."

While the markets did bullishly break out of the "consolidation" of the last couple of months, it did so rather weakly which keeps our guard up for now.

The breakout does keep our allocation model nearly fully allocated. We are holding onto a little larger than normal cash pile just to hedge some volatility risk during the summer months. Also, stops have now moved up to the bottom of the bullish trendline as shown in the chart below which coincides with the 100-day moving average which has been a running support line.

The "sell signal" currently in place from very high levels, and a full 2-standard deviation push from the 50-dma, also keeps us cautiously guarded for now.

Lastly, the deviation of the market from the 200-dma is also at levels that have previously not been conducive for a successive push higher in prices particularly with volatility at extremely low levels.

There is no denying the "bullish bias" currently remains in the market, and because of that "bias" we remain allocated towards risk.

However, it should be remembered this is exactly how "bull markets" are both formed and end.

"Bull markets rise, and in the end rise sharply, as the last marginal players are finally sucked in. It is only then, when there are too few buyers remaining to offset the rising tide of sellers, the inevitable unwinding occurs."

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