In looking over the situation facing investors, at present, it seems we are all faced with a series of relatively simple judgments to make in order to assess the portfolio allocation that would create the greatest expected value going forward. The decisions are as follows:
1. Does the fact that the S&P 500 is pinned to its all-time highs with steadily decreasing volatility present a bullish or bearish phenomenon?
2. Does the fact that the Dow Jones Industrials and Transports are pinned to all-time highs with steadily decreasing volatility present a bullish or bearish phenomenon?
3. Are both of the above mentioned questions negated entirely by the fact that the Nasdaq and Russell have been demonstrating the exact opposite behavior? In other words, both the Russell and Nasdaq have been declining with volatility attached to the move.
The third question is the most important as it seems to garnering the most attention. More importantly, it is creating the most fear and emotion among market participants.
Before we get to the indices that have broken down, here is a look at the S&P 500 on a weekly basis. The most important aspect of the current price action is the fact that volatility is so well contained along a key trajectory (in blue) and directly below another key trajectory. The behavior strongly suggests that the S&P is eyeing the trajectory (in red) sitting around 1950. A move of some 3% higher from current levels.
S&P 500
In a very simple sense, the S&P 500 is telling us what to think. In this case, it is telling us that the issues of the Nasdaq and Russell are of no concern.
It is the choice of market participants to believe that there are shadows lurking behind every corner. Volatility demons with jagged teeth looking to rip into the flesh of investors. That is an issue of investor imagination, rather than reality.
The answer according to the S&P 500 is very clear if you choose to accept it: The markets are preparing to move higher.
Let's look to see if the Dow agrees with the S&P 500. This is a look at the Dow on a monthly basis. What you see is an incredibly bullish picture the Dow is painting when you zoom out with a monthly view. Especially given the fact that it is occurring below a key trajectory that has acted as resistance for the 2000 top and the 2007 top. At present, the Dow is simply consolidating along this trajectory with a series of tighter monthly ranges. This is a continuation pattern in the direction of the primary trend. And it is a pretty powerful one, at that.
Dow Industrials
Now let's look at a key leading indicator or lie detector for the Dow: Dow Transports. The weekly look below shows us a market that is pinned at its all-time highs. Further validating what we are seeing in the Dow 30.
Dow Transports
Now that we have answered the first two questions posed at the beginning of this study, let's answer the final question by looking at the "trouble spots" of the market.
We will first look at the Russell 2000 on a weekly basis. It is resting right on a key generational trajectory going back more than a decade. There is certainly a good degree of underperformance taking place year YTD. The chart isn't really telling investors a whole lot. A break below the key trajectory looks to have equal probability as a bounce higher from here. While it is worth a look, more credibility should be placed with the averages that are displaying patterns that are far more predictable than what we see here. Namely, the S&P and Dow.
Russell 2000
Financials have been gathering a great amount of scrutiny recently, as well. While the Russell paints a difficult picture to interpret, the XLF (financial ETF) provides a much clearer picture. In this case, we have an average that is very neatly consolidating on a key trajectory point. The price action in the Dow & S&P lend credibility to the fact that the lows have been seen in financials over the near-term, with a bounce higher coming here shortly.
XLF
While traditional market philosophy will have you believe that a breakdown in the former leadership of a bull market is invariably a bearish event, the markets are far too dynamic an entity to adhere to such dogmatic views. Logic and proportion more often than not do fall sloppy dead.
Without any pretense of lurking fear or paranoia, the picture being painted here seems to be abundantly clear. While the former leadership of the markets have broken down in recent months, the Dow and S&P have absorbed it gracefully. This is a highly bullish event that should lead to surge in the markets over the coming weeks that will likely be dramatic in nature. The texture of that surge, along with the behavior of the Nasdaq, Russell, et al will reveal a great deal for what lies ahead in 2014, whether bullish or bearish in consequence.
