Originally published Sept 28, 2014.

Your August 1st Weekly Setup mentioned "...We expect volatility to increase over the next two months from the current historical lows including another price pullback...Don't be surprised if September starts strong as it has in thirteen of the last nineteen years. But the market begins to fade as money managers' start selling off losers and repositioning assets for the end of the third quarter window dressing..." This prognostication is playing out as advertised when last week all of the major indexes fell at least a percent and was the worst week for stocks since the week ended August 1st. It was a roller coaster of a week, with the Dow swinging more than 100 points on all five days. Some investment strategists expect to continue seeing wild swings as investors speculate over uncertainty surrounding global geopolitical events, U.S economic growth and the Federal Reserve's next steps.

Last week pointed out "...One item of note...is the Russell 2000 index dropping into negative territory for the year. You would prefer to see all the major indexes breaking out to new highs to have confidence in a bullish move. Small caps underperformance is an indication of investors wanting to avoid riskier trades at stocks current frothy levels..." The updated graph below supports our previous analysis as last week all the major stock indexes followed the Russell 2000 lower. The small cap Russell 2000 took a big hit and all the major stock indexes suffered losses.

The graphic below charts the performance of S&P 500 index compared to Treasury bonds. It appears that investors are pulling funds out of equities as the market falls and parking the money into treasury securities.

Market Outlook

We reported last week "...According to the Stock Trader Almanac the Worst Six Months, May through October have only averaged a 0.3% DJIA gain since 1950 versus a 7.6% average gain during the "Best Six Months", November to April. For S&P 500 the gain is slightly better at 1.3% during the "Worst" and 7.1% in the "Best" over the same time period. The market's resilience in the face of mounting geopolitical concerns throughout the "Worst Months" this year is impressive and suggests that the upcoming "Best Months" could also be above average. But, before the Best Months begin the market still has to navigate weak end-of-Q3 seasonal factors and the frequently troublesome month of October. With solid fundamental data and an accommodative Fed at its back, any market dips between now and the end of October are likely to be a great entry point for the next "Best Six Months" cycle..."

The worst performing market sectors for the third quarter in the graph below have been hurt by the exceptionally strong dollar and investors becoming more risk adverse. Treasury bonds is the best third quarter performer and benefits from the Federal Reserve's low interest rate environment.

We recently mentioned "...you can see in the chart below how the Russell 2000 small cap index is breaking down compared to the other major equity indexes. Investors are conscious of the chatter about the market's underperformance in September and October. Investors are avoiding the more riskier stocks typically associated with the Russell 2000 in case the concerns about market dip come to fruition - high risk shares usually fall the hardest during a pullback..." Like we previously said and as evidenced in the chart below, last week's price pullback hit the small cap Russell 2000 index the hardest.

Another tool that we use to help confirm the overall market trend is the Bullish Percent Index (BPI). The Bullish Index is a popular market "breadth" indicator used to gauge the internal strength/weakness of the market. It is the number of stocks in an index (or sector) that have point & figure buy signals relative to the total number of stocks that comprise the index (or sector). So essentially it is the percentage of stocks that have buy signals. Like many of the market internal indicators, it is used both to confirm a move in the market and as a non-confirmation and therefore divergence indication. If the market is strong and moving up, the BPI should also be moving up as more and more stocks make the "buy list." When the market moves down, one expects the BPI to also move down to confirm the market's weakness. The S&P 500 BPI down below is confirming the index's overall weakness.

Similar to the S&P 500 index above, the NYSE Bullish Percentage Index below further confirms large cap stocks longer term price weakness.

A standard chart that we use to help confirm the overall market trend is the Momentum Factor ETF (MTUM) chart. Momentum Factor ETF is an investment that seeks to track the investment results of an index composed of U.S. large- and mid-capitalization stocks exhibiting relatively higher price momentum. This type of momentum fund is considered a reliable proxy for the general stock market trend. We prefer to use the Heikin-Ashi format to display the Momentum Factor ETF. Heikin-Ashi charts are similar to the Japanese candlesticks charts you are used to seeing. Heikin-Ashi candlestick charts are designed to filter out volatility in an effort to better capture the true trend.

Last week we wondered "...the price peeking above the recent trading range. Over the next few days we will find out whether this is a false breakout..." The updated Momentum Factor ETF (MTUM) chart below answered this question as the price breakout was not confirmed and stock prices sank to continue trading range-bound. As highlighted in the chart, strength and momentum indicators signal stock prices can be expected to remain flat over the near term.

The dollar posted an 11th straight week of gains against a basket of major currencies, extending the longest winning streak since its 1971 free float under President Richard Nixon. The dollar has been driven higher by the divergent monetary policy outlooks between the U.S Federal Reserve's contemplating a rate hike and the ECB and Bank of Japan mulling further stimulus. Gold fell as a dollar-driven rally dimmed bullion's investment appeal. Spot gold was down 0.6 percent at $1,214.67 an ounce. As you can see in the updated chart below, both treasuries and gold were heading down in tandem as the dollar surged and rates began creeping higher. The strong dollar continues to sink precious metals but treasuries are recovering as inflation fears have diminished.

In the 3-month CBOE Volatility Index (VIX) graph below notice the index has been trending higher the past month. This indicates that investors are getting a little nervous about the market and are buying more put option contracts to hedge their long stock positions. The VIX is nearing the level it was at the beginning of August when stock prices were crashing, if stocks continue to slide investors will continue pushing the index higher.

The current American Association of Individual Investor Survey (AAII) survey results approximate historical norms which supports the current range-bound trend.

Second-quarter National Association of Active Investment Managers (NAAIM) exposure index averaged 81.64%, last week is was 67.09%, and the current week's exposure is 59.76%. Notice the percentage is creeping lower and lower close to the beginning of August level when stocks were in a downward spiral to start the month.

Trading Strategy

Last week we reported "...The Stock Traders' Almanac says...fund managers tend to clean house as the end of the third quarter approaches... the week after September options expiration, has consistently been one of the worst of the year. Since 1988, weekly declines average from -0.88% for NASDAQ to -1.43% for Russell 2000. S&P 500 has only posted full-week gains five times in the last 26 years..." Last week projected as advertised with stocks having the worst week in months.

The Stock Traders' Almanac also says October often evokes fear on Wall Street as memories are stirred of crashes in 1929, 1987, the 554-point drop on October 27, 1997, back-to-back massacres in 1978 and 1979, Friday the 13th in 1989 and the 733-point drop on October 15, 2008. During the week ending October 10, 2008, Dow lost 1,874.19 points (18.2%), the worst weekly decline in our database going back to 1901, in point and percentage terms. The term "Octoberphobia" has been used to describe the phenomenon of major market drops occurring during the month. Market calamities can become a self-fulfilling prophecy, so stay on the lookout and don't get whipsawed if it happens. But October has become a turnaround month -- a "bear killer" if you will. Eleven post-WWII bear markets have ended in October: 1946, 1957, 1960, 1962, 1966, 1974, 1987, 1990, 1998, 2001 and 2002. Eight were midterm bottoms. Current market weakness could be setting up October 2014 to be another "turn-around" year.

Notice in the updated graph below, over the past month healthcare remains the strongest S&P sector. Consumer staples normally strengthen in the fall and that is reflected below. Also the industrial materials sector is higher as home building and construction improves. Keep in mind if that if interest rates rise this should benefit financial stocks because this equates to more revenue for banks. Purchasing shares in any of these sectors should be a good bet as they will lead the market if stocks breakout higher.

Regards,