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Market Summary

September began in typical fashion this year, early strength that lead to mid-month new market highs and it also finished rather typically. The week after September options expiration week was down and then end-of-third-quarter window dressing saw major averages decline even further. The S&P 500 enjoyed its biggest one-day gain in nearly two months, while the Dow Jones Industrial Average tallied its biggest gain in seven months, thanks in large part to a stronger-than-expected jobs report that delivered a dose of confidence to investors. Friday's rebound put a dent in weekly losses, but the main benchmarks still finished the week modestly lower marking the second weekly decline in a row for major indexes.

Previous Weekly Setup commentary 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...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..."

We pointed out recently "...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 obvious question at this point is whether the market will follow through on Friday's price recovery. As you can see in the updated chart below the Dow Jones Industrial Average is in danger of following the Russell 2000 index into negative territory for the year.

The Stock Traders' Almanac reported that a mid-September breakout failed rather quickly and DJIA, S&P 500 and NASDAQ are once again trading in a choppy sideways pattern. All three indices are currently trading around their respective 50-day moving averages. The Russell 2000 is having the hardest time. Its 50-day moving average has crossed below its 200-day moving average, the dreaded "death cross" and it is currently flirting with its early August intraday lows. Since Russell 2000 does have a tendency to lead on the way up and the way down, its technical picture warrants attention, however it is behaving in typical seasonal fashion by underperforming through the third quarter. If seasonal trends hold for Russell 2000, a bottom sometime in October is anticipated. October is the last month of the "Worst Six Months" for DJIA and S&P 500 and the last month of NASDAQ's "Worst Four Months". Frightful history of market crashes aside, October has been stellar in midterm years, number one month for DJIA, S&P 500, NASDAQ and Russell 1K, number two for Russell 2K. Keep an eye out for the Official MACD Seasonal Buy Signal. It can trigger anytime on or after October 1.

The graphic below charts the performance of S&P 500 index compared to Treasury bonds. A few weeks we said "... It appears that investors are pulling funds out of equities as the market falls and parking the money into treasury securities..." The updated chart indicates investors are putting money back into equities 'buying the dips' as stocks sank and money managers completed end of third-quarter portfolio repositioning.

Market Outlook

Next week aluminum maker Alcoa kicks off the unofficial start to corporate earnings season. It is reasonable to expect the next few weeks will probably be similar to early April and July when price pullbacks were a prelude to a pickup in quarterly earnings announcements where investors bid stock prices back up. We have saying recently "...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... 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..."

Earlier in the week, investors were rattled by a sharp drop in small-company stocks, pro-democracy protests in Hong Kong, and falling oil prices that hurt energy companies, big components in stock indexes. 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 and financials are benefiting from Federal Reserve's low interest rate environment and technology stocks remain strong based on investors' future growth expectations.

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. As seen in the updated chart below, the S&P 500 BPI has been heading down for over month which confirms 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 over the past month.

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.

The updated Momentum Factor ETF (MTUM) chart below confirms stocks are in downtrend. What we are keeping our eye on is the bullish divergence developing in the chart. Notice that momentum is in a confirmed downtrend, but the strength indicator is displaying an oversold bounce. Technical analysts generally consider bullish divergence an early warning sign of a change in the trend. If there is a break above the downtrend line in the chart, this will confirm the bullish divergence signal.

Friday's better than expect payroll report catapulted the market higher. The good news pushed up the value of the dollar against other major currencies to the highest level in more than four years. U.S. bonds and gold fell as investors fled traditional "safe haven" assets. Recent analysis mentioned "...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...The strong dollar continues to sink precious metals but treasuries are recovering as inflation fears have diminished..."

In the 6-month CBOE Volatility Index (VIX) graph below notice the index has been trending higher the past month, last week we stated "...if stocks continue to slide investors will continue pushing the index higher...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..." As highlighted in the graph the VIX has approached the upper level of its trading range where stock prices usually retrench.

The current American Association of Individual Investor Survey (AAII) survey results approximate historical norms which is usually considered a range-bound trading signal. The neutral and bearish percentages are trending higher at the expense of the bullish number which is a reflection of the markets' current higher volatility. If the current AAII sentiment survey trend continues expect individual investors to become even less bullish.

Second-quarter National Association of Active Investment Managers (NAAIM) exposure index averaged 81.64%, last week is was 59.76%, and the current week's exposure is 41.03%. Notice the percentage is sinking to extraordinary lower levels, even lower than the beginning of August level which is the last time the market had a significant price pullback similar to what is currently happening.

Trading Strategy

Last week we reported 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.

Our previous analysis reported "...Consumer staples normally strengthen in the fall and that is reflected below..." In the updated chart below you can see that healthcare and financial sectors retained their value as other stock groups struggled over the past month. But what is most notable is the carnage going on in the energy sector. When stock prices recover the sectors that are holding up now should lead going higher.



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