Were the market gains to new highs last week the real deal or just a bearish setup?

Obviously, we never know when the market posts a surprise gain if it will continue or is it a bear trap. This time it appears to be a real move but that does not mean the week ahead is not going to be rocky. This of course option expiration week. I wrote in the Option Investor Newsletter this weekend there are $550 billion in S&P-500 options that will expire on Friday. The max pain point is 2,430 and about 20 points below the Friday close. Max pain refers to the point where an S&P close will force the most options to expire worthless. The index tends to gravitate to that level as expiration approaches. However, this is not always the case. When the market is making a directional move in advance, those expiration pressures can be overcome.

Analysts said on Friday that any further move over 2,450 could cause some hedging by traders in order to avoid losses from a runaway market. This hedging could limit the additional gains until the following week.

On the flip side, an unexpected move under 2,420 could create a chaotic situation where traders panic in a race to avoid massive losses on the naked puts around the 2,400 level. While I seriously doubt we will be faced with a large decline this week, we can never count it out. I just think the chances are exceedingly slim. Traders also believe the chances are slim and that is why there are so many short puts at that level. It looked like free money over the last couple of weeks once rebound began after July 4th.

The S&P had significant resistance at 2,450 but the gains of the last two days surged past that level as if it was nonexistent. That was the yearend target for the S&P for many analysts. If the index can continue to post gains, even if they are minor, we should see additional short covering in S&P stocks.

The Dow has surged about 450 points since the 21,197 low on June 29th. That is not a lot of points given the 10 trading days. However, the majority of those points were in the last three days since the dovish Yellen testimony. That changed the outlook on rates and the outlook for bonds and the market. Most analysts now believe there will not be any further rate hikes this year. Yellen basically supplied a market put that allowed portfolio managers to feel more confident about the next six months.

The Nasdaq has been the laggard but it closed only 9 points below a new high. The big cap techs are in rally mode again and several have broken out to new highs. If we get just one more day of gains the Nasdaq should join the other indexes in new high territory.

The index has erased all the losses from the late June decline. Support remains 6,100 but if we even look like we are going to test that level again, I would expect a complete washout. Nobody is expecting a material decline as we head into earnings. Maybe that should scare us since the worst market events are those that are unexpected.

The Russell finally made a new high after after five weeks of consolidation just under the 1,425 level. The selloff in the financials on Friday held the index back. That selling should be temporary and that would allow the Russell to move higher. That would be a big lift for market sentiment since the Russell has been trading sideways since January.

The earnings cycle kicked off with a bang on Friday with the major banks reporting. Netflix starts the tech confession series on Monday. There are nine Dow components reporting this week so there is a lot of opportunity for volatility in both directions.

The economic calendar is uneventful after the last two weeks of jobs reports, Fed speeches and testimony. The two housing reports and the Philly Fed Manufacturing Survey are the three most important events. Unless there is some major miss of expectations, I doubt they will be market moving. Everyone will be focused on the earnings calendar.

The reason I think the rally has a good chance of continuing is the market breadth. The advancers of 4,876 far outweighed decliners of 2,242 on Friday and it was a summer Friday with low volume of only 5.3 billion shares. There were 610 new highs and the most since June 9th. If the market breadth holds, we could see a significant change in altitude.

Evidence of the market breadth is seen in the Russell 3000 breakout to a new high. Having the majority of 3,000 stocks moving higher all at once is a powerfully bullish signal. While nothing is infallible, this should be an indicator that we are going higher.

I am not suggesting everyone mortgage the house and load up on new positions. August and September are the two worst months of the year for the market. After the first two weeks of Q2 earnings, it is not unusual to see the market begin to soften as the post earnings depression phase begins a little earlier than in normal quarters. This is portfolio managers raising cash to buy any Q3 dips. Be prepared.

Enter passively, exit aggressively!

Jim Brown

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