July 24, 2021

The averages hit record highs Friday as institutions plowed into the largest technology stocks ahead of the coming week's earnings releases.

The action, while impressive at first glance, left something to be desired in terms of volume, let alone breadth, which was about even on the Nasdaq despite a 1.04% gain for the Composite.

As noted on Twitter:

"The health of a market is best judged not by how it acts during a decline, but how it acts on the rally following a decline. It is then that breadth, leadership, and volume can reveal a market's true character."

Looking at each of these three in order, the recent start of a breadth divergence in the NYSE and Nasdaq advance-decline lines, discussed here recently, continued on this four-day rally, a minus. The chart below shows how the broader market, using the NYSE A-D line as a proxy for the average stock, could not muster the strength to confirm the S&P high with a high of its own. This divergence began June 24.

As well, there were 58% of NYSE issues above their 50 ma nine days ago when the S&P printed its most recent prior high. On Friday, when the S&P hit a record high, it was 43%.

The Nasdaq's divergence is even more stark when we compare the most recent high in the a-d line eight days ago to the Friday high. Unlike the NYSE A-D line, the Nasdaq A-D line is not favored as a long-term signpost due to its long-term downward bias. Nonetheless, it is of value.

As my public blog post indicates, a divergence is normally not a concern until it is three months old. We should, however, respect the message, which is that it becomes harder to make money when more stocks are rolling over into downtrends.

Volume on both NYSE and Nasdaq has been unimpressive.

Leadership has been discussed here for some time as being thin outside of the S&P 5, which is what has propped up the Nasdaq and made it look so good. As noted here repeatedly, institutions do not have the conviction in a 1-3 year commitment to the growth sector to buy the stocks amid a backdrop of higher inflation -- regardless of what the Fed says about this being a transitory phenomenon.

Next week's earnings reports by the S&P 5 are of interest from a sentiment standpoint. Will good reports be sold into? That is the question. Also on tap are Shopify (SHOP) and Twilio (TWLO), among other widely-held growth issues.

While we might expect defensive shares to begin attracting buying interest, the consumer staples sector ETF (XLP) has shown only slight outperformance. Beneath the surface, though, perennial defensive names like Service Corp International (SCI), Veeva Systems (VEEV), Waters (WAT), Waste Management (WM), and Yum Brands (YUM) trade close to their highs.

Our Li Auto (LI) triggered trade was a stop-out after dropping 8.1% Friday. The sell-off comes as U.S. regulators face increasing pressure to implement the Holding Foreign Companies Accountable Act, which could result in the de-listing of some Chinese companies from U.S. exchanges if they do not comply with U.S. auditing rules. Although this isn’t specific to Li, most U.S.-listed Chinese stocks have seen declines.

Because we are edging toward what has on average been the most historically turbulent period of the year -- September and October -- and throwing in the deteriorating breadth, soft volume, and thin leadership, it is logical to expect some weakness in the averages. Since we do not own a crystal ball, this is not a prediction, merely a connect-the-dots exercise.

The following names are believed to be the most attractive in the $13+ market for our strategy.

Innovative Industrial Properties (IIPR)

Mongodb (MDB)

Pinterest (PINS)

Smartsheet (SMAR)

Verve Therapeutics (VERV)

In sum, the health of a market is best examined on the rally following a decline in the averages. Specifically, breadth divergences have been in place for a month and worsened on this four-day rally, volume is soft, and leadership is sub-par. In looking at 1,200 charts after Friday's close, I was struck by how many titles did not advance on the current rally. The rally remains playable. Let's temper our expectations about what this market can do, and adjust risk accordingly.

Kevin Marder

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