What's Wrong With This Picture?

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Includes: AAPL, AMZN, CRF, DDM, DIA, DOG, DVAX, DXD, EEH, EPS, EQL, FB, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Bret Jensen
Summary

The Dow Jones Industrial Average crossed over the 22,000 level this week, its fourth 1,000 point milestone since the November election.

However, a good portion of the rally in 2017 has been lead by the so call FAANG stocks.  Most of the rest of the market has lagged behind.

With significant tax reform seemingly more and more unlikely, narrow breadth and historically higher than average valuations; is a market decline just ahead?

You don't throw a compass overboard because the ocean is calm.” - Matshona Dhliwayo

The Dow Jones Industrial Average crossed over the 22,000 level for the first time on Wednesday. It was the 32nd record close for the Index so far in 2017 and the fourth '1,000 point milestone' since the November election. Apple (AAPL) appropriately was the trigger for the latest milestone after posting better than expected earnings results after the bell on Tuesday. Apple is one of the so called FAANG stocks that have played such a big role in the rally in the market in 2017.

Apple is up over 35% on the year. With the largest market capitalization of any stock, this has an outsized impact on the overall market. In fact, as of the end of May, the five largest stocks by market capitalization on the NASDAQ had contributed over 40% of the overall return on that index in 2017.

Other FAANG stocks like Amazon (AMZN) have had similar moves despite posting only 40 cents a share in profit in the second quarter and being at the $1,000 a share level. These have been relatively paltry moves compared to the F in FAANG or Facebook (FB). Those shares now sell for dozen times this year's projected revenues.

This big rise in the values of the largest names in the market has been accomplished with a remarkable lack of volatility so far in 2017. The Dow Jones has gone the whole year without one pullback of more than three percent and volatility levels by some measures are at/near all-time lows.

While the S&P 500 and the NASDAQ have big double digit returns, most of the rest of the market has not kept up at all. The Russell 2000 which represents the small caps in the market has barely moved ahead so far in 2017.

It is true that large multi-nationals have been helped considerably by the fall in the dollar against major currencies recently. In addition, Europe is seeing its fastest economic growth in years and China growth has improved in 2017. That being said, the divergence in the performance and valuations of the largest stocks in the market compared to their more numerous smaller brethren is concerning.

It is almost feeling (although not to the same extreme yet) like the Nifty Fifty market of the 70s or the ending of the Internet Bubble when folks where paying nearly 100 times earnings for the likes of Cisco Systems (CSCO).

We have a low volume market over the past few weeks as we usually do during summer. August will probably bring much of the same as much of the trading community takes long weekends in the Hamptons and other vacation spots.

With the historically volatile months of September and October fast approaching, chances that this market driven for the moment on narrow breadth having a decent pullback is rising. This is especially true given the dysfunctional in D.C. and the slimming chances of any significant pro-business efforts like tax and regulatory reform ever getting to the president's desk to be signed into law.

I am not predicting Armageddon or even a noteworthy sell-off. However, the chances of a five to ten percent decline sometime over the next few months cannot be dismissed and its likelihood has increased in my mind over the past few months as the market has continued to grind itself up to new highs.

Therefore, I am going to slowly up my allocation to cash to just under 25% up to 30% in coming weeks before we get into September. I plan to do this primarily by selling some just out of the money covered calls on part of the holdings of some winners that have run up recently. These include Dynavax Technologies (DVAX) where I recently outlined by option strategy on that name.

In my view, risks are increasing to the downside. Caution therefore is the better part of valor at the current time. I think my outlook will remain the same on the market until we get lower entry points after a five to ten percent pullback, if small caps start to participate in the rally or if I am proven wrong on the prospects of significant tax and regulatory reforms that would boost economic growth.

Don't ever take a fence down until you know why it was put up.” - Robert Frost.

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Thank You and Happy Hunting

Bret Jensen, Biotech Forum

Disclosure: I am/we are long DVAX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.