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Five short days ago, the S&P 500 hit a new all-time high at 1987.98. The move appeared to be a breakout, albeit a modest one, from the recent range. And a great many analysts - particularly those possessing the rose-tinted Revo's - professed that 2000 was the next stop for the venerable market index.

However, the "breakout" turned out to be yet another in a long string of "fakeouts," in which the index in question quickly reverses and dives right back down into trading range. And in this case, the market has largely moved lower ever since.

To be sure, a "breakout fakeout" does not, in and of itself, represent a problem for the bulls. However, consider that this "pop and drop" action has become a bit of a trend in 2014 as the initial moves higher out of a range just don't seem to stick.

S&P 500 Daily

In other words, most of the breakouts are weak and quickly reversed. This suggests that the bull case may indeed be losing steam and just might be yet another reason to play the game a bit more conservatively right now.

Next Up: Technical Divergences

Along these lines, another reason to be cautious in here is the action on the charts. In short, the charts of the major indices have not been singing the same happy tune for some time now. So, another in our long list of reasons to perhaps consider some caution in this market is a little something called a technical divergence.

We've spent a fair amount of time on this subject over the last month or so. But what follows is a text-book example of technical divergences amongst the major stock market indices and thus, is worth revisiting.

Here is the way the game is played. First take a look at a chart of the S&P 500 above and NASDAQ 100 (aka the NDX) below. Note that the move since mid-April has been quite strong and one-directional. In short, this is what an uptrend looks like.

NASDAQ 100 Daily

Now take a peek at the IWM, which is the ETF designed to mirror the Russell 2000 small cap index. Note that while the NDX has been moving up since the beginning of July, the IWM has been moving in the opposite direction. Thus, there is a divergence between the two trends.

iShares Russell 2000 ETF Daily (IWM)

It is important to note that the Russell isn't the only index diverging from the S&P as the chart of the Midcap index displays similar action. Such divergences can and oftentimes are "fixed" via a good, strong rally. However, if they persist, the fact that the major indices are not in sync is a sign of trouble.

Then There is the Action in the High Yields

Another sign of potential trouble in the stock market right now is the action in the junk bond market.

Some folks refer to high yield or junk bonds (so named due to the credit ratings of the companies issuing the bonds) as "stocks in drag" due to the fact that the high yield market tends to trade in line with the stock market.

While junk bonds traditionally trade based on credit risk - the risk that the bond issuer will default - there is also some interest rate risk involved. So, if the price action in junk starts to go the wrong direction, it is a sign that either credit risk is becoming a problem or that rates may be rising.

And as the chart below clearly illustrates, there is a problem in junk these days.

SPDR High Yield Bond ETF Daily (JNK)

This time around though, there may be another rational reason explaining why high yields are struggling.

Normally, the spread between yields of junk bonds and government bonds is fairly wide. However, given that investors seeking to produce income in their portfolios have few options these days, the buying binge in high yields has caused that spread to reach a record low. This appears to have been a signal to those who trade in the junk market that it might be time to pack up and get out of Dodge.

Regardless of the reason, the breakdown in high yield bonds is something to take note of and may be yet another reason to avoid being complacent about the stock market these days.

... And the Readings of our Market Environment Models

To be successful in the stock market game over a long period of time, it is critical to stay in tune with the big-picture environment. The thinking here is simple. Using the same pedal-to-the-metal approach that tends to produce strong gains in a positive market environment is likely to prove problematic when the bears come to call. Therefore, it is a good idea to utilize different strategies in different environments.

The first step toward long-term success is to identify the type of environment you are dealing with. And it is for this reason that we have developed Market Environment Models, which unemotionally dictate the type of strategy that should be used at any given time.

While it may sound simplistic, in a strong bull market, the readings of our Market Environment Models tend to also be strong. However, it is worth noting that this is simply NOT the case right now.

No, while the S&P is just 4 days removed from an all-time high, our shorter-term Market Environment Model is currently neutral. In addition, the intermediate-term model, while positive, is so by the smallest of margins. And the bottom line is this just doesn't happen in a strong market.

So, while a strong pop higher could certainly rectify the situation, the current price action, the technical divergences, the action in junk, and the readings of our models tell us to stay alert and be ready to take defensive action when needed.

Coming Up... Some of the other reasons that it might pay to be cautious include: The levels of speculation, sentiment readings, public and private exposure levels, valuations, the return of the politicians, Europe's economy, streaks, and the VIX...


Turning To This Morning

Argentina has technically defaulted on debt payments for the second time in 13 years. Although the payments were due to hedge funds in a complex deal spanning years, concerns about contagion appear to running rampant this morning. In addition, Europe worries have also returned as traders fret about a return of deflation. Thus, European markets are down hard and U.S. futures are following suit.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    - Japan: -0.16%
    - Hong Kong: +0.10%
    - Shanghai: +0.95%
    - London: -0.30%
    - Germany: -1.18%
    - France: -1.12%
    - Italy: -1.54%
    - Spain: -1.92%

Crude Oil Futures: -$0.60 to $99.60

Gold: -$0.90 at $1294.00

Dollar: lower against the yen, higher vs. euro and pound.

10-Year Bond Yield: Currently trading at 2.568%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -8.72
- Dow Jones Industrial Average: -72
- NASDAQ Composite: -22.13

Thought For The Day:

The truth does not cease to exist when it is ignored...

Important Reminder: In order to keep pace with our growth, better serve our advisors and clients, and to provide scale for future growth, Heritage is teaming up with CONCERT Global - an SEC Registered Investment Advisor with more than $2 Billion in assets under management. CONCERT will provide more robust back-office, compliance, technology, and trading infrastructure. Client packets to make the transition will be arriving in the coming weeks.

Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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