STOCKS END THE WEEK ON A STRONG NOTE WITH THE DOW STILL IN THE LEAD -- SMALL CAPS REBOUND AS TRANSPORTS HOLD 200-DAY LINE -- JUMP IN BOND YIELDS KEEPS FINANCIALS IN THE LEAD -- OVERSOLD DOLLAR BOUNCES OFF MAJOR CHART SUPPORT

DOW HITS NEW RECORD WHILE NASDAQ HOLDS BACK ... The Dow Industrials continue to lead the market higher. Chart 1 shows the Dow ending the week at a new record. Its weekly gain of 1.2% led all other market indexes. Its 14-day RSI line, however, shows the Dow now in overbought territory. The S&P gained 0.19% on the week and traded mostly sideways (Chart 2). The Nasdaq Composite Index lost -0.26% during the week (Chart 3). Weakness in biotech stocks and some profit-taking in technology is the main reason why. This week's Dow gains were led by Apple (4.5%), 3M (3.9%), Intel (3.6%), Home Depot (3%), and Goldman Sachs (2.7%). I expressed concern earlier in the week about the Dow leading the market higher. Dow leadership is unusual in a strong market. Small caps and transports ended the week on an uptick. Both groups have been underperforming of late.

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Chart 1

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Chart 2

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Chart 3

SMALL CAPS AND TRANSPORTS STILL IN TESTING MODE... Small caps lost -1.19% this week to underperform the rest of the a market. That's usually a caution signal. Chart 4 shows the Russell 2000 Small Cap Index still trading below its 50-day average. Friday's bounce, however, kept the RUT above initial chart support at its early July low. Transports are undergoing a more important test. Chart 5 shows the Dow Transports testing a major support line at their 200-day average. The transports have diverged sharply from the Dow Industrials of late which is another caution signal. A Friday rebound in airlines and truckers kept the TRAN above that major support line. It's important for the tranport to stay above that red line.

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Chart 4

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Chart 5

FINANCIALS HIT NEW RECORD HIGH... Financials were the week's strongest sector. Chart 6 shows the Financial Sector (SPDR) hitting a new high on Friday. [The XLF just passed its 2007 peak to reach a new record]. The XLF/SPX relative strength ratio bottomed in early June and continues to rise. Some money coming out of technology stocks is finding it way into cheaper financials. Banks and insurers led the sector higher. That may be based on expectations for higher bond yields. Treasury yields jumped on Friday in reaction to a strong jobs report. So did the dollar.

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Chart 6

DOLLAR INDEX BOUNCES OFF MAJOR SUPPORT... The U.S. Dollar index also rebounded on Friday. That was partially due to a strong jobs report and some talk from Washington about the repatriation of funds held overseas by U.S. companies. And it came just in time. The weekly bars in Chart 7 show the USD testing major support formed along the 2015/2016 lows. That's a very important test. If the uptrend in the dollar that started six years ago is to remain intact, the USD needs to find support in this area. Its 14-week RSI line (lower box) has reached oversold territory below 30 for the first time since 2011 when the dollar rally started. Friday also saw profit-taking in most foreign currencies, especially an overbought euro which lost -0.8%. The weak dollar has been supportive for large cap multinational stocks. A stronger dollar might not be. So there's a lot riding on what the dollar does from here. A lot of that may depend on what the Fed does, or what the markets expect it to do. Which brings us to yesterday's jobs report.

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Chart 7

IS THIS THE REAL UNEMPLOYMENT RATE? ... Friday's job report saw 209,000 new jobs added during July which was well above expectations. Hourly earnings also saw a July again of 0.3% which attracted the most attention. That, however, leaves the year-over-year rise in wages at a relatively flat 2.5%. That's higher than the inflation rate, but well below what we should be seeing at this point in the economic expansion. Chart 8 shows the unemployment rate falling below its 2007 low of 4.4% to the lowest level in sixteen years (2001). Economists at the Fed remain puzzled as to why wages aren't rising faster in the face of near full employment. That may result from looking at the wrong numbers. The unemployment rate shown below (U-3) doesn't include people who have stopped looking for work; and counts part-time workers as fully employed. A broader measure of unemployment (U-6) includes those unemployed or underemployed and currently sits at 8.6%. That's twice as high as the number everyone is looking at. The spread between the two is also much wider than it was in 2000 and 2007 when the unemployment rate was this low. That suggests that we're nowhere close to real full employment. So does the low percent of workers participating in the work force.

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Chart 8

LABOR PARTICPATION RATE IS STILL TOO LOW... The labor force participation rate currently sits at 62.9% which is close to the lowest reading since 1977. That rate measures the percent of adult Americans who are still participating in the work force. Prior to 2000, the rate rose consistently for forty years. It peaked at 67% in 2000 and fell more sharply after the 2008 financial crisis. It bottomed in 2015 at 62.4% and has barely budged since then. That also seems to suggest that there's still a lot of slack in the work force. The current annual wage gain of 2.5% is also well below the 4% level seen in 2000 and just prior to the financial crisis in 2008 when the unemployment rate was this low. Something seems to have changed over the past two decades. I suspect it's the fact that deflationary forces took hold after 2000 (and again in 2008) and are just now starting to lift. That would account for why employers have been slow to hire and more stingy with wages. I can't help but wonder if the Fed is taking all of these factors into consideration. If it isn't, why not? And if it is, why does it remain so puzzled about the lack of wage inflation? One reason is that the Fed expects an economy nearing full employment to produce higher wages. But it may be looking at the wrong numbers to gauge full employment (or ignoring those that paint a weaker picture). It also believes that higher wages lead to higher inflation. I suspect it's the other way around. And that higher inflation leads to higher wages. It's harder for employers to raise wages when they can't raise prices enough to offset higher labor costs. That hurts their bottom line. Rising prices encourage more hiring and higher wages.