Time for Caution

In August, right before the market began to rally, we ignored an important buy signal in lieu of chart and volume patterns, which indicated more downside. Because we ignored this signal, we were caught on the wrong side of the trade. Now, interestingly enough, we are getting the same signal, only this time in reverse. NASDAQ 100 emini Sell Signal: At the beginning of August, futures markets for the NASDAQ 100 emini contract showed a breakout in money flow, which preceded the breakout stocks. Now the same contract has a money flow indicator that reveals smart money selling into the current rally.

Also note the important break in the uptrend line yesterday, even as QQQQ shares traded higher. Adding insult to injury, the S&P 500 made a new 5-year high yesterday, while the NASDAQ lagged significantly. This type of bearish divergence has preceded each failed rally for several years now. Gaming Window Dressers: End of month window dressing has been increasingly gamed by traders who have learned the pattern. Not that long ago window dressing would result in rallies which took place during the last three days of the month, and sometimes extended into the first two trading days of the following month. Now, however, traders have been taking advantage of the rallies and selling into them during the later days, causing the rallies to start to fizzle during the last day or two of the month. If this pattern persists, it means that today should market the last day where window dressing is able to push the market higher. S&P Rising Wedge: One of the most bearish of all rally patterns is the rising wedge, a pattern we have highlighted several times over the past few weeks in the S&P 500 index. We have hypothesized that before this wedge gives way to selling, a strong upside breakout would occur in order to draw in bag holders. Yesterday we got the initial move of just such a breakout, as can be seen below.

Window dressing may take this breakout up another day, perhaps two, but we argue that this breakout is very likely a bull trap, which will fail only to send the index tumbling back down to July lows during the month of October. Of course this last point is only speculation, but the rising wedge pattern is fairly predictable and given the divergence with the NASDAQ, the emini sell signal, and the fact that the 4-year Cycle low has not yet exerted its pressure, we think there are some pretty good reasons to take a seriously defensive posture starting this week. Once current buyers walk away and sellers are left without competition, this market can come down fast.

As Long as Everyone is Bearish, This Rise Will Continue

A few days ago we used the analogy of The Little Boy Who Cried Wolf in relation to the market's uptrend. We pointed out that as long as the market participants continue to try and time the top by buying puts into the rallies, the market would keep on climbing the wall of worry. Each time the market rallies higher, these shorts are required to cover their short positions at their stop loss points. Covering shorts drive the market ever higher. Eventually they will learn the market's lesson and stop shorting the rallies. When this finally occurs, the market, which has been crying wolf, will then reverse. The time is not yet considering that 2-1 puts were purchased against calls yesterday. This market could be headed for a blow off top this week, which will hopefully finally convince the bears to turn bullish. When they do, we can get the correction that we admit we have been way to anticipatory of. Much of the current strength can be explained by end of the month window dressing. Later in the week it is likely that this will be faded and we could see a quick reversal that at least does the job of shaking out the bulls. We are likely to see higher prices before that occurs though.

Window Dressing Should Prop Up Weak Market

With indices overbought and near extreme resistance levels it is getting too late to buy, bar for a few specific issues. Likewise, now that we are entering the last week of the month, fund window dressing (an illegal, but oft performed activity) should make life difficult for the shorts. As we move into October, the chances for a larger correction increase. The semiconductors have already likely seen their top as can be seen in the weekly view of the SMH below. Note the inability of this ETF to make it over resistance at $34 over the past four weeks. Each attempt has been met with stiff selling. Why is this index important? If you recall, it led the way up in this oversold rally that is now showing signs of aging. There remains potential for the S&P to test its highs this week. We will be surprised, but not completely shocked, if the QQQQ is able to also test its highs. We would use late week strength to look for short positions. Finally, for those feeling a twitch of concern at our market outlook, consider that after a corrective retracement, the probabilities for a strong late year rally are very good.

Market Cracks Some More

Profit taking yesterday and a continued divergence between big caps and the small caps and semiconductors shows that the cracks in this trend are increasing. We won't call it a top unless we see the S&P 500 break below 1310 though. Don't forget, we are nearing the end of the month where buying usually picks up.

SMH Fails to Make a New High

The tech sector had in fact not made a top as yesterday provided. The market did prove to utilize the bear trap as we predicted it would. Longs have been extremely aggressive in this market. This does not mean that we are closer to a true break out than we are of a more serious correction. The first crack in the trend is the fact that the QQQQ made a new high, but the semiconductors (original leaders of this rally) did not confirm. The QQQQ is making new highs on the sudden enthusiasm in the old guard stocks ORCL, MSFT, and CSCO; all of which are extremely extended and nearing resistance

Monday's Scenario Still In Play

Yahoo sneezed yesterday, traders dumped their positions in panic, and the options market was stormed with orders for put contracts. What does it all mean? That the bear trap has been set and that the top is probably not yet in place. In order for this bear market rally to top the market first has to teach the crowd to lean the wrong way so that it can catch them in a "hold and hope" situation as their positions slowly erode. In order for the market to teach the crowd this perverse lesson, it has to cry wolf a few times (referring to the story of The Little Boy Who Cried Wolf). Yesterday, we believe, the market cried wolf yet again. If the market rallies higher from here, stopping bears out of their positions once again, they will likely have learned the lesson that the market is trying to teach: that is, if you short me again, I will burn you again. But alas, once that lesson is learned and the crowd learns to be afraid of the short trade, then the market will get what it wants: a downtrend with as few people on board as possible. In fact, this plays out well with the scenario we drew on Monday. The S&P has now pulled back near support. A reversal here and a new high would catch the most people unaware and the market always takes the path that catches the most people off guard. A push higher from here would very likely get a lot of people bullish and would allow smart money to make their final distributions. The crowd will then very likely hold those positions they bought here at the top all the way down to this summer's lows. If the market then takes out those lows, those who held and hoped from the top will very likely release their shares at much lower prices to the same smart money crowd who sold to them at the top. This is why we say that the market has a perverse nature. Bottom line: We will be eyeing carefully any strength as we enter the end of the month for shorting opportunities. And, should the four year cycle low take the market back down to this summer's lows, we will start looking carefully at weakness for good long opportunities. The tech sector remains weak here and may have already put in its top.

Buyers Still in Control/Tech May Have a Top

The QQQQ left a doji and the semiconductor sector tailed off at the top yesterday as profit takers nervous about giving up gains kept the tech sector from extending its gains. It looks unlikely that the tech sector indices will be able to mount any further gains from here without first correcting. The S&P and Dow are in sideways corrections, so the scenario we drew yesterday, which indicated a dip, then a rally, then a sell off, may actually skip the "dip" stage as oversold pressure is worked off in a sideways pattern. Nevertheless, there should be some good long and short side trades that last through the end of the month.

Support Test Coming Up

Friday's high volume gap up on the NASDAQ marked what is likely a near term top. Over the next few days we are likely to see indices work their way lower back to support levels. Currently the QQQQ has support at $39 and the SPY at $131. We will be operating under the thesis that the market will bounce from support as the crowd once again becomes too quickly bearish. The following bounce then should take early bears out of their positions as the S&P tests overhead resistance. From there, however, we should see the larger 4-year cycle reassert itself (see SPY chart below). On September 5 we outlined five reasons why we were expecting the market to return to this last summer's lows before it provides a true longer term buying opportunity. We were a bit early in our analysis at the time, but those reasons remain valid and by October they should assert themselves on the market. The QQQQ set up is a little more unclear as it has shown good relative strength lately. The bottom line: We are seeing some good long set ups at this time that should continue higher over the next couple of weeks. As we enter October the market becomes more vulnerable to a larger correction. Should the above scenario play out like it looks like it might, the return to the summer lows will provide an excellent long term buying opportunity. Participants are likely to be extremely bearish at that point and those who play it cautious as the market makes its top here will be in great shape to capitalize at very good prices indeed.

Watching and Waiting

Today is triple witching options expiration, which is accompanied by several economic reports that are being looked to with anticipation. We will withhold comments today and wait to see how the market responds. Remember, it is not important what the news is, but how the market responds to that news that is key. Take a breather today and don't open new positions.

Pavlov's Lesson

Over the past 18 or so months the market has become increasingly less volatile as upside breakouts have been stymied by sell programs and downside breakdowns failed to gain momentum. This period of time has trained trades, including admittedly us, to distrust large market moves and to bet firmly against them. This "lesson" the market has been teaching is very much like the stimuli that Pavlov used to train his dogs. This pavlovian response caused a lot of people to distrust this rally and as such the rally scaled a wall of worry unlike one we have seen in quite some time. Up until yesterday, puts were purchased on every dip causing subsequent covering to drive the prices higher and higher. Even so, we need to be careful here as the market is very close to reaching that point of recognition which will cause the tables to turn. As mentioned yesterday, the rally on Tuesday quite likely pushed back the expected correction another couple of weeks. This is not the time to lose our heads. That said, the market internals have been quite good over the past couple of days as breadth has improved immensely and stocks making new highs continues to grow. There should be some long side plays as long as good trailing stops are used to protect against any downside. For the time being, we are going to abstain from any further predictions and stick with what is right in front of us. We are also going to try and take a bit more risk since being too conservative has kept us from participating in this rally. What is in front of us today are a few decent long side set ups. Will they follow through? It's likely, but who knows for how long?

Bulls Refuse to Give Up

After a weak rally built on poor volume and breadth, volume followed through yesterday and breadth turned utterly bullish as fund managers worried that they had missed the bottom for the year piled in. The head and shoulders pattern that the QQQQ had been putting together was denied after the index sliced through its 200-day average and closed at a new near term high. We continue to believe that the market is very vulnerable for a correction. However, yesterday's rally (based on dropping oil prices and speculation that the economy is due for a soft, rather than hard landing next year) very likely pushes back the expected correction toward the end of the month or even as late as early October. We are looking for the QQQQ to drift lower toward Friday's options expiration as options sellers "park the car" into maximum pain prices. Maximum pain for the QQQQ is $39 this month. The bottom line here is that you can't argue with the market. Has this rally been built on a poor foundation? Yes. Is it possible that yesterday's strong rally occurred based on spurious reasons? Yes. Can the market continue to rally higher than seems reasonable? Yes. Will it eventually correct and come back to build a better base? Yes.

Watching Tech's Head and Shoulders

We are doing our best to stay objective here and look for the bullish case to balance out our current bearish outlook. It's not easy to do however when even after two up days in a row now scans do not produce any long side set ups that don't scream "Risk!" The big story yesterday was the huge follow through lower in the commodities sectors. Oil stocks crashed through support levels on their double top patterns and the metals crushed their last line of support on heavy, heavy volume. This led to what could possibly be a rotation into the tech sector, but if so, it begs a question. If money that is rolling out of commodities is moving into tech, why did tech only experience a weak rally yesterday that was turned back at right shoulder resistance of the head and shoulders patterns we pointed out in yesterday's report? There is a huge amount of money leaving commodities and yet breadth was only slightly positive in the tech sector yesterday and it was negative in the blue chips (more stocks were down in the S&P than were up). All these negatives we keep harping about lately do not mean that the market cannot go up from here. They do probably mean that any upside move is likely to get knocked back down hard though. As mentioned, yesterday's upside move fits in well with the thesis that tech is trading in a head and shoulders formation. Any follow through higher today that sticks into the close would negate this hypothesis. What is very clear is the fact that things are just not real clear in the broader market and with options expiring Friday, it's difficult to trust this market. With so many unknowns, it's better to stay with open shorts and wait in cash with the rest of your money. Note: we would like to get short more commodities. If the sector can experience an oversold bounce here it will be worth looking for entry points. If it just keeps heading lower, we will likely have missed a speeding train lower.

Three Potential QQQQ Scenarios

Options expire this week, but bulls and bears are fairly even, so hopefully undue volatility will be held to a minimum. On Friday the market bounced, but it looked to be more of a corrective move off of the overly bearish sentiment that was building since the market reversed last Wednesday. At this point, the QQQQ could be building one of two patterns: Head and Shoulders top (bearish)

If this is indeed the case, we should see the price bounce around between $38.00-$38.70 through options expiration, and then potentially break lower. Cup and Handle (bullish)

If, however, the QQQQ is forming a bullish cup and handle pattern, we might see the price move back to fill the gap at $37.70, only to reverse and then potentially break higher. The third scenario could be that the market is done pulling back and prices will follow through higher from Friday's rally. Technically this should not happen, but as we found out a few weeks ago, you can't apply logic to the market's actions; it sometimes just goes where it reasonably should not.

No Advantages to Forcing a Trade

With the S&P now breaking the lower support line on the bearish rising wedge pattern, the path of least resistance is now down. As we mentioned yesterday, however, there are too many bears out there to get much downside momentum started. We saw this play out yesterday as dip buyers stepped in, probably in response to ultra bearish sentiment, and kept a bottom under the market. The QQQQ tried to rally yesterday, but sold off in the late day, indicating that sellers are in charge, even though sentiment is giving some support. Drilling down to our scans, though, we find a very neutral near term picture. Reading the indices, we need to keep a bearish bias until we have a better reason not to. At the same time, we struggled to find anything that constituted anything close to a reliable trade set up on either the long or short side. When stocks are not setting up, it is always best to go to the sidelines and wait for better developments. There is no better way to lose money in the market than by forcing a trade. Days like today are best traded only by day traders. Days like today are usually short-lived and those who are patient and keep some cash on the sidelines waiting to act are quickly rewarded as better set ups emerge in their wake.

Stay Patient, Sentiment Will Swing Again

Yesterday the QQQQ (NASDAQ 100) left a strong sell signal as it failed at major resistance. On the chart below, the green line represents the 200-day average. On Tuesday the price closed strongly above this line, which we described yesterday as a temporary head-fake move designed to entice enthusiastic longs to buy more shares. Yesterday's gap back down and subsequent strong volume sell off confirmed our theory. The tech sector will probably bounce from yesterday's lows, but now any rally attempts are very likely to get stuck in the mud and prices will begin working their way lower; frustrating any hopeful longs who buy the dips. The SPY (S&P 500) moved down to support yesterday, but it has not yet provided a sell signal. Money flow perked up at the end of the day indicating that smart money has not yet determined that the rally is completely played out. There are just too many retail traders who have quickly jumped to the bear camp after yesterday's weakness. The market's perverse nature is likely to frustrate put option buyers by failing to provide immediate gratification. If the SPY can break below the blue uptrend line it closed at yesterday, it will signal a sell.

Right now we wouldn't be surprised to see the blue chips retest the highs. Should the S&P turn quickly around here and move back up to 1325, which we outlined yesterday as a magnet price for this index, those who turned bearish so quickly yesterday will very likely get bullish very quickly. The bottom line is that tops take a while to carve out. We expect to see some good shorting opportunities in tech over the next trading day or two. What we are going to be looking for is a bearish divergence between tech stocks and blue chips. If the S&P can indeed retest its highs, but the NASDAQ and semiconductors can only manage a weak bounce, we will aggressively short tech. If on the other hand the S&P is so weak that it can't hold support, there will be a number of breakdown plays, which should also provide shorting opportunities. Go long today if you are day trading, but don't look for any sustainable rallies to develop from here.

Be Careful Here

The S&P is just about back at formidable resistance (1325). This area will likely act like a magnet as bulls seek to drive prices higher, keeping bears off balanced. The QQQQ temporarily regained its 200-day average, but with the semiconductors still struggling, it is unlikely that this index will be able to surmount much more of a gain from here. This is especially true with the bond markets struggling. Right now it is best to sit on your hands if you have the urge to go long. The prospects for any meaningful price gains from here are poor. Shorts should start nibbling on positions as the S&P closes in on 1320-1325.

What September May Hold

Today large money managers return from vacation in droves after spending the hot months of August in their vacation homes. Below we are listing our reasons for why we believe the institutions will unload their positions in September and why we believe that an excellent buying opportunity is coming later in the month. So, if you missed the latest rally out of distrust like we did, never fear, there will be a second and better chance to participate at perhaps even cheaper prices. Reasons we are looking for a decline from here: 1. During the last two weeks of August the market rallied, but on decreasing volume. The QQQQ rallied right into its broken 200-day average. Take a look at the volume patterns during the decline from April and the late summer rally. Note the increase in sellers on the way down and the decrease in buyers on the way back up.

2. Likewise, the S&P 500 and Dow have rallied back to their April failure points. However, note the notable decrease in stocks making new highs during the latest rally (the yellow bars represent stocks making new highs, while the blue line represents the S&P price levels). This is a very strong bearish divergence, which makes a breakout to new highs very unlikely.

3. September has traditionally been the worst month of the year. This September the market is facing an additional seasonal factor, the reliable 4-year cycle. Longs have thus far done a great job at shaking out early shorts from their positions, which is generally what happens right before a large market move. 4. Overly bearishness has given way to overly bullishness. Last week Baron's magazine was cheering on the market as it approaches new highs. Money managers have a perfect opportunity to book profits into the crowd's enthusiasm. 5. Market volatility levels are back near all-time lows; another measure of the crowd's complacency as the market moves back up to test its highs. Bull markets climb walls of worry, and there is just not enough worry to move the market through the ceiling. Summary: Given the fact that the market has rallied for two weeks on low volume, that fewer and fewer stocks are making new highs even as the indices are nearing their highs, and now that the crowd is getting excited, it's a good time for the 4-year cycle to reassert itself. Outlook: Not all is bleak. Tech has shown some excellent relative strength and there are murmurings now that the Fed will once again start lowering rates to stave off an impending recession next year. The bond market has been behaving in such a way as to indicate this is true. September could be an ugly month for the bulls, but if the market is able to move back down to its June and July lows, we will be buying madly as this will mark a clear opportunity to take advantage of what is shaping up to be a strong rally in coming months. If you are worried about the market, make sure you are not mixing up your time frames. The outlook is pretty bearish directly ahead, but not so many weeks out in front, the outlook becomes much more bullish. Today: As we mentioned, the financial magazines and the crowds are fairly bullish after last week's strong close. The S&P looks like it wants to make a run back at its May highs. Meanwhile, money managers are going to come back looking to book profits made by their assistance and programs over the past few weeks. Early week enthusiasm then makes for a very nice opportunity to sell into strength. For the reasons we outlined in today's report, any further strength is not to be trusted.

Watch the SMH for Signs of Profit Taking

The SMH is now firmly parked at resistance so we would expect to see profit taking start at any point. Other resistance areas pointed out in yesterday's report are also looming. Next week we will get a better picture of the market's near term intentions. Note: We plan to take off tomorrow for the holiday weekend. We wish everyone a nice and safe holiday.

Watch Out for Rising Wedges

The rising wedge pattern is one of the more reliable chart set ups as the contraction of price movement as prices rise reveal the fact that bulls are running out of fire power. Note the S&P 500 traded in a rising wedge pattern from the first of the year until April, when a breakout attempt proved to be a head fake and the price subsequently plunged into a two-week free fall, which gave back the entire gain from the previous five months.

Now take a look at the current S&P chart, represented below by the SPY (ETF) exchange traded fund.

The wedge here is in a much sharper uptrend, but the price is contracting nonetheless. Could the bulls rally the price of the SPY back up to $132? We don't know yet. But if they did, there would surely be a great deal of capitulation amongst the shorts. Likewise, given the low volume in which this steep climb has been driven with, the probable reversal could be sharp and swift. Now turn your attention to the QQQQ, which has been behaving a little better lately. Below we are providing a weekly view of this ETF. Note the red line on the chart just above $39. This represents the 50-week average. Note also the blue trend line drawn on the chart. This line represents the last broken uptrend. Stocks and indices often move back up to retest their broken trends before reversing. We don't know what exactly to expect next, but it is clear that any further rally from yesterday's close is sure to run head long into some serious resistance.

Finally, let's take a look at the semiconductor sector, represented below by the SMH ETF. The semiconductors actually look pretty good lately. They appear to be in a decent uptrend that is rising on decent volume. Also note, however, that yesterday's sharp move put the sector right near overhead resistance, as represented by the rising trend channel. Furthermore, $34.28 represents the broken 200-day average. Thus, any further rallies in this sector are also likely to run into heated resistance. The semi conductors could actually produce some good long side trades after a pull back if it is orderly. For now it is too late to try and catch this trend.

Bottom line: Professional traders are expected to return next Tuesday after the holiday weekend. Any breakout attempts following yesterday's strong close should be eyed very suspiciously. No one knows for sure what will develop next week, but several indices are poised for serious downside if the pros come back with selling on their minds. If, on the other hand, they come back in a buying mood, further upside is likely to be muted by serious overhead resistance. In other words, be extra cautious if you are trading the long side of this market and don't get too aggressively short unless we see some breakout failures start to emerge.

Bulls Need to Step Up as Time is Running Out

Tech indices appear to want to continue drifting higher as we move closer to the end of the month buying window. The blue chips, however, found serious resistance overhead as they tried to break out yesterday and once again the S&P and Dow sold off into the close; a bearish sign. The problems with this rally are pretty much the same problem all recent rallies have had lately. Volume is poor, breadth is poor, and there has been a disconnect between the indices. Blue chips have moved way out in front and tech, while making a decent catch-up move, continues to lag. Overall the technical picture isn't terrible, and is for the most part neutral except for a couple of reasons. First, while we are seeing some areas of tech make strong moves, reliable breakouts are not setting up in the sector. We are also seeing more reliable short set ups than reliable long set ups. Most significant, however, is the potential for the bond market to sell off later this week. Technically bonds are ripe for a sell off, which would likely put a nail in the coffin on the bullish case for stocks. Stocks can still improve and rally, but time is on the side of the bears here. The longer the bulls wait to put their technical pieces together the weaker their case becomes.

Don't Read Too Much Into This Week's Action

Look for volume this week to drop back to levels normally only incurred during the week leading up to the Christmas holiday as most of the remaining market participants take off for the beach. It's difficult, and probably unwise to try and cull too much meaning from last week's and now this week's activity. Last week was more representative of traders trading with other traders than it was of actual supply and demand. This week should be more of the same. With this in mind, look for both breakouts and breakdowns to fail. Bet against meaningful price action and look for stocks and indices to bounce between support and resistance. With volume levels low, it will be easier to manipulate prices and gun prices temporarily higher to take out the short's stop losses. Likewise, it will be easy to drop prices below support and take out the stops for longs. We plan to be very conservative this week, only trading where we can see a very clear advantage to do so. Next week promises a fair amount of fire works; though the jury is still out on whether there will be a market breakout or breakdown.

Slow and Boring Trading with Slightly Negative Bias

On the long list of indices we tract, relative strength readings yesterday were all negative, save for the SOXX, semiconductor index. We would read this as more of an anomaly than an indication that the semis are about to show leadership. No, this market is set to drift, with what looks to be a slightly negative bias, through next week. Unfortunately this lazy end-of-summer trading is not likely to lead to much excitement until after Labor Day. We don't recommend getting overly aggressive since what we are seeing now is more representative of small traders trading amongst themselves than it is of real supply and demand. Yesterday, once again, program trading caused a slight rally in the last 30 minutes of trading. One respected analyst indicates that this "propping up" of the market into the close is having only the effect of temporarily staving off the inevitable.

Follow Through Lower is Doubtful; This Week Anyway

Sentiment has swung wildly back to overly bearish after yesterday's down day. Tech led the way lower but the semiconductor sector showed some resiliency, as did the S&P 500. Our scans today show a lot of bearish set ups and few reliable bull set ups. Nevertheless, we would expect to see the market bounce some today just due to the fact that bears are pushing too hard here. The reason that an overabundance of bearishness can cause the market to rally is not that complicated if you think about it. When the crowd is leaning one way, it means that they have committed their money. If the market fails to go lower due to the fact that all money that can be committed is already committed, bulls can gain confidence and cause short positions to start feeling pain. Once shorts start to get stopped out, their covering causes the market to move even higher. It's not really a question whether the market will deny shorts their sell off event this week. Shorts are likely to be disappointed if that is their hope. The real question is, is this market going to continue to experience serious distribution that quickly shuts down the rallies? If the 4-year cycle is going to take hold when the professionals return after Labor Day, then we should see more distribution and should see stocks struggle as indices near last week's highs.

Immediate Trend Nuetral

There isn't much to add to recent comments. Volume is low and the immediate trend is neutral. Bears are betting on an S&P breakdown, which could give it support, but bulls are betting on a QQQQ breakout, which should keep it below resistance.

Problems Remain with this Rally

Low volume, as predicted, has arrived. Yesterday was predictably a negative day, but selling never really took hold after an initial drop. We may see more backing and filling today and then could potentially see the market move back up near last week's highs later in the week. There are a number of reasons to distrust strength at this point. First of which is the fact that the bulls never experienced a capitulation event during the last downturn. Moreover, the market has rallied on below average volume. Most significant, however, is the fact that new highs have been sorely lacking. Stocks that rallied last week were weak stocks that rallied on short covering as shorts were squeezed. Significantly, stocks with strong charts trading near 52-week highs, failed to participate in the latest rally. Why is this important information? It means that smart money was willing to buy strength in expectation of the market making a strong bull run. The rally was then dominated only by short covering, which is indicative of a bear market rally, not the beginning of a new leg higher.

Let the Games Begin

Over the next couple of weeks volume should be very low as the pros head out for vacation. Last week's options expiration skews analysis and we will get some idea what real demand is this week, but emphasis should be placed on the word "some" since this week is certainly not going to clear up all questions. Real demand will not be known until the pros come back from vacation after Labor Day weekend. Look for games to occur in this low liquidity environment, with prices swinging widely against both bulls and bears.

Has Everything Suddenly Changed? Don't Bet on It.

All last spring and most of this summer, strength has been sold into. Early this week we had a similar situation, where the market had been trying to rally, but had been knocked back on each attempt. The market is often perverse though and once the pattern of selling strength was well recognized, it did the opposite of what it was projecting and gapped over resistance. Moreover, we have yet to see a real pullback in this trend. Readers will recall that we had a similar situation in May, only in reverse. In May, the market broke down from its long term trend and then traded straight down without one serious pullback. The QQQQ traded down $4.00 before it experienced a 50% retracement of the move. Now we have a mirror-opposite of May's down move and the QQQQ has traded up $3.50 from its lows, again without a pullback. Today is expiration day and a close near $39 on the QQQQ would cause the maximum amount of pain for the maximum number of options buyers as it would cause many of their put options to expire worthless; this after tremendous profits had been logged from the previous few weeks. Interestingly enough, $39 represents the QQQQ's 200-day average and a 50% retracement of the entire downtrend started back in May. In other words, there is some tremendous resistance at these levels. Getting back to lessons the market teaches us: the market taught us that it is good to sell strength, then, once the lesson was well learned, it perversely changed the rules. Do we now buy strength? We argue firmly, No! If the trend has changed, then we will see an orderly pullback from this major resistance level and dip buyers will be eager to get in. If the trend has not changed, we will see something of a panic ensue when dip buyers are not to be found. Today we should see the QQQQ trade near $39. A move slightly over $39 in the next few days is possible, but we would consider that a good opportunity to sell strength. A pullback from this area over the next few days to a week is about as sure a bet as bets go in the market. It is the character of the pullback that will be most telling.

Watch Profit Taking for a Clue on What Comes Next

Yesterday bulls got the numbers they wanted on the CPI release, allowing them to follow through on the rally started from the PPI numbers the day before. We are still shaking our heads over the failure of the strong bearish signal, which we outlined earlier in the week. In all the years we have traded, it's the first time we have seen this type of failure. Had sentiment figures been overly bearish prior to Wednesday, we would have discounted the set up. They were not. Today we will not try and make any new predictions, but will take a wait-and-see approach. Profit taking should start very near current levels. All indices are approaching major resistance levels. The question is, how will the market react to resistance? Will it reverse with a vengeance? Will it consolidate as dip buyers come in? At this point it's anybody's guess. We will abstain from trading until we get some better answers. It would have been wonderful to have had a crystal ball and to have been buying the ugliness last week, but it doesn't take a crystal ball to see that buying or selling at current levels is risky indeed. Especially with options expiring tomorrow.

Bulls Get Their Revenge; Will it Last?

The market continues to be very hard to trade. The short set up we had on the QQQQ yesterday was about as good as they come; perhaps too good. Perhaps the signal was so clear that the only thing that a truly contrarian market could do was to fade the signal. Or, perhaps the lower than expected PPI numbers released before the market yesterday gave bulls an unexpected opportunity to exact some pain from the shorts. The later is the most likely explanation for yesterday's surprise rally. The QQQQ is in a bear market and this rally does not change this fact. It is possible that when the CPI numbers come out today that they will compliment yesterday's PPI release and give the bulls more ammunition to put the bears in pain. As bears cover their shorts, the QQQQ could rally back up to major resistance at $39. This is the reality of bear market rallies. They are quick and painful and they reverse just as quickly as the stopped out bears can slap their heads and say "Doh!" ala Homer Simpson. Alas, we cannot argue with the market, we can only react to it. Should the QQQQ rally up to $39, we will short it aggressively. Until then, it is important to keep position sizes small and trade discipline high.

Why are the Bulls so Confident?

Commentators are nearly all barking in unison pointing to relative strength and good breadth on yesterday's rally. Bulls are sure that bears are leaning too hard and that bears are ready to have their comeuppance served to them on a platter. Bulls in fact are so confident of this that they purchased nearly 2 1/2 call options for every put option on the QQQQ yesterday (remember, anything over 2 is overly bullish). We can't understand it. Yesterday we posted a chart of the QQQQ and pointed out how the price has tried to break the downtrend twice over the past several trading days. Yesterday marked a third high volume rejection in just the last seven days. The bottom line is, this market has been very volatile and as hard to trade as any market we have seen. As such, we would not add any more to the short side here, but we certainly would be very hesitant to go long and we would certainly hold current short positions open.

Indices Trading at Resistance

We start options expiration week with sentiment in neutral and with tech indices poised for another leg lower. There are several reasons we think that tech has more downside left in it before it finally carves out some meaningful support. First, the downtrend is still in tact and with prices trading right at resistance levels, sentiment figures, as mentioned above, do not reveal a great deal of concern. Should the crowd be overly bearish here, we might be more inclined to look for a breakout that surprises the crowd, but this just isn't the case. Second, our scans reveal an abundance of stocks trading in bear flags with technical indicators that are overbought. This has occurred due to the fact that the market has bounced softly in relief from the last down leg, which has put many stocks right up against their falling 50-day averages. Pros enter trades at the 50-day average. Finally, the QQQQ has made two recent attempts to break the downtrend, but was rejected on both attempts. Moreover, volume on the rejection days exceeded volume on the subsequent recovery days by a margin of nearly 2:1. Note the chart below. We have highlighted the rejection days and have drawn lines connecting the volume bars representing those rejection days. It is clear that distribution continues to exceed accumulation at this time. Understand that no one can possibly know what the market will do next. All we have to rely on are probabilities. It is important to short when it is scary to do so; when stocks are trading up against resistance and when you are afraid that resistance will be broken. Just like it is important to buy at support when everyone is worried and when your own emotions are telling you "don't do it, support might break." Why? Because it is at these times that probabilities are most strongly in your favor.

Yesterday's Rally Lacking

By now the market is trained to buy any weakness related to terror events. Despite the fact that the market is in a precarious position here, programs kicked in and bought the gap down yesterday and prices closed near daily highs. Wanting on the recovery was significant volume. Likewise, the move just pushed the indices up near resistance levels once again. We will be surprised if there is much follow through from yesterday's move. We would be much more trusting of a rally effort if the market would pull back down near recent lows to regroup and shore up support. We are not seeing any decent long set ups and short set ups look very good here. However, there is some concern that we will get a bit of an overly exuberant follow through rally, which while doomed from the start, could put our shorts in jeopardy of stopping out before the market reverses again. This is why we recommend keeping position sizes small in this market. Program trading has played havoc with position traders on both sides of the trade lately.

Trend Reasserts Itself

Fears about the economy proved to be too much for the bulls yesterday. Their last attempt at breaking the market's downtrend failed and they are likely out of firepower to lift prices higher from here. This puts the lows from July into jeopardy. Don't fight the trend here. Now is the time to be short this market.

Traders Sell the News

The pause in rate hikes sparked a very minor rally before prices took a sharp plunge. This shows that the downtrend is firmly in control and that lower prices are to be had before we get a significant bottom. Nevertheless, QQQQ bears are a little over confident and are leaning too hard one way. The put/options ratio shows that we should get something of a bounce today. The day after the Fed meeting, stocks generally reverse much of the previous day's activity, so it is likely that today will see some price relief from yesterday's sharp move lower. Since the downtrend is still in effect, today's expected strength should help set up better entry points for taking on new short positions. Most stocks remain technically overbought and any strength should be used to open new shorts.

Looking to Fade a Potential Fed Rally

Today the Fed is likely to take a pause on rate hikes. The market expects this, but such an event should spark a quick rally nevertheless. Unfortunately a pause at this stage is not going to clear up the worries that this market has in front of it. A pause this time does not take away the question about whether or not the Fed will choose to pause next month. As such, any quick rally after the release – or prior to the release in anticipation – is likely to be quickly sold. Indices and stocks alike are now technically overbought and rallies are generally sold when this is the case. Due to this long string of rate hikes, there are strong indicators pointing to a recession next year and the market knows this. The only scenario that might spark a legitimate rally would be an actual lowering of rates this round as it would indicate that the Fed is concerned with the health of the economy and the market. From what we can gather, however, it appears that the Fed is more interested in fighting inflation in the commodities sectors than it is in the current stock market outlook. This is why, we believe, stocks are projecting more downside.

Fed Meeting Looms Large

On Friday all major indices gapped up and then sold off the remainder of the day. Late in the day buyers started to come back in, but this could have been daytraders taking profit on their short positions. This sets up an interesting situation. The tech sector is overbought and has now sold off at resistance. There has been no evidence of accumulation and ideally, this is a perfect short set up. The problem is, tomorrow the Fed meets and tomorrow's meeting is perhaps one of the most important events the market has had to look forward to in some time. The yield curve on long term bond rates has now firmly inverted, threatening a recession late next year. This puts some pressure on the Fed to pause. The question is, is the Fed interested in avoiding a recession, or do they have something else in mind, such as putting the brakes on the world economy to get oil prices back into line? If the Fed takes a pause tomorrow, as it is expected, then the oversold condition of the indices is likely to move up to even more oversold as prices rally in celebration. We will probably short such a rally, but will need to see what the charts look like after the dust settles. If the Fed raises rates again, it would probably be very bad for stocks and we could see a sharp down day, for as we mentioned, stocks are ripe for a slide already.

Jobs Data Will Lead the Way Today

The market rallied back to resistance yesterday on a bet that today's jobs data will be weak enough to render the Fed with no alternative but to stop their rate hikes during next week's meeting. The problem is, market leading indices, including the QQQQ and SMH, were pulled along for the rally as opposed to having led the way. Accumulation indicators on these two indices have stayed flat even as the price has moved higher, indicating that smart money has not participated in the rally. There is a potential that the jobs data will propel indices higher today, perhaps even pushing them over resistance. We hope that this will not occur however. Capitulation, which is needed to mark a clear market bottom, is strikingly absent and any rally higher from current levels will be performed on very little buying fuel setting the market up for another extreme wave lower. It would be much better if indices turned back here and worked on building a base of support before they rally above downtrend resistance. We can't tell the market to do what we want it to do though so for today, we will wait and see what develops after the jobs report to be delivered before the market opens.

QQQQ Should Test Resistance

The tech-heavy NASDAQ continues to diverge from the blue chip S&P 500 and Dow indices. Until tech starts to lead the way, any move higher in the blue chip sector should be viewed with suspicion. We are operating under the theory that the NASDAQ, which has been the market leader on all rallies over the last few years, maintains its leadership role. As long as this leader is diverging bearishly against other sectors, the downtrend must be respected and strength must be faded (sold into). There is some evidence of accumulation in the small chip indices indicating we are in the middle of a basing cycle and not a distributive one. Nevertheless, it appears quite likely at this time that we will see the QQQQ head back down to its lows at least once more before it finds enough strength to make a break of its immediate downtrend. We do expect to see buyers continue to buy over the next few days lifting indices slightly higher. We suspect, however, that smart money will be using this as an opportunity to reload their short positions. Look for the QQQQ to test $37.40-$37.60 over the next day or two.

Bear Trap Being Set, or the Real Thing?

The QQQQ gapped down and led lower yesterday after a low volume rally up near resistance. The question is, is this a bear trap in the making? QQQQ shorts are buying 4 times as many puts as bulls are buying calls. With bears leaning one way so hard it seems unlikely that yesterday's sell off will gain much follow through momentum. Likewise, yesterday's gap lower is probably more bullish than bearish at this stage. Bears are getting overly exuberant while weekly charts are very oversold and due for some relief. It wouldn't take much to spark a strong relief rally and with the Fed possibly acting next week, this may be the spark that bulls are waiting for to challenge this latest sell off. It might be a better idea to start thinking about buying weakness as opposed to selling it.

Lead Dog QQQQ Still Leads Lower

The QQQQ found resistance at its pivot point (middle of the downtrend channel) and turned sharply lower yesterday. This created a bearish engulfing signal, and as the name implies, it is bearish. Since the QQQQ has been the market leader on this downtrend, it will also be the best indicator of when this downtrend is ready to provide a significant relief rally. We have had a few teaser rallies over the last few weeks, but nothing that lasted more than a few days. We suspect that as the QQQQ reaches down to its lows, and perhaps even makes a new low, that sentiment levels will once again reach extreme. We also suspect that we are very near a strong relief rally and that buyers will be soon stepping in to the consternation of overly confident bears. This is still a market to be short in, but it is also a market for the nimble. Next week we may have an opportunity to participate in a strong upside move if we can get the right mix of decent earnings reports and too many bears with their hands in the honey jar.

Tech May be Forming a Bottom

Breadth in the tech sector was good yesterday, indicating that we may be nearing a bottom. However, buying power has likely been used up in this latest rally off the floor, making it likely that the QQQQ will see a return to its lows before it can move significantly higher. If however the QQQQ insists on trading up back above $37 without a significant pullback to help it establish a better base, we will be forced to start shorting again as a move higher from these levels will be unsustainable.

Yesterday's Rally Likely to be Short-Lived

Yesterday's follow through day has a lot of bulls thinking recovery. The problem is that indices are once again near stiff resistance. It's not a good idea to make too much about yesterday's trading. Buyers could potentially come in and buy stocks up past support, but the probabilities are slim that this will happen. Moreover, without a decent base from which to rebound, a move higher is likely only going to attract more sellers and cause another steep drop.

Recovery Effort Weak Thus Far

Sentiment did indeed keep a floor under the market yesterday, but the bounce has thus far been uninspiring. What we are seeing so far is more indicative of consolidation as stocks work off their oversold conditions by trading in a narrow range than it is of a recovery effort. After such a steep sell off, we are quite likely to see at least one more wave down before sellers decide to take profits and buyers find the nerve to reenter the market in force. Our projections show that we could see the QQQQ drift slightly higher over the next week or two, while the blue chips trade in a sideways range. Unless we see serious volume come in and see an upside breakout that sticks in the blue chip sector, we need to call a club a club and admit that we are still in a downtrend. What does that mean exactly in practical terms? It means that rallies should be sold and that stocks should not be chased.

Overbougth Levels Could Spark a Rally

Sentiment levels are nearing all-time-high bearish levels. This should keep a floor in the market at current levels. It is also interesting to note that oversold levels and the weekly trading patterns in the QQQQ are now nearly identical to the week of August 9, 2004. If indeed we have a bottom in place, a rally out of this hole could potentially be quite significant. The tell will be how strong the bounce is. If the market fails to bounce and/or it bounces weakly, we may be looking at more downside. If we can get a good broad market rally on good breadth this week or next week, then we may be in for a very nice recovery. To be sure, it is too late to short in all but a few sectors.

A Better Oversold Rally is Nearing

Options expire Saturday so expect more meaningless trading today as options sellers attempt to work stocks into their maximum pain points. The QQQQ dropped lower once again yesterday, but frankly we wouldn't trust a breakdown at these levels. A break lower is likely to lead to a strong intraday reversal and should signal the beginning of a decent countertrend rally that will last more than just one day. Gold has done a fairly good job confirming that a top is now in and so it should be considered to be trading in an intermediate downtrend now. Any bounces should be sold into in this sector; baring off course a strong reversal due to a serious erosion of Middle Eastern stability (unlikely). Likewise, oil stocks are continuing to experience real pressure, even as the price of oil holds above $70. We wouldn't short oil here, but we would avoid buying it at this time.

Yesterday's Bounce Likely to be Short Lived

Yesterday was likely the only day that it was safe to enter for an oversold bounce. The trend is still down and the market leaders, QQQQ and SMH were both essentially just pulled along in yesterday's rally; as opposed to leading the way, which is what the market leaders should be doing if this recovery were legitimate. Ideally we will see the QQQQ come back up to just above $37 before it finds resistance again. It has room to vacillate for a few days before running into the downtrend resistance line, as you can see in the chart below. With options expiration on Saturday, that is exactly what we would expect the market to do; vacillate with a slight upward bias. It is best not to get overly aggressive in front of options expiration. Price movements will be less meaningful over the next two days. Settle in with your open positions and wait for stocks to bump back into resistance for a good set up.

Tech May be Ready to Run

The tech sector is close to staging a bounce. Negativity in the sector is at overly bearish sentiment levels and technically the sector is very oversold. It's not reasonable to look for more than a counter trend rally at this time, but a rally in tech could potentially run strong for a few days and is worth buying a few shares to participate in it.

Significant Low May Occur Next Month

World events are creating artificial conditions for a steep market sell off. These events have an artificial impact, because the correlation between the US economy and events in the Middle East, is somewhat dubious. Nevertheless, we have been looking for a significant market bottom sometime later this year, but with the perception that risk must be priced into the market based on unsettling world events, we may in fact get a significant low as early as the next few weeks. The four-year cycle low, we wrote about yesterday will still likely put pressure on the rebound from our upcoming significant low, but with this hard sell off, the four-year low could actually come in the form of a double bottom or even a higher low. In other words, we are very likely nearing a long term buying opportunity. For now though our focus must remain on what is right in front of us, not what could be around the corner. For now the immediate trend is down and this will impact the performance of most stocks in the market. Rallies are likely to get sold and oversold will likely continue to become very oversold until we see capitulation. When will capitulation come? It will come when it comes, no sooner, no later. It is best not to try and guess, but rather to trade with the trend.

Relief Bounce Likely, But Not Likely Sustainable...Yet

The market is oversold and due for a relief bounce. Keep in mind that any relief bounce should be shorted into at this point. Investors who were late exiting before this latest leg down in the sell off will be looking for better prices to exit. This will keep pressure on the market. Right now the market is in a confirmed intermediate downtrend. Until genuine capitulation takes place, the best policy will be to use the rallies to enter short positions. Currently we have a hypothesis about how this downtrend will play itself out. The QQQQ is trading in what looks to be a measured move pattern at this time. This means that the current leg down should run in equal length to the last leg down, from $42.00 to $38.50. Using the measured move hypothesis, we should see the QQQQ trade down to $35.00 before a sustainable rally can ensue. $35.00 also represents the next level of weekly support. Once a sustainable rally gets moving, it is possible that we could see a strong move up over the next month or two, perhaps even moving so far as to tag the broken support line at $39.00. Now, keep in mind that the 4-year cycle low is expected somewhere around November of this year. Thus, after the next sustainable rally (not to be confused with an expected one or two day bounce we are looking for this week), the market is likely to turn down again heading into November. November is expected to mark a significant buying opportunity for long term buyers. The trading opportunities heading into the 4-year cycle low should be nothing short of fantastic. Today we recommend not entering any new positions while we wait for the market to work off some of its oversold conditions. A lot of Friday's selling was an unwillingness to hold over the weekend in face of the ME crisis. Pressures should abate some as we start the new week.

Ignore Any Bounces, This Slide Has More Ways to Go

Once again options traders are overly bearish. Yesterday's instability in the Middle East forced the market lower despite the overly bearish posture amongst the masses. Nevertheless, we should see a bit of a floor today, if only a temporary one. The market is confirming the 39-week cycle low, which is projected to land toward the end of the month. It is doubtful that we will see a meaningful reversal until it lands. Any strength in the interim should be aggressively shorted. The strange thing about yesterday's market was the sudden disconnect between oil stocks and the price of oil. With oil soaring past $78 overnight though we should see strength return to this sector today.

Tech Weakness, but Too Many Bears Make a Minor Floor

Options traders on the QQQQ are overly bearish, so we should see some of yesterday's weakness reverse today. Nevertheless, the tech sector is weak due to fed bank policies in Japan and fears of further weakness do not appear to be going away anytime soon. As such, institutional money will probably keep on selling the rallies as they seek to sell down their inventories to the sleeping point (the point which they can sleep easier). The market is really in a state of indecision at this point. Selling pressures have abated somewhat, but buyers are certainly not rushing back in. There remains a lot of uncertainty related to future rate hikes and upcoming earnings. We would continue to short bounces in tech and consider a few longs in commodities. Cash is a good place to be heavy in though until next week when some of the question marks overhanging the market find resolution. Technically one of the bigger question marks is will we get a bounce prior to a hard move down into the expected 4-year cycle low, or will the market drift and then plunge, or will we get a tradable rally that then sets up for a bigger drop. With such widely contradictory possibilities, it makes sense that the market is confused right now.

Shelf of Distribution

In yesterday's report we outlined our thesis arguing that the market was under extreme distribution, but that shorts would likely be shaken out of their positions before the market turned significantly lower. Yesterday's late afternoon rally fits the thesis and if we are right, we will see the QQQQ rally sharply higher over the next few days to fill the gap near $38.90. The pros call this process "creating a shelf of distribution." It is to the benefit of institutional money to exit their positions at higher, rather than lower prices. If they can get the market to work its way higher buyers will create their own self-perpetuating momentum. This type of trigger tends to exhaust itself quickly since smart money uses the momentum to sell into. There continues to be evidence of distribution as money flow figures on some major sectors are turning down as prices turn up. Using this momentum to sell into appears to us to be the highest probability play. Understand that we, or anyone else, do not actually know what is going to take place in the market. The market is all about probabilities. Our work shows that the highest probability play will be to sell into this minor rally we expect will take place over the next few days. If we are wrong we will see stock set ups start to improve. The downtrend is still in effect and there is no money to be made in calling an exact bottom. If the trends turn back higher, there will be plenty of time to go long again as stocks back and fill to build support. It will be interesting to see if the market can rally sharply higher today the way it did on 6/15 and 6/29. Note the fact that after those two rallies distribution took place and no real follow through was realized. There does not appear to be any sense in grabbing long exposure for a one day rally (if it is to play out like this yet again). We will do better to sideline ourselves today and look to see what develops today and perhaps tomorrow. Options expire on Friday, making any rally equally suspicious at this juncture. The bottom line: This market is not providing high probability set ups and due to its one-day-up, one-day-down nature, the chances of getting whipsawed are very high.

Market Correction Setting to Continue

At the end of June the S&P 500 and Dow both rallied strongly over their downtrend lines indicating that the market correction had played itself out. Unfortunately the NASDAQ was not able to rally quite so far and while the blue chip indices have been holding up, the tech-heavy NASDAQ has been bleeding off. Likewise, the lead tech sector, the semiconductors, has proceeded to break down to even lower lows. All last spring the tech sector led the market lower as it underperformed. Now it is once again underperforming and the fact that we have not seen a strong follow through rally develop indicates that the market recovery attempt has failed. A slew of stocks continue to trade at 52-week lows and bounces have found distribution over the past few days. There is some indication that we will see one more thrust higher. The QQQQ has an open gap at $39, which could possibly fill. Likewise, it seems unlikely that the QQQQ will follow through lower after 4 days in a row of downside already at its back. The scenario we see possibly developing then is a sharp up move, which would stop out overly eager shorts, followed by a crumbling downturn. Due to the amount of distribution we have seen over the past few days, a downturn now could leave the market grasping for a floor only to find an air pocket below. In other words, This is a market for traders and traders should probably be easing into short positions on the bounces. Those holding intermediate long term positions should probably be in cash at this point.

4th of July Rally Fails to Garner Buying Interest

The lack of buying interest this week has been troubling. Equally troubling is the continued underperformance in the tech sector. This is exactly the same picture we saw in late spring of this year before the market took a turn for the worse. Since the market has not made a strong recovery off the recent lows we can only assume that the downtrend started in May is still in effect. Today's employment report is expected to come in with large numbers. The market will likely react harshly to a "good" employment report as they expect that the Fed will be forced to continue raising rates. The problem is that rate hikes have already impacted the outlook for the economy in 2007 and raising rates more will likely turn a soft landing into a hard landing. The market knows this and is panicky. We would like to start adding some short exposure, but with the big looming employment report to be released before the open today, we are unsure how the market is going to react. It is unlikely to correct the fact that the market is going to correct further over the next week or so, but today's reaction could certainly skew our entry calculations making it more likely that we would stop out of a good position.

Tech Underperforms Yet Again

Tech continues to under perform, just as it has over the last six or more months. It's early to determine if this is going to have a negative impact on the strength of the latest rally, but this is not a great way to start. The QQQQ pulled back much more harshly than the S&P 500 ETF (SPY). Now the QQQQ has met the mid point of its Bollinger bands, a point that will help mark whether sellers are serious or whether dip buyers are ready to come back in and rescue the tech sector from a retest of the low. The problem with a retest of the low would be that it would do a great deal of technical damage to the weekly chart. By our rules it is important that the QQQQ hold up at Friday's close or we may be looking at another leg lower in the market.

Market Overbought; Pullback Watch

The market was surprisingly strong on Monday but indices are over bought and prices are due to retrace some of the recent profits. QQQQ traders are overly bearish so this sector could maintain some support today. Nevertheless, prices at least need to trade in place for a few days to work off some of the recent overbought condition. We are looking for gold stocks to retrace most of their recent gains. A pullback in this sector should be considered a buying opportunity. Likewise, oil looks to be headed for $85 so while a pullback in sympathy with the broader market is probable, the pullback should come on lighter volume and produce a buying opportunity among the drillers as well. Today we are watching a list of oil stocks to get a better entry measurement. We would like to add oil to the portfolio, but want to see how some of the stocks perform as the traders come back from their long weekends. Keep an eye on ENG today as this will be one of our top choices.

Short Day Today

At the close on Friday program trading kicked in and a large number of stocks experienced distribution or accumulation. At this point it is difficult to determine. Technically indices are overbought and the 50-day average on the QQQQ could be problematic here as this major market indicator moved up to tag this level before selling down on Friday. This week we could see consolidation where stocks trade sideways or we could see stocks retreat and move back down to test recent lows, keeping the three-week trading range in tact. Oil and metals stocks continue to outperform and pullbacks in these sectors should be considered buying opportunities. We need to be careful with the broader market however until it proves itself. Again, program trading on Friday skewed our recent analysis and that data that we had interpreted as bullish is now in question. Today the market closes early and it will be closed tomorrow. Most traders have taken a long weekend and will not return until Wednesday. We recommend that everyone do the same. It is unlikely that anything meaningful will occur in today's market.

4th of July Rally Kicks Off

Right or wrong, institutional money bet on an end to rate hikes yesterday. In yesterday's report we outlined the similarities between Wednesday's market sell off and the down day on October 27. Now with the market up on big volume and the fact that the market never truly followed through lower after the June 8 capitulation day, the chances of a strong rally similar to last November's is quite high. Continue to manage volatility as this market can still shake people out of good positions, but consider accumulating aggressively on dips.

Indecision Rules Before Today's Fed Meeting

Scans today reveal that a very large number of stocks have moved up to tag the under belly of their respective 50-day averages. Meanwhile the major indices have yet to break their downtrends and are trading very close to resistance. Overly bearish sentiment kept a floor under the market yesterday but now we have extremely mixed readings. S&P options traders are extremely bearish, having purchased 4 puts for every 1 call option. QQQQ options traders on the other hand are getting a little too bullish once again. What we have here is a market that can go either way. Either stocks are going to break their respective downtrend lines and start moving back up in a continuation of the relief rally, or we are on the verge of another leg lower. The problem we face today is that virtually no one knows what is going to happen. The market is going to turn on today's Fed meeting and fireworks after the notes are released are probable. Doing anything in front of this meeting with this type of market set up is a gamble that will very likely not pay off for anyone. We would not be at all surprised to see the market move wildly one direction at the time of the Fed release, only to swing back wildly in the opposite direction as the comments are parsed and digested. Bulls and bears are both likely to get burned in the storm so it is our advice to just step back and stay away. We have some open half-sized positions. At this time it is best to just keep open position sizes small allowing for flexibility to react once the dust settles and there is once again an exploitable advantage. Oil stocks and some of the metals have thus far been holding up better than the broader market. It will be interesting to see how these sectors respond to the Fed today.

Gloom and Doom Spells F-L-O-O-R

It feels like we have been in a deep bear market sell off during the month of June but the truth is the market has virtually gone nowhere since it marked what we considered a capitulation day on June 8. Yesterday's sell off simply brought stocks back to the bottom of the current trading range and in doing so inspired hapless options traders to once again take an overly bearish stance. For the first time in weeks both OEX and QQQQ options traders are in agreement. They agree that we are going to correct lower to the tune of buying more than 2 put options for every 1 call option. As our long time readers know, when this group of traders leans too hard one way they are almost always wrong. In fact the accuracy of their bad market calls has proven to be a very reliable reversal indicator. During this 6-week sell off the QQQQ cut through its 200-day average like a knife through butter, not even slowing down to take a rest. In our experience over the years bulls just do not give up on the 200-day average so easily. There were extenuating circumstances as the Japanese equivalent to the US Federal Reserve raised rates last month causing heavy institutional speculators to pull out of their huge metals and oil positions last month causing a world-wide market crash. This in turn caused the waterfall breakdown that forced the US investors to sell down to their comfort levels. Now however as things look ever so gloomy and the market looks to break down to another new low we think there is a very good chance that many will be surprised as the market rallies hard and regains the broken 200-day average on the QQQQ. Note the similarities between yesterday's sell off and October 27, 2005. With bears overly exuberant and with everyone scared, it will be interesting to see if the market does indeed once again surprise the greatest number of people and rally. Today we would like to see a consolidation day. This will give us time to evaluate which stocks to buy and which to avoid.

Gearing Up for 4th of July Rally

We continue to experience wide daily price swings making it necessary to scale into our trades in pieces. Buying smaller shares sizes provides us with several advantages. First it provides flexibility, allowing for us to add on shares once the market provides more information. Second it allows us to move our stops out wider so that we don't get stopped out on market noise. We believe that these and other advantages far outweigh the small increase in brokerage fees. We are nearing the end of the month when trading advantages are strongest and where we generally see a rally due to an injection of new money into the market via retirement funds. This month we could potentially see a stronger rally than usual. The fourth of July rally is a cyclical rally that often arrives as pressures from the "sell in May and go away" culminate into an oversold condition that produces a mid summer relief rally. This year the factors are all in place for just such a rally to ensue. We may see some weakness in the beginning of the week, but we plan on using any potential weakness to accumulate.

Time to Start Buying Dips

There are many tried and true rules related to investing and trading in the stock market. One of these rules is "don't try and catch a falling knife." Contrary to this rule is the strategy of buying the dips. Buying the dips seems to contradict the rule of avoiding falling stocks, so which is it? Well, the answer is that there is as the Ecclesiastian noted, there is a time for everything. Buying dips at the end of May certainly turned out to be the wrong thing to do as the month of June started out with a waterfall-type slide that crushed the bulls. Now the major indices have returned to the downward sloping resistance line that turned stocks back early this month. We are very likely to get another slide back near recent lows. This time we argue however that the time has come to buy the dips. Why? Because there is evidence that smart money is already buying them. Money flow figures have been rising even as the market has been under pressure this week. We are very likely going to get some strong downward moves over the next few days that will shake loose the weak hands, but the way that smart money is now positioning itself we will be looking for a much stronger rally to ensue toward the end of this month. The bottom line is that now is the time to be buying the hard dips and avoiding strength. Use a scaling entry strategy because we don't know where the market will bottom. Recent lows may be tested or the market may bottom slightly lower or slightly higher. Europe is already showing signs that it is ready to move higher. We believe that metals will lead the way in the US markets. Again, don't chase what's going up, but begin to nibble at what's going down.

Europe Leads the Way

The broader US market is still churning, but it's time to take another look at Europe and the metals markets. European stocks beaten down after the emerging market crash has now produced a large number of stocks that have just pulled back to their long term up trends. The accumulation apparent in this market is quite strong and the strong European trend should be ready to resume. Gold and other metals have been hit harder than most but the majority of mining stocks showed accumulation even as they retraced as much as 50% of their recent gains. This shows that there is a lot of confidence in this market by smart money who has been using the gold crash to accumulate for their longer term horizons. It's a good idea to start getting aggressive with this sector as it has a lot of promise over the next few years and right now the miners are relatively cheap.

Bond Market Set to Rally

There is some indication that the bond market is close to bottoming and a potential rally could ensue. This would probably give a boost to the weak market giving us a tradable rally. S&P options traders have already become overly bearish, indicating a bottom is near in the big caps. There remains a disconnect with the QQQQ however as options traders are fairly complacent still and betting a little too heavily on the long side. There remains an open gap on the QQQQ at $37.65 so it is likely that we will see one more plunge before a real floor is in place. Hopefully a plunge back to the lows will inspire enough fear and bearishness that real capitulation can take place and we can then finally put this downtrend behind us.

Trend Still Down

$39.00 is the magic number for the QQQQ. This index is still struggling against its downtrend line, established from the drop, which started early May. If it can close near $39.00 then we might have a bottom in place. As of today however the downtrend is clearly locking in stocks and proving an entry point for sellers to reestablish their short positions. After a two-day rally last week, yesterday we saw what should be a resumption of the downtrend. Since the path of least resistance is down, it is best to position for more downside. Projections at this time show a retest of last week's lows and potentially a minimum of one more lower low before we will see significant support start to develop.

Play the Downtrend

The Japanese Central Bank has exerted pressure on the global market draining billions from markets around the world over the past several weeks. These are the realities of the global economy we are now in. It is likely that the US will pressure the Japanese banks and the bleeding will be tightened before the emerging markets are sent into a tail spin toward depression and western markets slump even lower. At this time the shock is serving to cheapen stocks and create a very nice buying opportunity as investors start to throw out everything in fear. Nevertheless, the downtrend we are now firmly in has not yet found a bottom and until it does shorting strength and breakdowns is the way to go. The stall on Friday should mark the spot where the market will once again turn lower. A move higher this week however should not be taken as a bullish sign, but should rather serve as an opportunity to short higher. As we outlined on Friday the market does not have a base of support and the move on Wednesday and Thursday is unsustainable. A move higher would merely take major indices up to the top of their falling Bolinger bands, setting up another waterfall-type leg lower. In essence, a move lower from the current level would actually be a more bullish scenario. Traders became too bullish once again last week and another long failure would very likely create the kind of demoralization that is needed to set the crowd in the right mood for capitulation. With the economy making some real strides over the past few months a move lower is the ideal set up for a very strong move higher, much stronger than that which we have experienced over the last two years. There is a good chance we will see capitulation this month, but again, until we see it, we need to be selling strength. Because we don't know if the market will fall from current levels or go up to test higher resistance first, it is a good idea to scale into trades.

Why We do not Think a Bottom is Yet in Place

The last two days we have seen a rally nearly as striking as the crash we experienced earlier in the week as last Thursday's reversal day didn't stick. Many want this to be a bottom but we believe that it is not for several reasons: 1. Today is quadruple witching expiration day. The QQQQ and SPY price rally over the past two days has simply moved these two ETFs up to their maximum pain prices. This is called "parking the car in the garage" by Wall Street traders. In other words, the prices have simply moved back up to the point where put sellers maximize their profits and where put buyers over the past few weeks have watched all of their profits erode. Coincidence? 2. The put/call ratio on the QQQQ has gone from 4-1 in favor of puts at the beginning of the week (overly bearish) to an overly bullish 2-1 in favor of calls. This wild swing in sentiment from the bear to the bull side by this group of traders who are almost always wrong at the extremes simply indicate that this wild ride we have been on is not yet ready to stabilize. When two calls are purchased for every put the market will usually reverse lower within a day or two. 3. The QQQQ has only rallied back up to tag broken support between $38.50-$39.00. The SPY has only rallied back up to tag its broken 200-day average. These are classic throwback patterns up to resistance. Pros will use these types of throwbacks to put on shorts and to exit longs that they have been burned on. The market may indeed have put in a bottom but the odds are strongly against it. Longs have a lot of proving left to do. Until we see real capitulation and bottom-building activity we have to recognize the fact that the trend of the market is now down. We are looking for a more significant bottom to form later this month. Right now though surprises are most likely to occur in favor of the trend and again traders are too bullish and the trend is down.

Yes it's hard, but now is where the money is made

The market slide we have experienced this week has been brutal. The drop has been so sharp and the slice downward so steady that it has provided virtually no bounces to sell into. A writer from Real Money made this interesting remark yesterday, which sums up perfectly this week's market environment: The action since the first week in May has been some of the most challenging that I've faced during my trading career. What has made it so difficult is that we have had so many days in a row in which things have gone straight down. Typically, when the market starts to break down, I will continually lighten up my holdings on a bounce. Usually the first big technical breach results in a fairly fast oversold bounce. If you are caught with long positions, that is often a very good time to sell down positions. This breakdown has provided few opportunities to escape long positions on strength. We had one bounce that was fairly limited and that was it. You either sold into weakness or suffered some tremendous pain while waiting for a better exit point. My feeling that this breakdown has been unusual in the degree that it has failed to produce any bounce seems to be backed up by James Altucher's QQQQ crash system, which failed for the first time after 61 prior successes. The idea behind this system is that when the QQQQ is more than a certain level below its 10-day moving average, there is a very strong likelihood that it will bounce back up at least temporarily. In this case, it didn't happen, and that has really made this meltdown much more difficult than ones we have suffered in the past. The good news here is that this correction is much more typical of a corrective move in a larger bullish trend than it is the start of a bear market. Bear markets tend to tease and tantalize hopeful bulls as they slip down a path of hope. Bull markets are known for fierce pullbacks and this can certainly be categorized as a fierce pullback. We would like to remind folks here that as tough as this year has been and as tough as the last few weeks have been that it is important to know when to take advantage of the market's opportunities. After the crash in 1987 many investors spent the remainder of the year looking to get out of the market. The crash was just too scary and the feeling of losing money was just too painful. These same folks didn't buy in again until the market was back in the news again in the late 1990s. The problem is that the crash of 1987 spelled opportunity and those who read the writing on the wall got rich by buying when there was blood in the streets. Take Microsoft for example. In 1987 MSFT was trading as high as $128 per share. After the crash in October of that year it traded as low as $37. Those same shares today are worth $3000 each (calculated for the splits). Right now it is time to start searching for the babies that have been thrown out with the bath water. We don't believe the low in the market has yet been put in, but we are close. Gold stocks are one of the babies that have been taken out to the woodshed in this market and we believe that these stocks are cheap at the current price. Remember, it's ok to get out when the market is falling but it is also important to remember to get back in again. Don't wait until the market starts to look good to get back in. You don't need to try and pick the bottom, but you don't want to wait until everything is rosy again either.

We Were Wrong

Last Thursday looked like things had gotten about has bad as they were going to get. We had expected a retest of the bottom this week but what we got yesterday was anything but a mere test. The bottom formed by a high volume reversal – the highest volume reversal mind you – did not even serve as a point of hesitation in the last hour of trading yesterday. The put/call ratio is nearing all time bearish highs and the VIX is breaking out in force. Both of these events predict a turning point in the next day or two. The problem is that momentum in this market has turned into a convoy of sellers as institutions sell down their inventories in front of the CPI and PPI numbers to be released over the next two days. We are concerned that under the right circumstances the market could find an air pocket to the downside that could bring us down to the expected four year cycle low in nearly one fell swoop. Frankly we had been expecting more lows to form, but we had believed that the market would have significantly retraced some of the damage that was done in May. We clearly called a near term bottom too early. At this point, if the CPI and PPI don't cause a waterfall sell off, we are expecting a relief bounce, but this bounce may be an opportunity to exit open positions and put on shorts. A better buying opportunity is near and this sell off actually sets us up for what could be a phenomenal summer rally. For now though our bottom calling is done and we will step back and wait for a better set up.

Correction Probably Over, But Likely to be Tested

We expect to see a bit more weakness over the next week as the market continues to work on a bottoming process. The danger of the market moving much lower than Thursday's low is minimal at best. Don't expect the market to carve out a "V-type" bottom and go straight back up here, but don't look for a breakdown either. Looking at the majority of stocks, which are in trendless conditions right now, we wouldn't be a bit surprised if they manipulated the market back down to Thursday's lows this week to see if they can shake loose a few more shares from the weak hands tree. Keep an eye on the overseas markets this week; especially the British and Australian markets. Both markets are very close to a bottom and any strength in these markets should trigger short covering and will give the bulls back their lost confidence. Meanwhile, try to avoid the broader market and focus on stocks that are trading somewhat independently.

Revisiting 2002

Prior to the open yesterday the outlook looked about as grim as it gets. We were very uncomfortable shorting against both a spiking volatility index (heightened investor fear) and a crowd that was so bearish that they were putting 4 times the amount of money into put options as they were calls. It is just not a good idea to run with the crowd when the crowd is leaning too hard in one direction. As a result we advised that sitting on your hands and not trading yesterday was the best alternative for all but the daytraders. This turned out to be good advice. After a panicky open we saw massive capitulation taking place as investors scrambled to exit their positions and as smart money grabbed up the shares. What is most notable were the market volume levels. The QQQQ had its all-time highest volume day yesterday as it traded an astounding 280 million shares; and this following a 234 million day two weeks ago, its highest volume number ever prior to yesterday. What does this mean? Well, there are some very strong similarities between volume and capitulation action which took place in July of 2002. Note that in July 2002 the VIX was spiking and the market was spiking downward into high volume reversal days. Following the low in July 2002 the market rallied sharply higher and then swooned into another late summer reversal. October of that year however marked a strong reversal that led to a two year rally. We remember this well because money was easy to make in the market during those two years and we made a lot of it. Why do we focus on July 2002 though? Why is it reasonable to expect a similar scenario to play out? Two reasons: First, the four year market cycle. Every four years the market tends to make a significant bottom as the market responds to lagging election year politics and other political and economic factors. More importantly though, four years ago marks the last time we witnessed such a large spike in volatility and market volume. Smart money is now making their bets and they are betting on upside, perhaps significant upside as early as this fall. Expect some nice roller coaster trading over the next few months. We should be able to make money on both the long and short sides as the market roils in a bottom-carving process. Expect yesterday's lows to be retested in the next week or two or three. Bears have not yet fully capitulated – but they will. Be flexible and be willing to switch sides quickly as the market whipsaws from week to week. This will be a fun ride if you ride with it and don't fight against it.

Crash System Fails

RealMoney's James Altucher developed the J Quad Q Crash Trade several years ago. This trade is triggered when the QQQQ takes a crash run like it did last month. What is interesting about this trade set up is the fact that it predicted a tradable bounce an incredible 61 times in a row. Last week the trade triggered again only this time, number 62, it failed for the first time. Yesterday the QQQQ had a great set up. It was oversold and at support. Tuesday saw a late rally ensue and yesterday morning we had follow through. Then Greenspan spoke. For the third day in a row the market has been battered by Fed members and now the former Chairman speaking publicly about inflationary pressures. This is not new information. They are not telling the market anything it didn't already know. Even so, the Fedspeak has worried the market to the point that every buy set up has gotten hammered back. Yesterday's buy set up rejection was the most troubling as it puts support on the QQQQ into serious jeopardy. Let's take a look: Note the rejection, which coincided with Greenspan's comments, as the QQQQ tried to regain the $39-level. The ETF then proceeded to sell off with the market into the close and even closed below the all important last level of support found just above $38.50. Is this a breakdown and a signal to go short? Yes and no. Technically the QQQQ has broken support and the S&P 500 is threatening its 200-day average. The problem with getting aggressively short here however is the fact that this market has been nothing but whipsaws for weeks now. As soon as momentum gathers in one direction it spins on a dime and heads back the other way. The other problem with getting aggressively short here is that this is what the crowd is doing and the crowd is almost never right at market turns. Four put options were purchased for every one call yesterday. The crowd is obviously overly bearish. What do we do in this situation? Sit on our hands and don't trade. This is the only reasonable course of action to take when the signals are so mixed and the advantages are so hidden. The dust will settle and once it does the pathway will become clear once again. Today going long or going short are both crap shoots.

Accumulation at These Levels

We don't know about everyone else, but the last two days have been exhausting for us. Support testing has been ugly this time around. With the Fed Chairman killing the market on Monday and then Fed board members voicing their opinions in public yesterday, selling has been fierce and support levels have been put to serious tests. Nevertheless, indices and stocks alike are showing bullish money flow divergences when compared to last Tuesday's lows. This means that even as hard as this market has been to endure that smart money has been accumulating even as longs capitulate and give up their shares. We believe that despite what the Fed has been saying in public that the end of rate hikes is probably very near. They of course can't show their hands and some might say that they are even bluffing here so we endure huge amounts of volatility in the interim. Today we expect to see higher prices. In the morning however we could see more support testing; it will depend on whether sellers are exhausted or not. If sellers are out of resources then short covering will likely lead to a quick rally higher. If weakness from Asia bleeds over to the open though sellers might find continued reason to stand firm. Again, historically days like yesterday have proven to be buying opportunities. We believe that we will be able to look back next week and see that indeed, it was a great buying opportunity. Right now it is just exhausting though.

Last Tuesday Revisited

There is something familiar about yesterday's market sell off. It seems like we have seen days like this before. Oh yeah, we had a day just like this last Tuesday. What is also like last Tuesday is the inordinate amount of options traders who are betting on further declines. Two put options were purchased for every call. You would think they would have learned a painful lesson by now but they keep coming back for another dose of pain.

The VIX, volatility index, took another jump yesterday as well. The similarities between yesterday and last Tuesday are mirror-like. The similarities between the market's behavior over the last two weeks and the way the market behaved during the last two weeks last October are also mirror-like in their similarities. The QQQQ still has support at $38.50 so unless that level gets taken out we seriously doubt that the shorts will see much momentum develop. In fact, historically days like yesterday have proven to be buying opportunities.

Yesterday the market sold off when the Fed chair Bernanke spoke about inflationary pressures with hawkish tones. Regardless of what the Fed actually does next the chairman must speak with hawkish tones in order to constrain inflation expectations. This is normal in the late stages of a tightening cycle. We would argue that the Fed is very close to taking a break in rate hikes despite what fearful traders thought yesterday afternoon.

Market May be Ready to Reverse - Oil Strengthening

On Friday the crowd reacted favorably to low job numbers in the employment report. This is because they were expecting that low numbers will force the Fed to take a breather on rate hikes. Of course the enthusiasm attracted profit takers and short positions as these buy the news events almost always do. Technically the sell off from the highs left the indices in poor technical shape with the dust settled on the day. The S&P tagged the under belly of its broken trend and sold off and the QQQQ sold off from its falling 20-day average. Momentum left from earlier buying last week however does not yet appear to have abated. We could potentially see higher prices this week but keep in mind that damage has already occurred and that shorts will be looking to build positions into any further rallies. The commodities market on the other hand is once again heating up. Many oil stocks are resuming their trends and gold prices are hammering out support. We are not confident that gold is done with the downside yet, but certainly any further dips in this sector will represent buying opportunities.