For quite some time now, I have noted the relative strength shown by the midgets, a.k.a. small cap stocks, since the middle of April.  As opposed to the broad market and countless other sectors and stocks, the small caps have yet to close below their respective 200 day moving average.  Historically, the transportation sector and small cap stocks are widely seen as leading/confirming indicators.  Thus, with both of those areas showing relative strength throughout this correction, I have been more apt to sit in cash than to put on short positions.

Excluding the fallout from the quagmire in the Gulf of Mexico via the attrocious performance of the energy sector, the small caps are notably weak today. As I am typing this, the broad indices are trying to stay green. However, the small caps are still one of the notable leaders to the downside today.  The intraday and annotated daily chart, seen below, should show that despite their relative strength thus far, the small caps leave much to be desired in terms of being a long setup.

Keep a close eye on the midgets for the rest of the trading session.  If they continue to roll over here, I suspect it will be a bad omen of things to come.

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Because I remain in 100% cash, I am constantly reevaluating my strategy for the sake of thoroughness. In my quest to look for reasons to get involved on the long side, however, I have come across several problematic monthly charts that I would like to share with you.  The charts seen below all involve bearish reversal patterns, particularly when viewed through the lens of Japanese candlestick charting.  The two patterns I would like to discuss are the shooting star and bearish engulfing reversals.

The “shooting star” is a type of reversal pattern that is made up of one candlestick with a small “body,”  a relatively long upper shadow and a minimal or absent lower shadow. Basically, the shooting star illustrates that the buyers have exhausted themselves via a blow off top.  The sellers then aggressively move in and push price down to where it was at the beginning of the month (on a monthly chart).  When seen after a steep uptrend, the shooting star should be taken very seriously.  A sharp gap down immediately following the shooting star helps to confirm the reversal’s validity.

The bearish engulfing pattern can been seen over two candlesticks, the first being white (or green, where the bulls won the month on a monthly chart) and the second one being black (or red, where the bears won the month with price finishing lower). The main idea is that the red candle is bigger than the green one, and thus “engulfs” it.  When seen after an uptrend, this pattern signifies that the bears were able to convincingly seize control of the price action away from the bulls.  The bigger the red candle is, the stronger the reversal.  As with the shooting star, the buyers had made a higher high in the beginning of the red candle, only to see sellers present themselves in a meaningful way and, unlike the shooting star, actually push price all the way below the low point of the green candle.  Also, as with the shooting star. follow through to the downside is key.

I have denoted the patterns in the following monthly charts, which include: $SPY, $COMPQX, $XLE. $XLI., $CREE, $VECO, $GMCR.

Note that there are still several arguments the bulls can point to as reasons to be optimistic, such as the fact that the hammer on the $SPX daily chart from last week is still valid.  Also, the small caps and transportation stocks have shown relative strength, and they are widely seen as leading/confirming indicators.  Moreover, after an historically weak month of May in terms of broad market performance, it is tough for me to become aggressively short right here, right now.

Thus, despite the troubling monthly charts seen below, I prefer cash at the moment.

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Heading into the final hour of trading before a long holiday weekend, the market is behaving in a decidedly non festive manner.  Concerns about Fitch’s downgrade on the creditworthiness of Spain, among other factors, have been pushing stocks lower all day. Trying to ascertain whether longs or shorts will be more apt to force the action before the three day weekend is a pure coin flip at this point. Beyond that, the rally we saw yesterday quickly worked off our oversold condition, and even put some indicators, such as The PPT broad market hybrid, into overbought territory.

Needless to say, we continue to be in a very tricky, news driven market.  To argue with Mr. Market, via bottom calling, has been a money losing strategy thus far. However, as yesterday showed, even the bears can get slaughtered in a sharp downtrend when they press their bets too hard and do not take profits.

Thus, cash is where you want to be right now.  I cannot overstate the power of holding high levels of cash when we see market conditions such as these.  By no means do I prefer cash over equities over the long run.  However, there are certain times when it is absolutely essential.  Whether you realize it or not, many traders are being wiped out as we speak by this most recent correction.

Eventually, these unhealthy market conditions will change. When it does, I will be eager to get involved again.  Until that time arrives, cash and patience are still where it’s at.

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Just as I was taking heat from bearish traders for referring to the candle we printed two days ago as a bullish hammer, allow me to equally irritate bullish traders as well, for good measure.  Despite our exuberant gap up this morning, we are coming to terms with some tough resistance from the past week. The 1090-1095 level on the S&P 500 has been a brick wall since last Thursday’s swoon. Even if we do negotiate that area well, we have some difficult levels above as well.

The current hourly chart of the S&P 500, seen below, clarifies the short term resistance levels, as denoted by the yellow horizontal lines.

As I indicate on the chart, we may be trying to complete an inverted head and shoulders bottoming formation.  However, I suspect we will need some more time to work through the right shoulder if we are going to make a healthy move up from here.

The overhead supply should prove to be formidable, as many traders have been eager to call a bottom to the correction over the past month.  Many of those who bought the falling knife are now losing money on their trades, and have endured a scary ride down. If they come even close to being made whole today or tomorrow, they are more likely to sell than to hold or buy more, in my estimation.

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[youtube:http://www.youtube.com/watch?v=ocV5bGHdYag 450 300]

BOTTOM LINE: More patience, grasshoppers. If, indeed, we are going much higher, then a few days of consolidation is to be expected. Of course, we could be consolidating before making another leg down, which is why I am content to sit in cash and let the market sort itself out. I know I am not winning any balls of steel competitions with my 100% cash position, but I could care less. I trade to make money. What do you do, sir?

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After a sharp gap up this morning to 1090 on the S&P 500, the market is now chopping around after a bout of profit taking.  So long as there is an underlying bid, we should begin to stabilize and follow through on yesterday’s hammer. If we are going to improve to a healthier market, then you should expect a fair amount of backing and filling.  A “V” shaped exuberant bounce to heavy resistance levels would likely invite significant profit taking, and allow bears to confidently reload their short positions. A slower, steadier stabilization process will give many charts time to heal and also help to form a sound base.

I am seeing some enticing setups for breakouts, such as $SNDK and $ORLY. However, keep in mind that in corrective markets, many setups break your heart and fail at the very last minute.  For now, we will let the big money bulls do the hard work for us, in terms of trying to provide a floor under this most recent selloff.  Our best risk/reward entry points will be if and when we see benign consolidation after a strongly bullish day or days.

Finally, here is an updated monthly chart of the Euro ETF.  I am now expecting many of the savvier shorts to begin covering and taking profits, seeing as the steep decline has more of less filled the gap dating back to 2006.  Given the sharp decline we have already seen, combined with main street news media declaring the death of the currency, it is important to remember that greedy bears are just as prone to being “bag holders” as are greedy bulls.

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