Weekend Update: Markets Continuing the Pain Trade?

While Friday's trading action raised some eyebrows, the week overall wasn't as bad as the media would make it sound. Headed into Friday's session the SP500 was trading flat, it wasn't until another afternoon swoon took the market to the lows of the week. Since testing the upper trend channel on the weekly view that we discussed last weekend, the market has slowly lost some momentum and is now looking like we will revisit the prior breakout level around 1600; this will be a big test for the market.

 From what I'm hearing throughout the media and blogs is that the SP500 will orderly pullback to 1,600 and set up a fantastic buying opportunity that will refresh the rally and send us again to new highs. While I do like the idea that this will be just a run of the mill pullback that leads to higher prices, I always struggle when so many people are fixated on one particular outcome. Which leads me to prepare for two alternative scenarios:

1. The market retests the 1,600 level but then doesn't hold and breaks lower sending all the breakout buyers running for the exits. This could create a waterfall effect where brief panic ensues and we get a quick trip lower into the 1,400's where the long term uptrend support comes into play. Whats interesting is a 200+ point pullback like this still is within the rally uptrend and the bull market is still intact...That's how extended this market is from long term support!

2. Or (what I feel is more likely) is that the S&P will trade lower Monday morning getting everyone geared up for the 1,600 retest, but will only make it down to about 1,615 or so before it stops and reverses course and the uptrend continues.

The second scenario as the more likely of the two here for a couple reasons. Every dip has been bought aggressively for some time now and this one should be no different, especially with the renewed assumption that the Fed will not be going anywhere soon. Second this would frustrate the most participants and that is the markets job. Going into Friday's close the market sold off hard on big volume, a short term bearish pattern triggered, meaning shorts were lining up to get in on the action. And all those who sold off into the panic wave are just figuring they will jump back on after 1,600 is retested. This would be the perfect scenario to trick all those players by confirming their selling with an initial down wave to open the new week, drawing in even more shorts and causing even more selling pressure from some of the weaker holders. All of these traders will be targeting the 1,600 area for taking profits on short positions or re-buying the shares they sold previously. But the market is not likely to cooperate so easily, and will likely turn around before anyone is ready for it. A snap back move on the markets favorite day recently, Tuesday (I believe the S&P has been higher the last 19 Tuesdays now and counting), trapping the shorts and forcing the under invested bulls to either chase or miss out once again.

This is just my opinion of course which doesn't mean much to the markets, but I always try to think of the scenarios that would frustrate the most, as that is the markets primary function. Max pain is what the market seeks to inflict on the herding masses. Its hard to imagine but the pain trade is still higher. What the under invested and lagging participants want are lower prices to justify their positioning. It has been my experience that those attitudes and hopes rarely get rewarded. Even for me its hard to hold onto the positions I have as my common sense says we have run too far too fast, so I still feel the market is headed higher.

As of the beginning of last week I was preparing my holdings for weakness and still feel comfortable with my positions down to the 1,575-1,600 level. If the 1st scenario plays out, I will likely have most positions stopped out and am prepared to act that way if needed. Barring the breakdown scenario, I will still be ready to take advantage of any positive developments that come along. I did buy a couple breakouts that triggered this week but am still under 2/3 invested across all accounts. I will continue to hold most positions above the key breakout level on the market and look for new opportunities that emerge should the sell off not continue beyond key support.

OK, enough opinion and thinking, lets take a look at what matters...price! Here is the short term pattern generating all the stir in the SP500 as of Friday's close:

This is the first multi-day bearish pattern trigger that we have seen in some time. You can see by the final bar on Friday afternoon that people were just dumping shares as prices sliced right through trend support and the prior lows. The measured move of this pattern targets the 1,590 area...That would be a level we would not like to see broken, although support does extend to 1,575 as that was a key prior high and now inflection point. What would be text book would be for the SP500 to trade down to the measured target, retesting the breakout level and then stabilize and move back higher. As I stated above, there will be tons of people fixating on this setup. Let's just stay nimble and react to what actually happens!

As for market internals after this week's selling, most sectors look to have held up very well. We'll take a quick look but its still the same story: Financials, Discretionary, and Healthcare are still leading the way in terms of relative performance. We have newer breakouts in Technology and Industrials. Energy and Materials are still struggling a bit but looking productive. Staples and Utilities are getting crushed. Almost every single sector is signalling higher stock prices.

XLF

 Financials are the strongest of the sectors right now. If you are not exposed to them in some way, you are not following the strength. Plays I like are WFC, JPM or simply buying the XLF.

XLY

Discretionary has been another strong performer and is testing the lower support of its relative trend. Strong plays are HD, F, TWX

XLK

Tech is holding its breakout and looks like one of the new leaders emerging. I like AAPL, GOOG, and INTC to play the rally in Tech.

XLI

Industrials are gaining some steam and holding up well in the face of Friday's weakness. Prospect CMI is attempting a breakout. Also BA, UTX and UNP all look like strong plays.

XLB

Materials are holding up as well, but just haven't shown too much conviction. I'm still at a wait and see with this space. Since breaking above key resistance at ~$40 the trading action looks to be setting up a bearish Head/Shoulder Top pattern. The projected move would still be within the uptrend range, but the breakout looks to be on flimsy ground.

XLE

Energy is showing some strong breakouts in many individual names. I like EOG, XOM, CVX as the strongest ways to play a rally in energy. Also for those bottom pickers out there APA and CHK have gained some mojo recently. Still we need to see a bounce from this breakout retest.

XLV

While Healthcare took it on the chin Friday, its relative trend is still intact. Stay tuned on this one. For now I still like UNH, ABT, and PFE as ways to play this space.

XLP

Staples are getting crushed, stay away until things turn. This is usually a positive for the broad market, but there where a lot of people hiding out in this space and if we see the new rotation plays (XLK, XLI, XLE, XLB) roll over as well, then we could be headed much lower. Money has to flow somewhere and cash can be one of those places. So far it has found its way into more offensive groups, lets hope it stays that way.

XLU

I hope anyone with long Utility exposure took my recommendation two weeks ago and reduced any holdings they may have had. Since breaking the trend support XLU has lost 10%! That's a huge move for Utilities.

The offensive sectors continue to show relative strength and until that changes the market is on stable footing. What we don't want to see is for some of these new breakouts in XLK, XLE, XLI and XLB to roll over and fail. Until that happens or we lose the leadership of Financials and Discretionary, this market still looks to continue higher in general.

Next week we will be starting a slightly different format with the blog. Being that this is the 6 month mark since the blog started I have decided to shift focus a bit. The feed back I have received from readers leads me to believe that you are ready to move on from the basics and start following some real trades. Initially I had intended on this blog as being a sort of trading journal for myself and a way to help others follow along. However I have been spending a lot of time discussing very general topics and not really helping those who need more experience following actual trades. What I am planning to do is to create (and I have been) a "blog portfolio" that I myself invest in and that way my readers can follow exactly along with my trades and recommendations.

The portfolio will include 19 potential holdings:
1. The 9 sector groups that we follow regularly: XLF, XLY, XLK, XLI, XLB, XLE, XLP, XLV, XLU
2. The Top 10 list that we started following at the beginning of the year:
    WFC, F, HD, AAPL, CMI, MOS, ENB, PBW, HAIN, DDD
3. The portfolio will either be invested or cash in each position based on the technical criteria we have learned and follow.
4. Rarely will all 19 be held at the same time due to sector rotation and relative strength. By its very nature every group should not be relatively strong.
5. This will allow anyone reading the blog to know what groups and stocks are outperforming and set up well technically, and will allow them to buy and sell those positions as changes occur.
6. I will be updating the holding status weekly and will also post updates to buy/sell decisions as they occur.
7. Each position will be the same size. I will enter on a breakout or key support test and we will continue to monitor the trades as they progress.
8. By including the sector groups AND the individual names, this allows investors to choose if they wish to just buy a basket of stocks through the sector groups or pick individual stocks or both.

As of right now 12 positions are invested and 7 are in cash:
Invested: XLF, XLY, XLK, XLI, XLE, XLV, WFC, F, HD, PBW, HAIN, DDD
Cash: XLB, XLP, XLU, AAPL, CMI, MOS, ENB

Both AAPL and CMI are flashing buy signals as of the end of the week. I will be looking for some follow through on those signals to initiate a position.

We'll see how it goes!