A Mini Blow-off Top?

Did equities just set up a mini blow-off top? I don't know the answer to that question since the pattern is not very clear, but there are some indications and price action during the next days will be crucial to determine quality of the summer rally.  

A parabolic move prior to the top is a major characteristic for a blow-off top. Price should decline rapidly in the coming weeks to finalize the pattern. The problem of course is that you can't wait for the decline for confirmation because potential gains from long positions would have been nullified.

Parabolic moves tend to be more common and clear-cut in commodities, just look at what happened in the Gold market last year. The potential parabolic move is not obvious when looking at the S&P 500 because the index is a mix of offensive and defensive stocks.

Certain leading sectors, however, might have recorded a parabolic blow-off move as can be seen below with Consumer Discretionary, Financials and Small Caps:

As for the Covestor model portfolio, I reduced long exposure yesterday and even closed the long XLF (FAS) position, which I opened the day before. A weak rebound would offer good opportunities to enter additional short positions.

Why I'm Long Financials

Yesterday, I added FAS, the leveraged Financial Sector ETF to the Covestor Model portfolio. The sector had been outperforming in recent months and offered a nice entry opportunity after a pullback:

The longer term picture is even more interesting. Financial stocks have been trading in a range for the last years, similar to Homebuilders. However, ITB broke out textbook-like in summer and has been rallying since then. I believe that Financials could follow a similar pattern and start to run soon. Longer term interest rates are rising, which is positive for banks and could offer a catalyst.

Why Stocks Probably Won't Decline That Much

Futures are quite weak this morning, so I wonder how much of a correction we could get without violating the intermediate term bullish case. You have three options; pick your favorite crystal ball:

1) The upward sloping trend line which starts at the June low offers first potential support.
2) Horizontal resistance around 1420, which is still just 2.5% lower than the close of last Friday.
3) Finally, first major Fibonacci retracement can be found at 1395, almost 5% lower than current levels.

As you can see, the S&P has to plenty of potential support below. Will these levels hold? I wouldn’t make any predictions, but I'm interested in analyzing price action at these points because bounces could lead to significant moves.

How to (Swing) Trade This Market in the Next Weeks

OK, the last weeks were a lot of fun. You just needed to buy something and it probably went up. Now begins the hard part. Even though I’m bullish for the next months, it will be very important to stay disciplined and not get caught up by the Bernanke-infused euphoria. 

From a swing trading standpoint, there are basically three setups that one can play in the next weeks: simple pullback plays (1), downside gap reversals (2) and breakout pullbacks (3). 

#1 is a setup we could see on many charts. Many stocks had strong runs and trade outside their channel. Pullbacks will likely be bought so it is important to have these stocks on the watchlist. DLX is one of these examples. Note that I'm looking at company size below large cap since smaller names should outperform in the current environement. I would wait for tight consolidations and buy closer to the 20 day MA:

#2 is a bit trickier and quite rare, but actually one of my favorite setups, a “downside gap reversal”. Essentially, the stock gapped down after some negative news but investors step in and take lower prices as a buying opportunity. Once price breaks out of the tight consolidation, I buy. TGP is a current example. Buy stop at 38.5 with potential for a quick 5% gain. Note that a similar pattern occured in July:

Option 3 is breakout plays. The trick here is timing and not be all in on the breakout. Buying a small position on the breakout itself and get the rest after a potential pullback can help managing volatility around these critical levels. In normal environments, I would always wait for the pullback before pulling the trigger, but I have seen a couple of break-and-run plays recently. VMI is a stock high on my watchlist for this type of setup:

In order to find these setups, you'll need to eyeball hundreds of charts and for the gap plays run scans every night, but that's what traders do anyways.

Good luck.