The current market action is important

The short-term activity of the S&P and major indices may yield important clues as to future action here. The major indexes are testing May’s highs – and how they behave on this test is important. The S&P is into a Fibonacci time frame and a Fibonacci retracement level and is testing key resistance at May’s highs and is having a bit of a reaction. A key question is whether it is tracing out an ascending triangle or a wedge. A strong and high volume close over 133-34 next week will be bullish and suggest further upside to around the 137 level. Conversely a decline from here below the trend line drawn up from the July lows to September lows, meaning a close below around the 130.5 level, would complete a wedge and suggest a sharp retest of July’s lows. Therefore how the market reacts from here could be critical to its next short-term direction.

While the big-cap indexes have been making a good show, the majority of smaller and mid-cap stocks have been lagging badly. Chart 2 below, which shows the small cap growth i-share illustrates this point clearly. The S&P large cap index fell in May from around 132 to 121 and has come all the way back to the 132 level. Contrast this with the action of the small cap growth i-share which fell from around 81 to 67 and is now reacting back down off of 74, the 50% retracement level and also 200 ma resistance. Many indexes are approaching resistance levels here. Despite the divergence, note that IWO is also at a critical resistance level of 50% and 200 ma, and that a breakdown below the up trend line drawn from the August lows to September lows following a failed test of the 200 ma would not be positive action.

One of our favorite trades since May has been large caps over small caps, and the above two charts illustrate how much stronger large caps have been since then. We have also emphasized the importance of the breakdown in commodities and metals over the last few weeks. The large-cap market in particular has gotten some wind in its sails by the drop in crude oil. We wonder though whether the declining growth that is likely behind the steep drop in crude will not eventually impact earnings enough to spook even the big cap indexes for a spell as the slowdown develops.

Short-term traders should watch the wedge versus ascending triangle result carefully here and go with the direction the market clearly indicates via a number of indexes in this regard. A bullish resolution could be used to trade some of the stronger sectors on the long side such as pharmaceuticals, insurance, and software. Conversely, a bearish resolution of the wedge formation in a number of indexes should send traders to the sidelines or betting with (SDS | Quote | Chart | News | PowerRating) or other inverse iShares on at least a short-term correction.