Your best set-up today is to wait for the downside to be tested. Once support is confirmed, buy strong stocks.

PRE-OPEN MARKET COMMENTS MONDAY – The market feels like it has been in FOMC “wait and see” mode for the last week. This rally is news driven and as soon as one event passes the attention instantly shifts to the next potential catalyst. The breakout from a week ago has not been able to gain traction and it is unlikely to ahead of the Fed.

The CPI will be posted tomorrow and the FOMC statement will be released Wednesday. Analysts are expecting the Fed to pause (70%). Canada raised 25 basis points last week and the ECB will hike 25 basis points Thursday.

The market does not care about smoke, it only cares about fire. We’ve gone two months without another regional bank failure and that has emboldened buyers. I would caution that line of thinking. Credit issues build quietly and when an inflection point is reached, conditions change instantly. I recall a similar market bounce in 2008 after Countrywide Financial was purchased by Bank of America (worst deal ever). Later that year, the bottom of the market fell out. JP Morgan Chase has already stated that it is done buying distressed banks. Last week we learned that defaults (greater than 30 days in arrears) for commercial offices (CMBS) reached a 5 year high (4%). Regional banks are trying to unload loans at deep discounts, but there are not any buyers. If interest rates continue to rise, regional banks will be “on the ropes”. According to Jaime Dimon (JPM CEO), regionals are not positioned for another 1% rise in rates from here. I am not mentioning this because I believe that a credit crisis is brewing. At a time when the sun is shining and the market is making a new 52-week high, I want you to be aware of a potential undertow.

The prevailing thought is that CPI and PPI are going to come in light this week and that the Fed will have the latitude to pause for more than a month. That explains why the VIX has been in a sharp decline and why the market is flirting with a 52-week high. We are seeing a rotation out of mega cap tech and consumer staples and into small cap stocks. This is a “risk on” rotation and I consider it healthy for the market.

So how do we trade this? I like favoring the long side, but keeping the trades less than a week in duration. This allows us to catch the rally and to keep our longer term risk exposure down. If we can get through September without another bank failure, I will start to get more aggressive with swing trading from the long side. On a short term basis, we want to see a bullish reaction to the FOMC. That would confirm the horizontal breakout for SPY and we will see follow through buying. That continuation needs to happen this week. If instead the market falls back below SPY $417.50, we are back in the prior trading range and the price action the rest of the summer could be very lackluster. I am rooting for a breakout, because that will provide us with the best backdrop this summer.

Overseas markets were slightly higher on average. This will be a big week for central banks. Friday is triple witching and that means that we are likely to see one really busy day this week. My guess would be Thursday after the FOMC statement. If the CPI comes in much hotter than expected, it could produce a big market drop because everyone is expecting a decline in inflation. Surprise favors the downside, but I’m not positioned for this because the market did not tank last month when the number was “hot”.

The SPY is up before the open, but it is below the high from Friday. The first move this morning will challenge that resistance. If you have overnight longs, I would take gains as we approach that level. Friday we saw a swift round of selling after an early rally. The market was not able to recover and it never got close to that high. That is a sign of resistance. If we get a nice 1OP spike near the high from Friday and a bearish hammer or a bearish engulfing candle I would take some small shorts. For most traders, the better approach is to wait for bullish speculators to get flushed out. Once support is established, get long. On the way down you will be able to identify the stocks that have relative strength. Our best trading scenario is a gap down, but we don’t have that. Gap reversals have lots of room to run and buying that support would allow us to join the longer term up trend.

Don’t chase. The market is not going anywhere and the volume has been light. Expect dull trading today. We have two major events Tuesday and Wednesday. If you can hanker down in a couple of good stocks, you don’t need anything more.  

Friday’s range represents support and resistance and I believe we are set up for an “inside day”.