Good morning traders,

Drawing heavily on my morning Waverly Advisors report again today.  First on equities:

A mixed session yesterday saw large caps struggling to recover while smaller cap stocks continued their decline.  We believe the dominant technical pattern on the S&P Cash index is the small consolidation highlighted on the chart above.  Taken in context, it is important to realize that this consolidation follows a downward move that had strong momentum and displayed a distinct change of character from the previous market pattern, so there is a very high probability that this pattern will resolve to the downside.  Our clients should be carrying lighter equity exposure at this point, as first stops were hit in early trading yesterday.  As we said in yesterday’s note, we are willing to give this move some time to resolve before moving too quickly to add to positions.

The pattern we are dealing with is also a pattern traders on our desk trade in the very short-term:  A change of character in a market followed by a consolidation that usually breaks down into a trend change.

And on sectors and international equities:

One thing that seems to be clear is that enough damage has been done to Basic Materials stocks that most of the sub-sector groups are not candidates for leaders on the next rally.  (Note that we alerted our clients on 1/13/10 that we no longer considered overweight exposure in Materials to be appropriate.)  Let us stress again that we are not looking to add long exposure too quickly, but we expect to be looking at Energy, and Financials when the time comes, with secondary candidates in Tech and Industrials.

On the international front, UK Broad indexes have patterns that suggest a fairly significant decline may be in the cards.  We continue to have serious reservations about Chinese equities and are watching various Chinese indexes fail to hold important support levels.  On 11/29/10, we wrote: “We are also concerned about elements of market structure in Chinese Equities that very strongly suggest another wave of selling is likely, perhaps trimming as much as 15% from major indexes”, and suggested that portfolios should be overweight domestic equities and underweight China.  Since that time, our China index has declined -9.4% against the S&P’s gain of 7.8%, and, frankly, we believe there may well be considerably more downside in China.  We maintain a cautious and skeptical stand toward Chinese equities until we see something significantly different in that market.  (Note that what we see in the cash indexes we follow may differ dramatically from the picture available to investors who only analyze FXI, HAO or other China ETF’s.  We would argue that market structure and price pattern analysis on a managed ETF is misguided and may not give the best picture for the broad market.)

This may have implications for daytraders, as a further decline in China could put some Chinese names very well in play some days.  Something to keep an eye on.  It is also worth considering the validity of doing in-depth technical analysis on something such as FXI… there are many blogs and technical analysis “experts” that do this, and it has never made sense to me.  (Look at TLT vs a properly-rolled (key factor there) continuous contract for 30 year bond futures for another example.)

• Coming in to a bit of a mixed bag this morning.  Asian markets ex China are down roughly a percent, while China is up 1.2%.  Europe up, and up strongly, across the board.  Broad European indexes up 2% (which is roughly 2 standard devs.)   Minor markets are generally off.  South Pacific is hammered, down 1.5% – 2.5% ex Australia, which is flat.  Middle Eastern markets off fairly significantly as well.  Morning strength, then, is European-led.
• US Futures are up fairly strongly premarket.  Expect some crosscurrents but daytraders should be aware of the bigger picture market structure outlined above.  Breaks below resistance could “activate” this pattern, leading to a more significant selloff.  Be careful of fading weakness in index products today…. give the bears a chance.
• Keep an eye on USDCAD which failed to rally above parity yesterday and is now set for a potential breakdown.  Still looking at potential weakness in the US Dollar index, but this is a longer-term idea.
• Nothing significant in futures overnight, though Energy has a generally positive tone (watch Brent/WTI divergence this morning though), and the precious metals are a bit soft.  NYBOT softs up strongly across the board in early trading, but this may be primarily a reflection of Dollar weakness.
• A handful of good earnings stocks to watch today are probably more compelling than sector plays.  Basic Materials are probably short-term oversold, so be careful of pressing shorts too aggressively there.  If you are looking for serctor plays, think about Financials and Tech for shorts, and Energy and Industrials for longs, but, again, best plays for daytraders will most likely be in earnings stocks.