It’s hard to sit through pullbacks, but as Jesse Livermore said, the real money is made by sitting, not by coming and going.  The last two days have been a tough chop fest where you really don’t want to be trading.  I took off a decent amount of long exposure yesterday morning at the top, but not enough to keep me from looking at my book today and cringing, just a little.  Even when you know what’s about to take place, and that your plan is to let it happen and buy into it, watching your P&L move against you is never fun.  Today my second largest position, and what is a normal position size in $WPRT is down 10%, not fun.  Other than that, everything is acting predictably soft, consolidating nice gains from the past week or so.  We’re not playing for peanuts this time as has been the case the past three months.  It’s time to make some real money as the market has become a bit healthier.  Raise your stops along the way and buy the pullbacks.

Volume today is extremely light, 30% under the average from the past 30 days and the lowest volume of that time frame.  The market action is healthy, we are consolidating in an orderly fashion.  That doesn’t mean that we can’t roll right over, it will be very important that along the way the bulls make it tough for those trying to short this overbought market.  If the bears gain momentum and we see some high volume bouts of selling, I will change my tune pretty quickly.  For now though, I continue to believe we will find support at or above $SPX 1100 and make another trip higher into next week.

I added a pretty decent sized position in the agricultural ETF $DBA this morning.  Wheat, Coffee, and Sugar are on fire and this ETF has it all.  It’s a slow mover, but I love to trade commodities as they often trend very well.

I’m stalking a bunch of names, some that I mentioned yesterday and a few others.  I like the action in $GMCR this afternoon, keep a close eye.

Keep a close eye on $GS and $INTC, the action in both should give good clues over the next few days as their sector ETFs $XLF and $SMH are at big resistance levels.  If they break through this market can rip.

As I said, if you’re a swing trader and you took good entries last week, sit tight and trade your plan.  We should know more come the end of the week.

There’s been a lot of talk the past few weeks about the buildup of China’s military assets, particularly its navy.  Most of the literature you’ll read in the press will be decidedly pessimistic, alarmist, or downright fear mongering.  I’m going to take a few minutes tonight to review what is actually happening, on both sides.  This is of course a hotly debated topic, and because of the limited amount of information made public by the Chinese regarding their foreign policy, the best policy experts are giving it their best guess.

The procurement of blue water naval assets by the Chinese military has increased in velocity recently.  Blue water naval assets include air craft carriers, submarines, and large frigates.  We usually refer to these assets as being able to expand a military’s force projection.  Force projection is exactly what it sounds like, the ability to project military force beyond your borders.

Within certain policy circles there has been much talk over the past couple of years regarding the relatively small number of blue water naval assets within the Chinese military compared to the size and scope of China’s economy.  There is a general principal which states that as a country’s economy grows, it’s military expenditure normally grows to a certain percentage of its GDP.  This is especially seen in its naval assets, as the country expands its force projection to match the increasing amount of global trade it conducts.  We’ve seen this recently in India especially.

China has lagged in both over the past 10 years.  Their military expenditure as a percentage of GDP is still extremely low.  Their ability to project force around the world is still extremely weak.  China is now the largest energy consumer in the world, yet their ability to secure the safe delivery of those raw materials is relatively weak.  So taking this into consideration, China’s recent increase in the velocity of their naval asset procurement program is not out of the ordinary.  I would make the argument that they are still well behind the curve compared to where the United States was at this point in its economic development.

But why now?  Why are the Chinese now becoming more concerned with force projection?  This is the most difficult question to answer, largely because they are so far behind the curve.

Here’s my theory.  The United States and China have had an agreement in place over the past 15 years regarding global trade security.  China would forgo it’s military asset buildup and instead buy a large amount of US treasury bonds.  In return, the United States has continued to spend a tremendous amount of money on its force projection and global trade security.  In essence, China has outsourced global security to the United States.  This arrangement has worked extremely well for China, they have seen a decade and a half of extreme calm around the world, and the ability to grow their economy at a rapid pace without an interruption of the flow of raw materials.  War isn’t good for global trade, and China’s economy is completely reliant on exports right now.  Until the Chinese can stoke their domestic economy, they will be extremely careful when it comes to their international relationships.

This for a large reason is why you have not seen them become more involved in the Korean peninsula in a greater way.  Of course China knows that the midget dictator is a pain in the ass who should be blown off the face of the earth.  But you would be remiss to believe that they are willing to see a large scale war take place which would disrupt trade between them and South Korea, not a chance.  For now, keeping the midget dictator in his box is just fine with them, and it never hurts to have another card at the table with the United States when it comes time to talk turkey (not the country).

As well, you will not see China make even the slightest step towards Taiwan, not a chance.  There is no way on gods green earth they are willing to disrupt trade between that island and the mainland in order to change the defacto relationship which is just fine with them.

The Chinese are focused on one thing and one thing only right now, not seeing their economic growth collapse.  So why the recent naval asset buildup?

I believe the relationship between the United States and China is changing.  The Chinese recognize that the United States can not continue to spend the amount of money that they have on the underwriting of global security.  When the US is done in Iraq and Afghanistan, it will most likely slip in to another isolationist period, especially given its fiscal position.  The Chinese are preparing to take on their fair share of the burden for global security.  This means greater force projection.

Some may be fearful of China’s rise, I am not.  Thus far, China has conducted itself in a very low key manner when it comes to its global dealings.  No, they do not operate with the same moral ground that the United States does (or says it does).  We’ve seen energy and raw material deals made by China with some rather ugly and failed states, particularly in the Sudan, and other African states.  But they have leveraged their economic power far more than their military power to this point, something I don’t see changing.

Another reason you are hearing a good deal of fear mongering within the press has to do with our own military procurement process.  Let me fill you in on a little background first.

There are two camps within both the military and civilian leadership at this point regarding China.  There are those who believe that we should continue to buy heavy assets in order to prepare for the day when we may have to go to war with China.  I find these people to be rather over the top and alarmist, but none of the less, they are important.  Why?  Because we have a history of preparing and buying assets for the last war we just fought, not the war we may have to fight down the road.  The last two wars we’ve fought, or are still fighting, in Iraq and Afghanistan, have exemplified the people heavy, weapons light doctrine of counter insurgency.  Don’t be confused, not all wars are fought in this manner, and there will be wars fought in the future that require heavy assets with little man power.  For this reason, it’s productive to have a voice which keeps the equilibrium between those who feel that heavy assets will no longer be needed, and those who believe otherwise.

Don’t be surprised as well that those on the side of being weary regarding China and for a continued buildup in our own heavy assets are also of that mind because they represent military budgets or people who would lose their jobs.  You see, when it comes to military budgets, things are rather simple.  Find a way to spend the money, or have your budget slashed.  So you may not need to be spending X dollars on platform A and B now, but in 5 years when you will, if you want the money to be there, you better find a way to spend it now.  For representatives, no one wants to see a government contractor lose a big contract which puts jobs on the line in their district.  I think you can connect the dots there between the money and the China fear mongering.

The other side of the table belongs to those who believe that we need not worry about China, but transform our military to deal with failed states around the world.  This means less heavy assets, more people.  The military isn’t in love with this to begin with, they aren’t too fond of hand holding, teaching, nation building, diplomacy, it sucks, it’s hard, and it’s not what they do well.   The American military was built to break stuff, not kind of break stuff and then put it all back together in a better way.

So which side is right?  Well they both are to some extent, and it’s good that we have a balance.  But at the end of the day I would side with those who believe we will be doing a greater deal of nation building over the next 40 years or so, and less fighting with China.  In fact, I would be willing to sell you insurance on any kind of military engagement between China and the United States on either’s sovereign territory over the next 40 years.  It’s just not going to happen.  The military isn’t going to like this, and certain budgets will be slashed.  The Chinese are prepping to take over a greater deal of responsibility, I see this as a positive sign.

The more the Chinese are involved in the global economy, global security, engaged in global politics, the better.  The more they are involved, the more they have to lose by going to war.

Trading is all about patterns, whether you are a fundamental investor or short term technical day trader.  Maybe you study the very cyclical nature of the semiconductor business, buying high beta names when demand looks at its worst and swapping in to lower beta higher market cap names when demand is extremely high.  If you’re a technical trader you look for patterns like multi month bases or flags.  Maybe you’re a global macro trader and you make your living following the ebb and flow of capital around the world.

We all play patterns, we’re not here just throwing darts at a board (well some of us aren’t at least).  We learn these patterns in three ways.  You can either be a savant, like John Lee who instinctively understands patterns and has internalized so much of it that it has become second nature.  These people are the same as the math geniuses who can do linear regression in their head or tell you how many marbles are in a jar.  We learn patterns just from experience, being around the market enough, standing in the pit or sitting in front of the screens.  And finally, we learn pattern recognition from our mentors who pass along their knowledge to us.  Internalizing what is taught is extremely difficult.  Not everyone can be taught, it takes a certain type of brain and a certain disposition to learn different things.  I can’t learn languages to save my life, it’s just not how my brain works.

Anyway, certain patterns are harder to learn on your own, or just aren’t intuitive like technical pattern recognition.  One of the best lessons I was taught by my mentor was that one, big cap stocks like $IBM and $INTC do not move quickly.  He used to call it the cruise liner theory.  It takes a lot of time and effort to turn a cruise liner around and head in the other direction.  A lot of water has to be moved out of the way of that hull which has a large draft.  The same can be said for big cap stocks.  Institutions don’t just dump stock all at once, there’s too much of it.  They feed it out into the market in little pieces.  If it get’s knocked down too hard too fast, they will actually go out and buy some to support the price, so that they can unload more stock at higher prices.

So if you’re an investor in these stocks, save for some unforeseen and very strange piece of news connected with the company, like a CEO quitting, or an accounting scandal, don’t freak out when the stock gaps down 5% on earnings, it’ll most likely close the gap.  If you’re looking to take the short side of one of these names, wait until all of the major moving averages have rolled over, topping out is a huge process for these names, not an event.

Do I believe we are at that point now, where these names are topping out?  Well until a few days ago it was front and center in my mind.  But certain events over the past couple of days have changed my view a bit.

Yes, it’s ok to change your views on the market, don’t for a second think that means I’m being wishy washy about my stance.  In fact, having a stance on the market isn’t always necessary.  Sometimes cash is the best position and being completely agnostic regarding direction is best.  Economists are payed to have views, traders are payed to make money, it’s as simple as that.

Two things turning my head in the past few days are the action in Deere $DE and Caterpillar $CAT.  Another great lesson taught to me was that $CAT is an amazing bellwether for the market and the economy.  Why?  Because $CAT and $DE give insight into several different segments of the economy, and risk in the market.  First, they represent heavy machinery manufacturing, something we don’t do a lot of anymore in this country.  Second, orders for this machinery is very tied to commodity prices and global economic growth.  If miners are making a ton of money and expanding, they are ordering this stuff, if not, they aren’t making the capital investment in the heavy machinery.  Third, because they use so much steel, their input cost gives a good gague on inflation and overall demand.

So when we see these two companies seeing high demand for their products, pricing power, stock prices that are climbing, and a healthy bottom line, you can bet the global economy isn’t doing too poorly.  When they see orders drop, have to lay off workforce, see their input costs plummet, you can bet we’re having trouble around the world.

Over the last few weeks $CAT and $DE have shown great leadership in terms of price.  These are very cyclical names and you should be paying close attention to how they act.  If they break out now and run, another leg to this rally could be at hand.  These two have the power to pull the rest of the market with them.

Yes, the global macro environment is still crappy.  The domestic economic numbers look even worse.  But don’t disregard the action in these two names, you’ll find yourself on the wrong side of the market.

I took a look at some of the better weekly charts that still set up well to the long side tonight.  Remember, if the overall market does not cooperate, these setups will not work.  But if the market churns sideways or gets its act together, these are the stocks you really want to be looking for in terms of entries on the swing to position trading time frames.  Consult your daily charts for proper entries.

These videos were all made using the new Chart.ly screencaster.  If you are new to this blog, please remember to check my Chart.ly page on a daily basis as I post most of my individual setup technical work in real time there, it’s just a much easier platform to use to share ideas in real time.  You can find the link to that page on the navigation bar above.

As I’m flipping through a few charts this morning on the deck while marinating steak for dinner tonight, I noticed one specifically that really epitomizes what was the bullish case for this market, until Friday afternoon.  It represents exactly why I will not get involved in this market to the long side until we see several days of sideways action after good movement off oversold levels.

The market has not been able to hold a bid while sellers were present for more than three months now.  Moves to the upside have come swiftly and on very one sided up/down volume ratios.  This represents a market where sellers step to the side for a few days, completely, allowing fast money to take the market higher.  When that fast money runs out of gas, the sellers step back in, and we see days like Friday.  Notice in the S&P 500, we have not had many minor sell offs on light volume over the last three months.  When the fast money gets exhausted, there’s no underlying bid, they just pull it and down we go, on high volume.

Back in February, before the big March rally, we saw four days of light volume movement to the downside in an organized fashion.  This got me extremely bullish, I loaded the boat to the long side, and made my whole year in the following month and a half.  I haven’t seen this type of action in the past three months, where the market holds a bid after making a move off the lows.  Thus, I have not gotten bullish and won’t put on significant long exposure.

So I’m flipping through my long side watch list and The Cheesecake Factory (CAKE) comes up.

After moving below the 200 day moving average a few weeks ago, CAKE broke through the downtrend line on Wednesday after some good same store sales numbers and multiple upgrades.  It also moved back above the 50 day moving average.  I put the stock on my list at that point, looking for some sideways consolidation on light volume.  This was generally the bullish case for many of the better relative strength stocks.  After strong moves off the bottom, some on decent volume, these stocks gave back very important support levels on Friday, on high volume.  Instead of moving sideways, bids evaporated, and the fast money sold out.

I fully expect further price action to the downside now.  The next bullish case would be for these stocks to hold their early June lows and form inverse head and shoulder patterns.  Specifically in CAKE, look for the 200 day moving average to hold next week.  I wouldn’t look to get involved until stocks showing this type of pattern break back above yesterday’s high.

Until then, chill out.