A lot of traders are talking about, and betting upon, a new surge in inflation caused by the bailout plan. But I’m not sure that is a done deal. Putting any amount of money into the banking system will not expand the money supply and stimulate the economy at all if the banks don’t increase their lending.

The Fed has already pumped billions into the banking system, and it has simply disappeared into the black hole. It has not stimulated the economy because the banks have not increased lending. In fact, they have decreased lending and the money supply has not expanded.

So, the moral of the story here is that the Fed does not expand money and credit. The Fed pumps money into the black-hole system and hopes that banks will increase lending. That worked in 2003. It is not working in 2008.

Can the banks swallow up another trillion dollars? Maybe they can because not only is the banking system broken, but so is the real-estate market. As long as house prices are falling and deadbeat Americans have no money for down payments, it will be difficult for banks to inject much money into the economy even it they wanted to.

Banks are hoarding capital as revealed by the Libor rate, which is more than 50% higher than the Fed Funds rate. Any new money injected into banks is likely to go straight into the mattress.

I have written about this before here. In that post, there is a link to the True Money Supply which I think is the best measure to use.

I am not betting on a giant tidal wave of inflation just yet. If it comes, it may be awhile.

Maybe I’m crazy to continue doing chart analysis after Dick Fuld detonated his suicide bomb last week sending all asset classes flying in random directions like so much shrapnel, but let’s just see what we have anyway.

The SPY bull-flag intra-day pattern that I first discussed on Sunday has evolved like this (click chart to enlarge):

The purple line marked “A” is the same. That’s the first half of the flag pole. Remember, the flag flies at half mast. Line “B” is the same height, but it is moved down because we measure from the tip of the flag. So, our upper target keeps falling the longer the flag waves.

Now comes the interesting part. I have stretched out the chart so that you can see that the flag, bounded by lines “C” and “D” has formed into a falling wedge pattern.

Falling-wedges are bullish patterns. Make sure to click the link and read up on them if you don’t know what to look for.

Most intriguing is the last bar. Look at the volume. That increase in buying may signal that SPY is about to break out of the wedge to the upside. Your chart may look a bit different depending on how your charting program makes its bars, but if you look at a 5-minute chart, you will see the surge in buying before the close. As I write, the futures are also up a few points.

If I wanted to short here, I would wait until prices pushed line “D” down far enough to erase the wedge. If I wanted to go long, I would wait for prices to break above line “C” with a surge in volume.

The way it breaks is likely dependent upon what Congress does.

Will the market continue to gyrate in wild swings because traders don’t know what the rules of the game are? Are 1% moves in the major indices just noise now, and much larger moves the norm? Maybe we can get answers to these questions today. After a giant up-wave like we had last week, you would expect the market to consolidate in a much narrower range. Let’s see if it can do that.

Watch the comments for updates throughout the day.

Here is a 60-minute chart of SPY from Thursday and Friday showing the bull-flag pattern that has formed (click to enlarge):

The purple lines outline the pattern. If it completes, the target would be $136, which agrees with David’s analysis (see David’s links in the comments of the previous post.)

While flags are not the most reliable of patterns, it is usually not a good idea to fight them until you see them begin to fall apart.

The market is short-term overbought, so I would expect some more consolidation from here. However, longer term, the market is not overbought at all, so technically, there is plenty of room to run up the second half of the flag pole.

This is an intra-day pattern, so it does not carry the same weight as a multi-day pattern. Also, SPY’s volume increased in the last two hours on Friday which is a sign that the flag may unravel. Volume is supposed to remain light in the flag-part of the pattern as longs take profits and traders wait patiently for a pullback to initiate new longs. SPY could correct more than it already has, but volume is still the key.

Another problem is that flags are continuation patterns, not reversal patterns. However, since the Brits announced their ban on the short selling of financial stocks while the US market was still open, we may have a legislated bottom that will not look “normal.”

And finally, knowledge of technical chart patterns has been developed during an era where short-selling has been allowed. Will chart analysis still work while the shorting of stocks in the most important sector of the market is outlawed? I don’t know the answer to that, but I’m sure that there are traders somewhere with experience in the Chinese and Pakistani markets who could tell us.

Since this relief rally is occurring while the economy is contracting, it has to be classified as just another bear-market rally until proven otherwise.

I see a lot of traders around the web getting excited by this ban on short-selling financial stocks. Why don’t we take a look at how well banning short-selling has done in another major market. Here is a chart of the Shanghai index from Yahoo Finance (click to enlarge):

Hmmm…a drop from 6000 to 2000? …doesn’t strike me as bullish…

If anybody knows the history of the ban on short selling in China, please post a comment. After a few minutes of searching I wasn’t able to google-up anything beyond the fact that the Chinese don’t allow short selling.