I started mentioning the XME a couple of weeks ago because it had launched up to the top of the sector list, and had briefly surpassed the XLF as the top sector since the March low.

And now, it is a wreck, sporting the worst kind of head-and-shoulder topping pattern: one that slopes downward (click chart to enlarge):

This pattern projects down to the XME’s breakout level of 31.25, and very possibly a bit more.

Sorry bulls; it ain’t over.

SMN is the inverse ETF to go along with the XME, and as I mentioned in the comments over the weekend, it has a bull-flag pattern on its chart:

A 100% extension of the bull flag would target the SMN’s May 14th peak (red circle). However, given the sorry state of the XME, the SMN may be intending to extend farther up and fill its April 30th gap (blue box).

If the XME wants to bounce up and back-test its neckline tomorrow, I will load up with some more SMN. (Note: UYM is the ultra ETF to go with the XME.)

The FOMC will be discussing “exit strategies” at its meeting this week, though they have leaked to the Wall Street Journal that they will not be turning off any money spigots any time soon. Nevertheless, the market wants none of this “exit strategy” talk.

On this daily chart of SPY, you can see that it formed a bear-flag pattern last week (click chart to enlarge):

The flag is bounded by the red lines. The blue arrow points to Thursday’s volume, which was the lowest of the week on the one day that SPY closed up. So, both the price and volume patterns match that of a bear flag.

The purple arrow points to the top of the flag channel on Friday to highlight the fact that SPY failed to reach the top channel line. It is possible that SPY has already topped out and the ideal short entry point was at Thursday’s high. However, SPY can move higher and still remain within the flag. Retracements of 50% and 61.8% are perfectly normal, and as we see on the next chart, SPY has not quite made it to the second, 38.2% retracement level:

If SPY is done retracing, then a 100% extension of the bear flag would take SPY down to the 88 area to test the support at its May 4th gap:

SPY has dipped into that gap, the red box on the chart, but has never filled it on a closing basis. So, I would say that it is a support level, though weakened, and a good candidate to be filled by this bear flag. If SPY can retrace upward some more, then the downside target would have to be raised accordingly.

At some point next week, I will likely buy some SPY July $88 put options (SZCSJ). At the moment, this option’s stochastics are oversold on its 60-minute chart, and its 15-minute chart is turning up with SlowK crossing above SlowD, and MACD crossing above zero. So, it already has two amigos, and is only a penny away from crossing above the 9ma for the third amigo. A 9/36/15 cross-up isn’t too far away either:

The 9ma is the black line and the 36ma is blue. The MACD only made a shallow dip below zero, and is now slightly back above zero.

So, the setup looks promising now, but whenever I look at flags like this, I always say to myself: “there will probably be more of a retracement.” On the other hand, if SPY can only muster a 38.2% retracement, then that is a sign of weakness, and may indicate that SPY will exceed a 100% extension on the downside. Maybe it will hit the 127% extension down at 86.

As always with bear flags, you want to see volume decline when prices move up. So, if SPY can rally with better volume next week, then it can invalidate the pattern. But any light-volume rallying will only improve the shorting opportunities.

Looking over my charts, one thing that struck me was how the SPX has barely corrected at all compared to how badly breadth has deteriorated. The McClellan Oscillator is at levels last seen in early March, and the SPX isn’t even 30 points off of its high close of 946.

I suppose that this means one of two things. The bullish perspective is that many, many stocks have dropped, but by only very modest amounts, which indicates mild profit-taking.

The bearish perspective is that the market is a lot uglier on the inside than it is on the surface, and the worst is yet to come.

Tomorrow we will get a clue as to which perspective is right. SPY’s 60-minute slow-stochastic is overbought. The last two times it got overbought, on June 9th and June 11th, it rolled over pretty quickly. So, if SPY can push higher on Friday without first unwinding it’s overbought condition, then that will be a feather in the bulls’ cap.

The sell-off was a low-volume affair until Wednesday when the XLF got slammed for a 2.8% loss on the heaviest volume in four weeks. However, both the Q’s and IWM surged on improved volume, so Wednesday was a sector-rotation day. But, the market can’t get far without the XLF, and the XLF obviously is not enamored of Obama’s new financial regulation plan. What will the market look like with a neutered financial sector? I don’t know, but I’m guessing this dims the long-term outlook.

The Q’s and IWM are still holding above their June 1st gaps. Those gaps are critical now that Obama has killed off the XLF.