Well, I can't say I'm surprised the market failed to follow-through on Monday's bullish effort. I don't mind confessing I'm surprised the bulls gave up this soon, however. I woulda thought Monday's gains inspired a bunch of people to get off the fence and into the game for at least a couple more days. No dice. Traders are once again hesitant. Advertisement Today's Top 10 Penny Stocks - Free List Just released! This complimentary list will continuously rank today's top 10 stocks under $10 using MarketClub's technology and scanning tools. Show Me Today's Top 10 Penny Stocks List Advertisement We'll look more at the details and what to do about them in a moment. The main task I want to accomplish for you today is taking a good look at the market's valuation, and small cap stock valuations in particular. Janet Yellen really stirred the pot (not in a good way) last week with her cautious comments regarding small caps, but after giving her theory its due time and attention - and then digging up the numbers for myself - I'm quite sure we don't agree with her. Small Caps Overvalued? If you don't know what I'm talking about, here's the Q&D synopsis: Last week, in her regular Congressional testimony, Federal Reserve Chairperson Janet Yellen mentioned in passing that she felt certain pockets of small cap stocks were overvalued. She didn't elaborate, but considering it wasn't a response to a specific question, the fact that she brought it up at all is interesting. I don't recall the last time a Fed Chair made such a specific, opinionated comment about a certain category of stocks. I have to say, however, I like it. It's a sign she's in touch with the equity market, which likely means she wants to babysit it as much as she wants to babysit the economy (and no, the two aren't the same). The $64,000 question is, is she right? There are a lot of ways to answer the question, but when you get right down to it, valuations are ultimately relative to earnings and earnings growth. So, for our purposes, a plain ol' look at small caps' P/E ratios should answer the question well enough; we'll use the S&P 600 small cap index as our proxy. And what did we find? As of right now, the S&P 600 is valued at 28.9 times its trailing twelve-month earnings. Now, before you freak out because the small cap index P/E ratio is radically higher than the S&P 500's (large cap) trailing P/E of 17.4, don't! Remember, a lot of small cap companies are still unprofitable, which makes it tough for the index as a whole to look reasonably priced. In other words, a P/E in the 20's is actually normal and healthy for the S&P 600, as net-earnings aren't necessarily expected in all cases. The question is, where does that trailing P/E of 28.9 fall on the relative "too high/too low" scale? Admittedly, it's not cheap. As far as small caps go, however, I don't think it's expensive either. While we don't have enough long-term data to say what the average P/E ratio is for the S&P 600, I don't mind guessing that it's in the mid-20's. And, the S&P 600 was trading at a trailing P/E of 31.8 near the end of last year and nobody seemed to have a problem with it then. Point being, 28.9 doesn't scare me in the least. In fact, while nobody can say with absolute certainty that these companies will meet expectations for the remainder of 2014 and all of 2015, it's pretty clear that the pace of earnings growth here is expected to ramp up in Q2... which we're halfway through now. The forward-looking (full-year 2014) P/E for the S&P 600 stands at 19.8, and 2015's projected earnings put the S&P 600 at a forward-looking P/E of 16.2. Folks, that's close to being in line with the S&P 500's forward-looking P/E ratio. The only reason somebody might still be wary of small cap stocks - that I can see anyway - is doubt that these companies will actually hit their lofty 2014 and 2015 earnings targets. I get that. I tell you what though... I don't doubt they can. Q4 was a record-breaker for the S&P 600's earnings, and even with Q1's economic malaise, that was still the most profitable first quarter ever for small cap stocks. I really do think small cap stocks are presently making the pivot from good to great, just like our chart suggests. Heck, the next couple of years should be better for small caps than large caps. So, sorry Janet Yellen - we don't see what you're talking about. Of course, that's the macro view. None of the valuation situation will alter what's going to happen to stocks in the near term. On that note... Still on the Fence Like we mentioned to you above, it's a little surprising - though not completely shocking - Monday's rally already ran out of gas. Honestly though, today's inaction isn't something either side of the table needs to read anything into. We knew there'd be a struggle here, and we're getting exactly that, right where we should be. Patience is going to be required for the next few days. To give credit where it's due, the S&P 500 managed to hit a record high of 1902.17 on Tuesday. The problem is, it couldn't hold on to that high. I suspect the upper Bollinger band at 1899.4 was too much of a ceiling for the market, sending stocks back from whence they came. The concern is that the upper Bollinger band is going to do now what it did back in early April. And, I can't help but wonder if we got all the clues of an impending struggle we needed to get on Monday, when the VIX finally fell into a major support level around 12.40. If the VIX can't move any lower, it's going to be wickedly difficult - albeit not impossible - for the S&P 500 to move any higher. Today's go-nowhere result is a glimpse of that possible reality. I thought John Monroe made a great related point about all of this in today's Elite Opportunity newsletter by saying: "When you drill down into the short-term charts, it's no secret the markets have been extremely volatile. As a matter of fact, just have a look at this daily chart of the Russell 2000, which is the benchmark index for everything small cap. As you can see here, I've pointed some arrows and circled a particular level. What I'm showing you here is the only way anyone could have really been making some nice profits on an extremely short-term basis over the last several weeks, was to play contrarian and buy the new lows on the hourly charts, which are what the arrows represent. However, in hindsight, when to sell was never quite that predictable. In other words, sure, you could have bought the new short-term lows but at what point did you flip them back to the other side, take profits and wait for another potential re-entry? The reversals made no sense." And he's right - picking the bottoms has been easy lately, but pinpointing the tops has been near impossible. I don't think that's changed... at least not yet, which is why we're going to keep our powder dry for the time being to see just how far the bulls are willing to go. I'm not afraid to sell and short into new thrusting highs, nor am I afraid to buy strong dips (even when it feels like I'm catching a falling knife). The one thing I don't want to do, though, is call a top or a bottom when the market is just grinding away like it is now, unsure of which direction it's supposed to go. In any case, John Monroe went on to explain later in the Elite Opportunity newsletter why he circled the level he did on his chart of the Russell 2000. That's his big inflection point, which means stocks could still go a little higher without getting back into a full-blown uptrend. In fact, he thinks they could move a little higher just for the purpose of starting a downtrend. That's something I've been saying for a while too. We really need to see all the indices set up technical bases above their current ceilings before digging in too deep. We may still be able to do it, but we haven't even gotten close to doing it yet, nor have we wiped away a couple of other potential pitfalls like the low VIX, The bottom line is, forget today - the S&P 500 is still basically stuck under a ceiling, and even a little more bullish progress won't snap the market out of its funk (because the NASDAQ has a long way to go before doing that). The VIX is still ridiculously low too, which is going to be a problem sooner or later... and probably sooner than later. Let's table it for the time being and let some more of the dust settle. The make-or-break line for the S&P 500 is still the 50-day moving average line, currently at 1868. If you want the full-blown analysis from the Elite Opportunity's John Monroe, which is way more in-depth than mine, I recommend using the SCN EO's free two-week trial offer to see exactly what he's saying here while the market tries to find its bearings. Here's how to get it, or cut and paste this link: https://www.smallcapnetwork.com/?vmpd_ckstr[click_track]=Newsletter&vmpd_ckstr_redirect=/pages/SCNEO/v1/