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July 09, 2009

Head and Shoulders, No Not for Dandruff...
by Mark McMillan

7/9/2009 11:51:05 AM

Introduction

We intended to cover the Presidential Election Cycle but are deferring that to another issue as we wanted to cover a technical subject in more depth as it is apropos. There is a specific chart pattern we wanted to address as this issue's special subject and will then discuss our outlook with this in mind.

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Head and Shoulders

The Head and Shoulders pattern is probably the best known pattern of a bearish reversal. It tends to lead to significant moves lower when the neckline is broken. Of course, once something is widely known, it tends to be less useful as trading that ensues because of it tends to affect the overall market. Let's start out by defining the pattern and provide reasons why it is generally a reliable indicator.

A head and shoulders pattern consists of a left shoulder, a head, and a right shoulder. We are going to use the term "market" to mean a security (stocks, bonds, futures), currency, commodity, etc. that can be charted. The pattern occurs when the market is in an uptrend and the left shoulder is formed by the market making a new high. That new high is followed by a higher low (forming the left shoulder) and the market moves to a new higher high (the top of the head). That high is followed by a new low which may be higher, even, or lower with the previous low. The market moves higher a third time and this time forms a lower high (lower than the top of the head) and begins to move lower forming the right shoulder. The most important area to watch is the neckline, drawn from the low of the left shoulder through the low between the head and right shoulder. If volume increases and the neckline is broken when the right shoulder is formed, it tends to lead to violent sell-offs.

You can see the head and shoulder pattern clearly in the chart of the S&P-500. In addition to the head and shoulder pattern, there is a clear support/resistance level seen at around the 875-880 level (the long horizontal black line with grey no-mans land highlighted above it). That is a level that, if broken, will cause the market to sell-off further and have a problem rallying later on.

So what actually happened to the S&P-500? I didn't include volume on the chart because the volumes aren't included for the major indexes. The volumes are easy to obtain for ETFs and when we look at the SPY ETF, which mimics the S&P-500, we see that the volume increased on the downward move. Some of this may be self-fulfilling as all the chartists jump on board given the well known nature of the pattern. I would like to see how things play out after a few days of what I think will be a short term rally here.

If the pattern holds true, what predictions can we make as to where the S&P-500 will move down to?

The projection is easy to make and it is easy to justify the level by the fact that markets tend to retrace to close open windows (gaps). We'll monitor this and we aren't married to it. We don't tend to use projections in our trading but they can be useful sign posts along the way and if you decide to short the market based on other criteria it is probably worth taking some profits when it reaches that level.

I still intend to cover what is known as the Presidential Election Cycle and how it affects trading and U.S. markets in particular. I just felt it would be timely to explain the current state of the markets from a chartist perspective at this time, since I regularly share my economic outlook and fundamental perspective with you.

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Market Outlook and Conclusion

The TED Spread continues to trade in a normal range signaling interbank lending markets are functioning normally.

The price of oil dropped like a rock from the high $60s to the mid-$60s last week and closed at $60.14 on Wednesday. This has been echoed across the commodities spectrum as the dramatic run up in commodities prices has reversed. Our annual forecast/predictions included a range up to $70 for the year so this wasn't unexpected but it is still dramatic.

Last week, the markets reversed yet again from a short term bounce, as we expected and moved lower. In fact, the major indexes have actually broken down and we would expect a further move lower as indicated in our special topic discussion. This is anchored by a broken downtrend for the VIX which I have been predicting for quite some time now (I would really like to always be correct on my timing, but the market is an unforgiving environment for anyone who insists on always being correct so I have to bend with its movements).

However, I see reason for optimism in one sector and we will be entering trades based on that in our short/intermediate term portfolio.

As you know, we have been decidedly bearish at the tail end of this run-up, and correctly so, thus far. Now, we'd like to be a bit bullish, even as we try to provide a realistic take on the market.

The semiconductors put in a reversal pattern on Wednesday. Even though they closed lower, our proprietary indicators show strength in the semiconductors suggesting they are ready to rally. This rally could lead the NASDAQ to once again move higher and provide leadership for the markets overall.

We think that it is prudent to have an intermediate term bearish view on the markets overall at this time, but to take advantage where strength is showing at this time. In this case, semiconductors offer a compelling buying opportunity here.

Similarly, while the commodity space has been beaten down, International Paper (IP) has shown remarkable strength during this latest sell-off. Clearly, the elephants (professional money managers) are buyers of IP probably perceiving the value inherent. IP has the cash to weather the recession and many of its competitors are insolvent with Weyerhauser having declared bankruptcy this week. IP is in our long term model portfolio and generates consistent dividends as well.

Let's turn our attention to the VIX. Last week, I said that we wouldn't use the charts until the VIX broke the downtrend. It did and we are going to show the chart.

In our opinion, there isn't sufficient reason to believe that the VIX run-up is yet over, but because it actually ran up to touch the upper Bollinger Band, many traders will bet on a move lower. We interpret these things slightly differently but it should be sufficient for a short term move higher for the S&P-500 and other major indexes.

As I have disclosed in our special subject, the head and shoulders pattern suggests that the intermediate term direction for the markets is a continued move lower and I have given specific levels that we believe the move could continue to. This fits with my view that the market needed to retest the lows and that I didn't believe the market would make it all the way there. [Note: the market doesn't care about my opinions but it is nice when market action aligns with my opinion. I am more than willing to change that opinion should conditions warrant, but so far, so good.]

We would advise a lightening up on long positions during this short term bounce, even as we add some short/intermediate positions to take advantage of strength in semiconductors. The move lower will test the faith on many bulls and the stocks that led the way up from early March aren't going to be the same ones that lead from this bottoming process.

We would recommend a bullish trade on semiconductors in the short term which could become an extended move higher and would lead the overall market higher and curtail our projection of a move lower for the S&P-500. Time will tell but we have seen enough to reduce short exposure at this time.

We believe it is time to take advantage of an impending market reversal. To see how we will play this actively, you should consider a subscription to the McMillan Portfolio.

I hope you have enjoyed this weekly article. You may send comments to mark@stockbarometer.com. Please don't be shy in expressing your opinions of what you would like to see covered.

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Mark McMillan
The McMillan Letter

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