Head And Shoulders Now Forming On This ETF

The broad market followed up
Wednesday’s bearish reversal with a day of
sideways consolidation near the previous day’s lows. The S&P 500
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traded in a very tight and narrow four-point range before finishing the day
0.2% higher. Intraday action in the Dow Jones Industrials
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also gained 0.2%, was equally uneventful. The Nasdaq Composite
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advanced 0.3%, while both the S&P 400 Midcap and Russell 2000
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indices bounced 0.4% higher. Mirroring the lethargic activity of the broad
market, individual sector performance was dull as well. Only two sectors we
follow gained or lost more than 1% — Utilities
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Home Construction ($DJUSHB) lost 1.4%. Most industries closed near unchanged
levels.

Volume fell sharply in both exchanges, which is typical of
low volatility days. Total volume in the NYSE declined by 18%, while volume in
the Nasdaq was 24% lower than the previous day’s level. Market internals were
positive, but only by a small margin. Although the major indices recovered a
fraction of their prior day’s losses, it is bearish that they did so on much
lighter volume. A rise in turnover would have indicated institutional demand
to buy stocks at depressed levels. However, the light volume of yesterday’s
bounce tells us that Wednesday’s sellers simply took a break as opposed to new
buyers aggressively stepping in.

In the weekly newsletter that was published yesterday, we
pointed out a potential short setup in ICF
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that tracks Real Estate Investment Trusts (REITs). To reiterate, the daily
chart of ICF is now forming the right shoulder of a "head and shoulders" chart
pattern. We have illustrated the components of the "head and shoulders"
pattern on the chart of ICF below:

The "head and shoulders" pattern is bearish because it often
indicates the end of an uptrend by forming a "lower high" on the right
shoulder. After the neckline is broken, the projected downward move of ICF is
typically equal to the distance from the top of the head down to the neckline.
In this case, that equates to a projected downside target of around $63 (7
points below the neckline of 70). Obviously, it could easily take several
weeks or more for this to occur, but patient traders will be rewarded if the
pattern follows through to the downside.

The ideal time to short a "head and shoulders" pattern is
during the formation of the right shoulder. Alternatively, you could wait for
a break of the neckline, but that carries a higher risk because ICF could
reverse quickly if it fails to break the neckline. If you short the right
shoulder, your stop should be no higher than the top of the head.
However, keeping a stop just above the left shoulder, near the 75.50 area,
provides you with a much better risk/reward ratio. If ICF rallies above the
left shoulder but does not break out above the high of the head, the pattern
is technically still valid, but the chances of success are greatly diminished.
Given the convergence of the 20 and 50-day moving averages just overhead, ICF
should not rally much beyond 74 before going lower. If it does, we probably
don’t want to be short. As a side note, you may also consider shorting IYR,
which is another ETF that tracks REITs and has a similar chart pattern.

Yesterday’s gains did little to change the technical picture
of the major indices. The S&P, Nasdaq, and Dow each remain below their 50-day
moving averages, while the Dow is also below its 200-day MA. Given the wide
range of the prior day’s selloff from the intraday highs, it is normal for the
broad market to digest those losses either through a correction by price or
time. Although the indices closed marginally higher, the narrow, sideways
consolidation of the broad market was basically a correction by time that
allowed the intraday moving averages to "catch up" to the prices of the major
indices. To illustrate this, take a look at the hourly chart of DIA (Dow
Jones) below:

When DIA
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August 24, notice how far the price became extended away from the 20-period
moving average (the beige line). Then, as DIA traded sideways yesterday,
notice how the 20-MA continued to move lower. If DIA is going to move to new
lows, it will probably do so near the time the 20-MA drops down to touch the
current price. Notice how the 20-MA was the exact resistance that started the
August 24 reversal. It also acted as resistance on the morning of August 23.
This type of action is known as a "correction by time" because the sideways
action enables the market to digest a big move without bouncing higher, into
resistance of the 20-MA. Generally speaking, a "correction by time" is more
bearish than a "correction by price" because it indicates the market is so
weak that it can not muster up enough momentum to bounce higher. In uptrends,
the same scenario applies, except in reverse.

The same support and resistance levels we discussed in
yesterday’s Wagner Daily are in effect going into today, so you may
wish to review them if you are trading the broad-based ETFs. It probably goes
without saying, but be careful on the long side right now. With each of the
indices trading below their 50-day MAs, overall odds favor the short side of
the market, even though there may be a few pockets of sector strength. Keep
tight stops on any existing long positions and consider initiating new short
positions in sectors showing the most relative weakness to the broad market
(brokers, home builders, retail, et cetera). At the very least, remember that
having a cash position is better than fighting the trend of the market.

Open ETF positions: