A Head and Shoulders BOTTOM!?!?

There has been a certain amount of chatter lately re the prospects of a head and shoulders topping pattern. To the best of my knowledge, however, I am unaware of anyone who has put forth the prospects of a head and shoulders BOTTOM. So, here goes.

The accompanying chart illustrates the prospective bullish pattern with the obvious necessary future price action to make it happen. While not fitting the textbook version of the pattern, considering the heavy bearish sentiment in the air such an outcome would have to rank fairly high as a contrarian call. The measured move of the pattern is not a biggie – 100 points above the neckline, which is around 1120. That means the upside potential is limited to the approximately the previous high, which is around 1220. And that gets us into a whole other set of potential patterns. (Double tops, anyone?)

A Word of Caution

As someone who has conducted numerous events and interviews with some of the very best in technical analysis, when it comes to head and shoulders patterns there is one piece of advice each of these veterans of technical analysis cite: NEVER anticipate a head and shoulders pattern. Like a good boy scout, being prepared is always a good thing to do. Whether to act or not before the fact is risky business.

That said, acting on what others might act on can be a profitable exercise. Which brings me to the main point of this blog commentary.

If you have read my blog for any length of time you know I am not a chart pattern guy. Like investor sentiment and volume measures, I find chart patterns necessary to be aware of as so many others reference and sometimes act upon them. However, as a highly predictive tool in and of themselves, not so reliable. Therefore, as a student of the market, it is essential that I understand the market structure and the behavioral aspects of how the game is played. In other words, knowing the nature of the beast (structure and participants) should be an essential part of every investor’s investment decision-making toolkit.

Accordingly, the structure of the market (e.g. high frequency trading, the role of ETFs, dark pools and structured products and how they disguise the true nature of investor interest) and the players, their motives and behavior (e.g. hedge funds, traditional institutional investors, the virtual disappearance of individual investors) has become an essential part of the investment decision-making process. Put differently, if you are sitting at a card table and don't know who the sucker is, it's you. In all this, pattern recognition and other use such tools (that others tend to use) are most helpful when it comes to playing the game, hopefully tilting the odds more in your favor.

What About The Bounce?

By the way, the bounce potential for stocks is intact. The bottom parts of the accompanying chart show near term weakness (momentum and MACD) and a short term oversold (slow stochastics). The conclusion reached the other day is unchanged – a bounce and little more.

Whether the bounce is like a ball going down a flight of stairs, bouncing up after each progressive lower step (the reverse of most of last year’s market action) or the start of some stabilization culminating in the head and shoulders bottom remains to be seen.

What About Small Caps?

There are two primary reasons to watch the performance of small cap versus their large cap brethren. First, being a generally higher risk category, small caps provide an insight into the degree of risk appetite investors have for equities. Second, because they tend to be more US centric in their businesses, the performance can provide some insight into investors' expectations on the US economy, in general, and US centric companies, specifically. So, what does the accompanying chart and related data reveal?

The underperformance since the April 23rd high is apparent, but not so dramatic as to warrant ringing the bearish bell on the sector and market overall. In fact, since the bull market got started in March 2009, the group has underperformed the broad market more dramatically last fall only to rebound quite nicely shortly thereafter. Moreover, last fall's relative performance slide was accompanied by a meaningful divergence breaking to a lower low while the S&P 500 not only held above its correction low but was actually trending upward. Contrast that with the present, where it has yet to break below its previous pullback low. And even if it does, it does not appear to divergence in the dramatic fashion serious market tops typically indicate.

When looking at the index itself, there is nothing that stands out vis a vis the action of the S&P 500. Both have deteriorating long term Mega Trends, solidly down near term trends (momentum and MACD), and are into strong short term oversold territory.

From a fundamental point of view, the higher P/E for the group and higher projected growth in earnings for the next 12 months compared to the large cap S&P 500 is something of a concern but does not fall into grossly overvalued territory.

Investment Strategy Implications

Small caps are not helpful for the bull case. Neither are they overly hurtful. At least, not yet.

The bounce is still the most likely next move for stocks. What follows will help clarify the picture and should lead to a resolution of the multi month trading range that stocks have been locked into since last fall.

A Bounce and Little More

The following is primarily for those who are very short term oriented.

I have some bad news for the bulls: the hoped for bullish non confirmation is not occurring. Here's why:

The first chart shows the internal divergence dynamics of the market. What you see are lower lows being made in momentum and MACD. Contrast that with the July 2 low when momentum was going sideways and MACD headed upward. In both cases, the short term indicator, slow stochastics, is oversold and lends itself toward helping a sold out market bounce.

It is also worth pointing out that on July 2 the Mega Trend* was in modestly better bullish shape. This time, it is right on the cusp of a bearish call.

The second chart illustrates the external divergence dynamics and compares the S&P 500 to the EAFE (EFA), Asia Pacific ex Japan (EPP), Europe 350 (IEV), and Emerging Markets (EEM). At present, all markets (save EEM) are making confirming lower lows. And EEM is just a hair away from joining the parade. Contrast that (through the spaghetti lines) to the price lows made by most markets in late May, which when the S&P 500 made a lower low on July 2 the other markets did not. All of them save none were at or above their May lows, including the sick man of markets - Europe.

Bottom Line: Bounce potential exists. Then we have to do it all over again and make non confirmed lower lows. One bright spot in all this - there is the real potential of a more significant bullish non confirmation call should stocks bounce then slip below the current lows. In the process of the bounce, emerging markets might take themselves sufficiently high enough that the lower low in developed markets will more clearly not be confirmed. The dark lining on this seemingly silver cloud is the fact that in the process of making that lower low in the S&P 500 the Mega Trend will likely turn bearish.

As noted many times since the end of last year, nothing has been easy for equity investors this year.

Note: There is another serious issue to consider - the recent poor relative performance in small and micro cap issues. I will describe this issue tomorrow.

*Use the search function in the top left area of this blog to read comments and definitions on the Mega Trend.

Parked At the Gate

The following is primarily for those who are very short term oriented.

We are parked at the gate for a decent bullish non confirmation signal - provided the following: Should the S&P 500 break below its intra day and closing lows of August 16 (1069 and 1079, respectively), which given the deterioration in momentum and MACD and the failing rally (see first chart* and prior blog posts) seems likely, the key to watch for is whether that low is matched (i.e., confirmed) by other important indices - such as the EAFE (EFA) and emerging markets (EEM).

As the second chart shows, EFA may break to a new low as its momentum and MACD are showing most of the same signs that the S&P 500 is. However, as the third chart shows, EEM is in better shape but it, too, has deteriorating momentum and MACD readings.

Investment Strategy Implications

It looks like my "failing rally" blog posting warning two days ago has occurred. Now, watch for the downside break with a non confirmation in the above noted and other indices to see if the S&P 500 has company (making new lower lows). If it does, then the second scenario noted last Thursday will apply. If it doesn't, then the first one applies.

The bears prefer the former while the bulls the latter. Stay tuned.

Note: This is primarily all short term stuff. For investors, it is important to note that none of the above resolves the longer term trading range, which will determine the next major trend move for the market.

* click images to enlarge

A Failing Rally?

As the accompanying chart shows, a crossover in the near term indicators tracked (momentum and MACD) occurred last week. That crossover suggests several weeks (or more) of work to undo the damage. However, today's bounce (while certainly justifiable on economic terms for a number of reasons) is taking place very early in the undo-the-damage process.

Given the short term oversold (third indicator - slow stochastics), the bounce is not entirely unexpected. However, in light of the aforementioned crossover, the bounce today has all the characteristics of a failing rally.

Therefore, out of the four probable market sequence outcomes noted last Thursday, the first two referencing a failing rally now appear to be the most likely.

Whichever market sequence ultimately plays out, however, it is toward a resolution of the multi month trading range that the market sequencing outcomes have the greatest value.

Market Sequencing

The following four charts depict the four most probable sequences for stocks over the near term. They are representative of my Investment Theory of Relativity, which I have described in previous blog postings and reports to subscribers but will do so more formally in future blog postings.

Vinny on Bloomberg radio

In case you missed the Monday appearance on "Taking Stock with Pimm Fox", you can listen to it on the Blue Marble Research media blog, Beyond the Sound Bite.

Could Be Wrong, But...

To all investors in the bold category (>90% in equities):

* Not sure how anyone can read today's Fed minutes as anything but bearish. The Fed is impotent when it comes to the primary issue in the US - employment. Taking the baby step of QE2 lite will do virtually nothing to help the situation.

* What's the next bullish catalyst for stocks? We are passed earnings season, now what?

* Analyst reports today re Intel not good re 3Q10 orders.

* Technicals are poised for downside breaks - first pullback, then rally, then ????

Now that investors are getting comfortable with deceleration but no recession, the greater risk appears to be on bullish disappointment side of the equation.

That said, it is always advisable to remember the Keynesian beauty contest: It's not who you think will win, but who you think everyone else thinks will win.

The Fed's Kobayashi Maru

For the equity markets, the Fed faces a no win scenario today.

If it eases, it sends both a contradictory signal re Obama and Geithner and a message that things are worse than the US economic deceleration data suggest (see prior post below).

If it doesn't, then the fast money crowd (they are the market) will likely react rather dourly, throwing their usual temper tantrum when not getting their short term way*.

The accompanying chart** shows the key internal market indicators at their tipping points. Should the decline broaden out, it will most likely NOT lead to anything more than a pullback of modest proportions as there are virtually NO divergences (either internal or external) at this time (not to mention the fact that the Mega Trend is bullish).

A decline, however, will set the stage for such divergences to develop. The likely timeframe for clarity on this is 2 to 4 weeks.

P.S. With President Barack Tuvok Spock in the White House, is Captain Kirk at the Fed?

*Given their generally abysmal performance this year, many hedgies are on edge and will act rather dramatically to preserve what little gains they have.

**click image to enlarge

Why Would The Fed Act Today?

In light of the poor productivity report issued this morning, an even greater amount of focus is on today's FOMC meeting. The politically propitious time for the Fed to act would be today, but it likely won't. Here's why:

With rates zero bound, some are hoping that the Fed will take further quantitative easing steps (a so called QE2) to help prevent a clearly decelerating US economy from decelerating right into a recession. Yet, one data point does not a trend make. Clearly, the US economy is decelerating. Macro economic data issued since mid May have been consistently coming in BELOW consensus expectations. Yet, not all the data is pointing south (see ISM reports issued last week), and most that do tend to disappoint modestly. Therefore, it is more than a stretch to conclude at this time that deceleration will inevitably lead to recession. Certainly, global growth data does not support such a negatively certain outcome. Moreover, this morning Economic Cycle Research Institute managing director (and recent Beyond the Sound Bite guest), Laksman Achuthan, stated that their data does not conclude a recessionary outcome.

Then you have the feedback from the financial markets, which have sent a fairly sanguine signal this summer re the current and future economic climate. Lastly, we have the political dimension in all this.

If the Fed were going to act, now would be the politically appropriate time as the next meeting will be much too close to the mid term elections and would be almost certainly perceived as politically motivated. Yet, in light of the Treasury Secretary Geithner's recent NY Times "Welcome to the Recovery" op-ed piece along with the Obama administration's self-described "summer of recovery" road show, an act of further monetary accommodation by the Fed today would send a signal of confusion and lack of coordination between the key branches of government. Obama and company say yippee, while Bernanke says uh oh?

Given these factors the question becomes, "Why would the Fed act today?"

Upcoming Media Appearances

Bloomberg radio, "Taking Stock with Pimm Fox", today, Monday, August 9, @ 4 pm (eastern)

Vinny on Yahoo Finance "Tech Ticker"

My Yahoo Finance Tech Ticker appearance with Savita Subramanian, Chief US Quant Strategist, Bank of America/Merrill Lynch is posted and can be found at BeyondTheSoundBite.blogspot.com

I Would Love To Sell But...

I feel like a cat on a very hot tin roof. And it isn't the heat wave that's causing my furry investment pads to cook. It's this damn summer bounce within a cyclical bull within a secular bear that's making me so jittery.

I would rather see the bearish signals first generated by certain global markets (Europe, most notably) spread to all markets and produce a clear downside signal. Unfortunately, when it comes to the social science of investing the best laid plans of mice and men have a nasty habit of following their own path and rhythm.

So, as much as I want to write the blog posting before summer's end fittingly titled "Everyone Out of the Pool", I cannot. Or as Orson Welles said in a commercial of years ago, "We will sell no wine before its time". For me, the same applies to the current stock market environment.

Here is why:

1 - The Mega Trend* for the S&P 500 never went negative. As I noted several weeks ago (Death Cross: Fact and Fiction), the false signal produced by the so-called death cross using the simple moving average was not generated using the exponential moving average. Therefore, the bullish Mega Trend is intact. Until the market generates a Mega Trend reversal, the existing trend (which is bullish) must be presumed to be in force. This is quite clear in the first chart.

2 - There are still no important divergences - not internally (Momentum and MACD, first chart) nor externally (inter market, see chart #2). None. Zero. Zippo.**

Re internally generated divergences: as I noted last week it is only when both momentum and MACD generate a divergent signal from price that the odds of a near term trend reversal increase to a sufficient degree to take action. The past week has proved that view. And here we stand one week later with momentum now rejoining MACD in bullish near term confirmation of price (first chart).

Investment Strategy Implications

Cautiously bullish (equity exposure between 60 and 90%), generate absolute returns, lose alpha. Could be worse.

*Use the search function in the top left section of this blog to find prior postings (there are many) re the Mega Trend.

**It is true that there are times when fully synchronized and confirmed markets do reverse themselves. But they are the exception and not the rule. Therefore, it seems advisable to go with the higher probabilities that divergences produce.