STOCK MARKET FOR BEGINNER | Stock & Option Guide

BREAKING DOWN THE HEAD-AND-SHOULDERS IN THE S&P 500 — AN ALTERNATIVE FALLING WEDGE FOR THE S&P 500 — YEN AND SWISSY RISE IN THE FACE OF UNCERTAINTY — DOLLAR AND EURO STALL AFTER COUNTER-TREND MOVES

S&P 500 DECLINES FURTHER WITH A DANGEROUS DIVERGENCE … After a hair-raising decline on Tuesday, the S&P 500 continued lower on Wednesday. Buyers are simply nowhere to be found ahead of Friday’s employment report and the three day weekend. Chart 1 shows the index closing below 1040, which is below the lows from late May and early June. At this point, the ETF clearly formed a lower high around 1130 and closed below its prior closing lows. A lower high and lower lows make for a downtrend. After a 7.77% decline in 8 days, the index is getting oversold and ripe for a bounce. However, the knife is still falling with the blade pointing down. It reminds me of the 1970’s Life cereal commercial with Mikey. Just substitute words “buy before employment report” with the word “cereal”. Those looking for a refresher can search “Mikey likes it Life cereal” at youtube.

Momentum followers probably notice a positive divergence brewing with MACD over the last few weeks. While the S&P 500 closed below its late May and early June closing lows (red dotted lines), MACD formed a higher low in early June and remains above this low (green dotted line). This is a potentially bullish divergence. As the name implies, bullish divergences are allegedly bullish setups for momentum indicators. However, in reality, the bigger downtrend trumps the bullish divergence. In fact, bullish divergences are the norm, not the exception, in downtrends. Most of them fail to produce good buy signals, but they sometimes foreshadow weak bounces that will lead to a lower high. Just the opposite is true in uptrends, where bearish divergences are the norm, not the exception. Chart 2 shows MACD forming several bearish divergences during the 2009 rally (May-June, August-September, September-October, October-November). One will ultimately work, but there are usually a few bad signals before a good one.

BREAKING DOWN THE HEAD-AND-SHOULDERS IN THE S&P 500 … By now, the whole world is probably aware of the head-and-shoulders pattern at work on the S&P 500. Chart 3 shows the S&P 500 breaking neckline support to confirm the pattern. Based on traditional technical analysis, this would target a move to around 887. The height of the pattern is subtracted from the neckline break. John Murphy showed retracement targets yesterday with the 62% retracement target coming in around 880. Should the S&P 500 continue lower, broken support around 1040-1060 would turn into a resistance zone. There is sometimes a throwback rally to broken support. For now, the index is still within spitting distance of the neckline and has not declined enough to consider this area as resistance just yet.

Volume plays an important part in confirming a head-and-shoulders pattern. I am showing a close-only daily chart to make the most of On Balance Volume (OBV). The indicator window shows OBV moving lower in May and then drifting lower the last five weeks (blue dotted line). OBV is currently at its lowest level of the month. I would have expected a bigger decline, but OBV remains in a downtrend and needs to break above the June high to revive its uptrend.

AN ALTERNATIVE FALLING WEDGE FOR THE S&P 500 … There are two sides to every story. I am not about to present a bullish case for the S&P 500, but rather a less bearish cased based on a potential falling wedge. The right half of the head-and-shoulders pattern is a falling wedge. With the whole world turning bearish after the neckline support break, we should at least be prepared for the market to make fools of the most people possible. That is, after all, Mr Market’s specialty. Chart 4 confirms a downtrend since early May with the falling wedge lines. Drawing the Fibonacci Retracements Tool from the July low to the April high shows a 50-62% retracement zone around 1000-1050. The index entered this zone this week. A decline to the 62% retracement around 1000 is still possible. 1000 is also a round number that might grab some attention for support. This may be the first area to watch for a bounce. Technically, the trend remains down as long as the wedge falls with lower lows and lower highs. At this point, a close above the June high is needed to reverse this downtrend. We can lower resistance should another lower high form in the coming weeks.

YEN AND SWISSY RISE IN THE FACE OF UNCERTAINTY… International macro themes continue to dominate the US stock market. Equity markets in Europe and China are weak. US bonds are surging in a flight to safety. Gold remains strong as one of the few currency alternatives. Currency dynamics are also shaping the appetite for risk in global equities. Relative strength in the Yen and relative weakness in the Euro has been a common theme in the risk-off trade. The Swiss Franc also came alive in June with a big surge, especially against the Euro. I heard one analyst refer to currencies as dirty shirts. All the dirty shirts in the laundry basket stink, but some stink less than others. Over the last two weeks, the Yen and Swiss Franc show big gains. The Swissy, as it is called sometimes, was considered a safe-haven currency, but its banking woes and close ties to Europe kept it down. This seems to be changing. Chart 5 shows the Swiss Franc ETF (FXF) surging higher over the last four weeks. Most of these gains are at the expense of the Euro. Chart 6 shows the Yen ETF (FXY) breaking wedge resistance over the last few weeks. The pattern over the last 20 months looks like a large cup-with-handle. Rim resistance resides around 115 and a breakout would be bullish for the Yen, but bearish for just about everything else.

DOLLAR AND EURO STALL AFTER COUNTER-TREND MOVES… The DB Dollar Bullish ETF (UUP) and the Euro ETF (FXE) are closely correlated due to the construction of the US Dollar Index ($USD). The Euro accounts for over 50% of the US Dollar Index and the DB Dollar Bullish ETF. As such, the Dollar Index and Dollar ETF move pretty much opposite the Euro. Chart 7 shows the DB Dollar Bullish ETF (UUP) stalling around 25. The overall trend remains up, but the ETF has yet to recover from the sharp decline three weeks ago. Look for a move above 25.20 to revive the uptrend in the Dollar. Chart 8 shows the Euro ETF (FXE) stalling just below broken support. This is no ordinary support level though. This break forged multi-year lows in the Euro ETF and now turns into resistance. After becoming oversold, the ETF bounced above 122.5, but fell back again this week. Follow through above the June highs is needed to spark a rally in the Euro. As the chart now stands, the Euro failed and the bears are still in control.

By Arthur Hill

ONCE AGAIN, FOREIGN STOCKS LEAD GLOBAL DECLINE — MORE 200-DAY AVERAGES ARE BEING BROKEN — REVIEW OF POTENTIAL DOWNSIDE TARGETS

DOWNGRADE OF CHINA GROWTH CONTRIBUTES TO SELLING … As has been the case since the market top in May, foreign stocks are leading the global retreat in stocks. Today’s main headline was a downgrade in Chinese economic growth. That’s not too much of a surprise to those of us who have been watching (and reporting on) the downturn in Chinese stocks. Arthur Hill wrote about relative weakness in the Chinese stock market just last Wednesday. The Shanghai Index fell more than 4% today to another 52-week low today. Chart 1 shows that the Chinese market has been falling since the end of 2009 and has been one of the world’s weakest markets. I’ve written several times that Chinese stock weakness was bad for global stocks and commodities. Today’s plunge in foreign stocks set a very negative tone which is pulling U.S. stocks (and commodities) sharply lower. Most foreign currencies are falling against the safe haven U.S. dollar. The Japanese yen (another safe haven) is the day’s strongest currency. Treasury bonds and investment grade corporates continue to attract scared money. Riskier high-yield corporate bonds are experiencing some profit-taking.

MORE 200-DAY AVERAGES ARE BROKEN… All major U.S. stock indexes started the week trading below their 200-day moving averages which is bearish sign. Up until today, several group indexes managed to stay above that long-term support line. Unfortunately, most of them are breaking that line today. The list of breakdowns include the Consumer Discretionary SPDR (Chart 2), Russell 2000 Small Cap Index (Chart 3), S&P Midcap Index (not shown), the Nasdaq 100 (Chart 4), the Semiconductor Index (Chart 5) and the Dow Transports (Chart 6). [Several sector indexes have experienced a "dead cross" when their 50-day averages fell below their 200-day lines. That list includes materials (XLB), healthcare (XLV), and energy (XLE). So far, only the New York Composite Index has experienced a dead cross owing to its heavy material weighting]. Most foreign stock indexes (including China) have already experienced the “dead cross”. That’s an even more bearish sign for them and increases the odds that U.S. indexes will break their February lows.

DOWNSIDE TARGETS FOR S&P 500 REVISITED … I wrote a message on May 25 entitled: “Most Foreign Stocks Have Already Broken Their February Lows — Technical Odds Suggest the US Market Will Probably Do the Same — Using Fibonacci Retracement Lines to Look For Possible Downside Targets If the February Low is Broken”. I applied those potential support lines to a weekly S&P 500 chart which are repeated in Chart 7. The support lines were 1010 (a 38% retracement of the 2009-2010 rally), 945 (50% retracement), and 880 (62% retracement). Let’s refine those targets a little more. The January/June peak has the look of a “head and shoulders” top which would be confirmed by a break of the February lows (which appears likely). There are two ways to measure a potential downside target from a H&S top. The first is to double the size of the first downleg which was 180 points (using intra-day prices). That projects a downside target to 860 (which I would round up to the 62% line at 880). A more conservative procedure subtracts the 180 points from the June peak at 1131 which measures to 950 (which corresponds closely to the 50% line). I ended the May 25 message with the opinion that: “A drop into that zone could provide a buying opportunity during the second half of the year (especially in the autumn) when the four-year presidential cycle bottom is schedule to appear”. I repeated that view in a more recent message. The only problem was that I expected more of a bounce (a summer rally) before the second half downturn. Last week’s market downturn, however, ruled out a summer rally having started.

HOW TO SPOT THE END OF RALLY… A number of readers asked what happened to the summer rally that I wrote about recently. As you may recall, I was expecting the recent bounce to carry into July before turning back down into the autumn. That’s the normal pattern. The short answer is that the rally ended quicker than I expected. But it didn’t go unnoticed by either myself or Arthur Hill (please see last week’s bearish messages). I expected more of a short-term rally when the S&P 500 rose above its June peak at 1105 and its 200-day average. I then expected a test of its 50-day line. The market tested that upper resistance line and retraced exactly 50% of its April/June decline. Then things turned sour. One of the big advantages of charting is that it tells us pretty quickly when something has gone wrong. That became pretty obvious when the S&P 500 closed back below its January peak and its 200-day line (which I pointed out last Tuesday). It then became clear that the June low would be retested. I suggested last Thursday that it was time to take more stock money off the table and consider bear fund protection. It’s important to distinguish between “short-term” trades and a “longer-term” strategy. On June 17, I advised that “while short-term traders might want to play a short-term summer bounce, longer-term investors might be better advised to wait until the autumn”. By now, short-term traders have exited the market (or gone short), while longer-term investors are still on the sidelines (or in a more defensive mode). I don’t apologize for changing an opinion if the market dictates a change. The main goal is to get it right.

By John Murphy

A KEY TEST FOR THE STEEL ETF — CONSUMER STAPLES LEAD MIXED MARKET — TOBACCO STOCKS LEAD CONSUMER STAPLES HIGHER — EURO ETF CONSOLIDATES AT RESISTANCE — INTEREST RATES CONTINUE TO FALL — 1-YEAR TREASURY YIELD FORESHADOWS STOCK MARKET

MOMENTUM TURNS BEARISH FOR THE MATERIALS SECTOR… The Materials SPDR (XLB) showed some relative weakness on Monday as the sector with the second largest loss (behind energy). Chart 1 shows XLB with a rather volatile range since late May. XLB tested the February low with two long white candlesticks in May, but then broke to new lows with a plunge in early June. The ETF recovered along with the broader market and broke above its late May high. However, this breakout did not hold very long. In fact, this breakout held less than one day. XLB appeared to break resistance with a strong open last Monday, but the ETF moved lower after the open and closed below resistance. No breakout. Further more, XLB declined sharply the last few days and CCI broke below zero. This centerline tells us when the momentum cup is half full (bullish bias) and half empty (bearish bias). The red and green dotted lines show prior crosses. These signals are not perfect, but they can be used in conjunction with other technical indications. At this point, the failed breakout and last week’s sharp decline are bearish until proven otherwise. XLB tried to firm near the 62% retracement on Friday and then fell back again on Monday. At the very least, look for a break above 30.5 to revive the bulls. A close above resistance at 31.2 is needed to fully reverse the downtrend.

A KEY TEST FOR THE MARKET VECTORS STEEL ETF … Chart 2 shows the Market Vectors Steel ETF (SLX) with a rising wedge over the last few weeks. This wedge retraced 38-50% of the April-May decline. For now, the wedge is still rising as SLX tests the lower trendline. The indicator window shows the Commodity Channel Index (CCI) testing the zero line as the ETF tests its wedge trendline. Prior zero line crosses (green/red lines) generated pretty good signals in the recent past. Even though past performance does not guarantee for future performance and indicators can produce whipsaws, a CCI move into negative territory would be bearish for momentum. This would likely coincide with a break below the wedge trendline. A key test lies ahead this week for the Market Vectors Steel ETF.

CONSUMER STAPLES LEAD MIXED MARKET… The Consumer Staples SPDR (XLP)showed some relative strength as the sector with the largest gain on Monday. Even though XLP has been following the broader market since late April, it is holding up better on a percentage basis. Chart 3 shows XLP testing support from the February-May-June lows with a bounce today. This is the third bounce off the support zone in the last five weeks. The indicator window shows XLP relative to the Consumer Discretionary SPDR (XLY). These are two diametrically opposed sectors. Consumer staples represent necessities such as soap, toothpaste, groceries and tobacco. Consumer discretionary represents non-necessities such as clothes, electronics and restaurants. The overall market performs best when the consumer discretionary sector outperforms the consumer staples sector. Conversely, stocks perform poorly when the consumer staples sector outperforms. This reflects a defensive market that is risk adverse. As the chart shows, the price relative broke triangle resistance and edged above its May high. The consumer staples sector is outperforming the consumer discretionary and this is negative for the market overall. Notice how the consumer staples underperformed from February to late April. This period was positive for the stocks.

TOBACCO STOCKS LEAD CONSUMER STAPLES HIGHER… A surge in stocks of tobacco companies is helping the consumer staples sector. There are also gains to be found in Wal-mart (WMT), Procter & Gamble (PG), Kroger (KR) and Coca-cola (KO). Tobacco stocks were up after the Supreme Court rejected an attempt by the Justice Department to grab as much as $280 billion in tobacco company profits. Chart 4 shows Reynolds America (RAI) holding its February low in late May and working its way higher in June. The stock surged over 4% on Monday. Chart 5 showsAltria (MO) holding well above its February low and surging above resistance with a high volume move on Monday. Chart 6 shows Kroger (KR) with a pennant consolidation over the last six days. A move above 20.5 would break pennat resistance, while a break below 19.8 would break pennant support.

EURO ETF CONSOLIDATES AT RESISTANCE… Chart 7 shows the Euro ETF (FXE) surging in mid June and then stalling the last two weeks. The ETF has traded between 122 and 124 since June 15th. What happens at resistance could affect US stocks. A break above the June highs would signal a continuation of the mid June advance and project further strength. Another bounce in the Euro would show some confidence in the European debt situation and this could provide a lift for US stocks. This would stimulate the appetite for risk. Failure to break above 124 and a break below 122 would argue for a continuation of the downtrend. This could trigger a flight to safety that would be negative for US stocks and oil. The indicator window shows RSI meeting resistance in the 50-60 zone for at least the third time since March. A break above 60 is needed to turn momentum bullish.

INTEREST RATES CONTINUE TO FALL… The 10-Year Treasury Yield ($TNX) fell further today and forged another new 52-week low. Chart 8 shows the yield breaking triangle support last week and falling below 3.10% today (31 on the chart). The indicator window shows the 10-Year Treasury Yield along with the S&P 500. As John Murphy wrote last week, stocks and interest rates have been positively correlated the last few years. Most recently, both declined from April until June. The S&P 500 remains above its June low, but the 10-Year Treasury Yield broke below its June low. Should this positive correlation hold, we can expect stocks follow yields lower. Chart 9 shows the 10-Year Treasury Yield breaking below its September 2009 low over the last two weeks. This is also negative for stocks.

By Arthur Hill