The Wagner Daily | August 26, 2005

Commentary:

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 traded in a very tight and narrow four-point range before finishing the day 0.2% higher. Intraday action in the Dow Jones Industrials, which also gained 0.2%, was equally uneventful. The Nasdaq Composite advanced 0.3%, while both the S&P 400 Midcap and Russell 2000 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 ($DJU) gained 1.2%, while Home Construction ($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, the exchange traded fund 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 sold off sharply on the afternoon of 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.

Today’s Watchlist:

ICF – iShares REIT
Short

Trigger = below 72.90 (below 20-MA on hourly chart)
Target = 69.80 (just below support of neckline)
Stop = 74.75 (above Aug. 16 high)
Shares = 300

Notes = We sent out an intraday alert to enter this trade yesterday, but it did not trigger. So, now we are listing it as an “official” setup for today. Explanation of the trade is in the commentary above. Although our target is only at the neckline near $70, we will re-evaluate at the time and may adjust the target lower if the head and shoulders pattern follows through to the downside.

Daily Reality Report:

Below is an overview of all open positions, as well as a performance report on all positions that were closed only since the previous day’s newsletter. Net P/L figures are based on the $50,000 Wagner Daily model account size. Changes to open positions since the previous report are listed in red text below:

Open positions (coming into today):

will add 150 shares below 128.10

unrealized P/L = ($53)

BBH long (100 shares from Aug. 24) –
bought 190.85, stop 188.73, target new highs (will trail stop), unrealized points = (1.34), unrealized P/L = ($134)

Closed positions (since last report):

net P/L = ($134)

Current equity exposure ($100,000 max. buying power):

$38,309

Notes:

Click
here for glossary and explanation of terms used in The Wagner Daily

Click here to view MTG’s past performance results (updated monthly).

Edited by Deron Wagner,
MTG Founder and
Head Trader