Commentary:
The major stock market indexes attempted to follow-through on last Friday’s gains yesterday morning, but weakness during the final hour of trading caused stocks to give up early gains and close near the flat line. The Nasdaq Composite slipped 0.1%, the S&P 500 advanced 0.1%, and the Dow Jones Industrial Average was unchanged. The small-cap Russell 2000 lost 0.3%, while the S&P Midcap 400 eked out a gain of 0.1%. The Nasdaq Composite closed in the bottom third of its intraday range. The rest of the major indices settled near the middle of their ranges.
Turnover fell to its lowest levels in weeks, causing volume in both exchanges to come in below 50-day average levels. In both the NYSE and Nasdaq, total volume dropped 15% below the previous day’s levels. As stocks have tried to recover from last week’s sell-off over the past two days, volume has successively dried up in both sessions. Advancing volume in the NYSE was on par with declining volume, but the Nasdaq ratio was fractionally negative.
Many of the international ETFs, among the best performers of the recent bull run, have begun to form bearish “head and shoulders” chart patterns since last week’s correction began. If you’re long any of the international ETFs, this should be a warning sign to tighten your stops and/or be prepared to reverse your positions. The iShares Brazil Index (EWZ) is one such international ETF that is forming the right shoulder of a “head and shoulders” pattern, easily seen on the hourly chart. We have labeled the components of the “head and shoulders” pattern on the hourly chart of EWZ below:
If targeting a “head and shoulders” pattern for potential short entry, there are typically two valid entry points. The first is during the formation of the “right shoulder.” In the case of EWZ, this has been forming over the past two days. With this method of short entry, there is a higher chance that the pattern will fail to follow-through to the downside, instead invalidating the pattern by rallying above the “head.” However, the benefit of entering on the right shoulder is a better risk/reward ratio. With a “head and shoulders” pattern, the predicted drop is equal to the distance measured from the top of the “head,” down to the “neckline.” Using EWZ as an example, that equates to a downside target of approximately 6 points below the neckline (just below $50). From a point of entry near the current price ($59.22), this would represent a downside profit target of 9 points. With a protective stop just over the top of the “head” (around $62), you would be risking just 3 points. If risking 3 points to net a potential gain of 9 points, you would have a risk/reward ratio of 1 to 3 (3 divided by 9). Although a 1 to 3 ratio is a good risk to take, realize there are greater odds of the pattern failing and being stopped out when selling short during the formation of the “right shoulder.”
The second way to enter a “head and shoulders” pattern is to wait for a break of the “neckline.” By doing so, odds are much greater that the pattern does what it is “supposed” to do by following through to the downside. However, the risk/reward ratio is also lower. With an entry below the neckline, we usually set a protective stop based on a 61.8% Fibonacci retracement from the neckline, up to the top of the “right shoulder,” making sure that the stop is also above any 20 or 50-day moving averages in that vicinity. With this type of short entry on EWZ, it would equate to a stop just over the $58 level, which also clears forces EWZ to recover back above its 20-day EMA. Risking nearly 3 points to net a potential gain of 6 points reduces your risk/reward ratio to 1 to 2, the minimum we look for with any new trade entry.
In addition to EWZ, there are a plethora of other international ETFs that have formed similar patterns over the past several weeks. The iShares Emerging Markets Index (EEM) has also formed the right shoulder of a “head and shoulders” pattern, but we stopped out yesterday because we set our initial stop a bit too aggressively the previous day. In hindsight, we may have been a bit too early on the EEM short entry, but we have no problem re-entering it, or another international ETF, after confirmation of downside follow-through seems likely. A break below yesterday’s lows would put many of the international ETFs back below their 20-day EMAs, increasing the odds of a “neckline” break. For a thorough list of other international ETFs to check out, please download the free Morpheus ETF Roundup.
Like the Utilities HOLDR (UTH) that recently collapsed, the streetTRACKS Metals and Mining (XME) is another ETF that has begun to roll over. Take a look:
On June 1, XME broke out to a new all-time high from a multi-week base of consolidation. If this occurs and the breakout “sticks,” it is normally quite bullish. However, it is equally bearish when the breakout above the pivot fails to hold because it traps the people who bought the breakout, forcing them to sell. This, of course, creates additional selling pressure that subsequently attracts short sellers. The end result is that failed breakouts often reverse fast and furiously. So far, that’s what appears to be in the making with XME. Specifically, it’s bearish that it fell from a new record high, below its pivot, down to its 50-day MA, in less than one week. Last Friday’s bounce off the 50-MA was positive, but XME failed to hold on to the recovery bounce in yesterday’s session. Instead, it gapped down, then showed relative weakness the whole day. It eventually closed just below its 50-day MA. Not only has the failed breakout created resistance, but the inability to hold last Friday’s gains has created a lot of overhead supply as well. The next move in XME is likely to the downside, so we entered a new short position in XME near its intraday high yesterday.
With the major indices holding above their 50-day MAs, last week’s sell-off has not yet killed the market, but ETFs or sectors with decisively bullish short-term chart patterns are now few and far between. Even the typically defensive sectors such as Gold are now looking pretty negative. Perhaps the sector ETF with the most relative strength is the Semiconductor HOLDR (SMH). As you may recall, we bought SMH a few weeks ago when it appeared to be reversing its downtrend, but we quickly scratched the trade last week when it failed to hold above its 20-day EMA. Since then, SMH has dipped below its 50-day MA, shaken out the “weak hands,” then bounced back firmly above its 50-day MA last Friday. It pulled back a bit yesterday and closed just a hair below its 20-day EMA. More importantly, the “undercut” below the 50-day MA and subsequent recovery has positioned SMH to break out above its newly anchored downtrend line:
Because we have been discussing the value of being positioned on both sides of the market right now, SMH is one of the better ETFs to be long. However, it’s important to wait for a break of the downtrend line illustrated above. This simply correlates to a rally above yesterday’s high. We are stalking SMH for such a potential buy entry. Regular subscribers should note the trigger, stop, and target prices for SMH long entry below.
Today’s Watchlist:
SMH – Semiconductor HOLDR
Long
Shares = 400
Trigger = 36.93 (above the downtrend line)
Stop = 36.04 (below the 50-day MA and 61.8% Fibo retracement)
Target = new 52-week high (will trail stop)
Dividend Date = Regular distribution on individual stock basis
Notes = We scratched this trade last week when it failed to hold above its 20-day EMA. Since then, SMH has dipped below its 50-day MA and shaken out the “weak hands,” but bounced back sharply on Friday. It is now back above its 20-day EMA and poised to break out above its newly anchored downtrend line. If it does, we will buy it. As previously discussed, it is wise to currently be positioned on both sides of the market, long the ETFs with relative strength, and short those with relative weakness. Given last Friday’s impressive performance that followed an “undercut” below the 50-day MA, SMH is now one of the best looking sectors on the long side.
Daily Performance 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:
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Open positions (coming into today):
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EWO short (300 shares from June 6 entry) – sold short 40.77, stop 41.13, target 37.75, unrealized points = + 0.58, unrealized P/L = + $174
DXD long (250 shares from June 6 entry) – bought 50.00, stop 49.59, target 53.18, unrealized points = + 0.55, unrealized P/L = + $138
XME short (200 shares from June 11 entry) – sold short 63.55, stop 65.82, target 58.90, unrealized points = + 0.53, unrealized P/L = + $106
Closed positions (since last report):
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DBC long (400 shares from June 7 entry) – bought 26.07, sold 25.72, points = (0.35), net P/L = ($148)
EEM short (150 shares from June 8 entry) – sold short 124.71, covered 127.73, points = (3.02), net P/L = ($456)
Current equity exposure ($100,000 max. buying power):
- $37,298
Notes:
Per intraday e-mail alert, we made a judgment call to sell DBC into the morning bounce, as its recent breakout to a new high had failed. It subsequently recovered further intraday, but still closed below the pivot. Crude oil’s looking okay, but gold is technically looking pretty bad and will weigh on DBC unless it somehow recovered quickly.
EEM stopped out, but we subsequently entered a new short position in XME. When the market sold off in the afternoon, XME showed more relative weakness than EEM, so the trade is looking good so far. We like how XME failed to close above its 50-day MA after bouncing sharply off it last Friday. Expect further downside in the Metals and Mining sector. Our long setup in SMH did not trigger, but remains on the watchlist going into today’s session.
Edited by Deron Wagner,
MTG Founder and
Head Trader