Broad Market Analysis - International ETFs forming "head and shoulders" patterns
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 to The Wagner Daily should note the trigger, stop, and target prices for SMH long entry below.
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In this column, MTG presents you with a FREE, actual trade setup that we are stalking for entry at some point during the week. Note that, unlike the daily guidance that regular Stalk Sheet subscribers receive, this free Stalk of the Week does not take into account overall broad market conditions that can easily affect the trade over the next several days. This week's setup is:
Click to receive your free 1-month trial to The MTG Stalk Sheet so that you can receive an average of one to three trade ideas such as this one on a daily basis (limit one free trial per household). Subscribers are always provided with detailed entry, stop, and target prices for each trade, and intraday e-mail alerts are sent as needed.
Below is the weekly commentary that accompanied this week's updated ETF Trend Tracker that was e-mailed to subscribers at the beginning of the week. The Morpheus ETF Trend Tracker, a perfect supplement to the ETF Roundup guide, is a comprehensive table of Exchange Traded Funds (ETFs) designed for informed investors and longer-term traders who prefer to hold their ETF positions for a few weeks to several months at a time. Based exclusively on a weekly analysis of trendlines on the daily and weekly charts, the ETF Trend Tracker provides subscribers with a thorough snapshot of the primary trend direction of ETFs in every category from broad-based to industry sector to international. This information is e-mailed to subscribers weekly, in a user-friendly format that groups ETFs based on the direction of their primary trends.
Commentary:Volatility picked up last week, as several of the major indices broke support of their 20-day moving averages and uptrending channels. This caused several MTG Stops (S1) and Reversal Stops (S2) to become hit along the way. More stops will trigger in the coming week if the weakness continues. The price action over the next several weeks is likely to determine the market's direction throughout the summer. Stocks attempted to recover some of their losses on Friday, but the attempt was met with lower volume. The recent "swing highs," an excellent way to determine resistance, were far from being breached.
Several ETFs reversed onto the "descending trend" list, but many industry sectors were already showing weakness to begin with. The sectors that triggered to the bearish list are those that were on the "ascending trend" list, but were showing relative weakness by not participating in broad market rallies in recent weeks. Some of the ETFs that reversed were already on the "ascending trend" list for several months, so sizable gains of 10 - 20% were locked in when the reversal stops were hit. Numerous other stops are updated, some aggressively, meaning stops are set very close to the current prices. Please review this week's updated ETF Trend Tracker for updated information. Remember that rows shaded in the color of blue are those that reversed their trends since the previous week's report. Cells shaded in pink indicate changes to the stop prices since last week. Scanning each week's report using the color coded system is an efficient way to quickly determine what has changed in the ETF markets since the last report.
As anticipated, our focus ETF from two weeks ago (XLV) has trended well as a short-term, counter-trend trade. The US Dollar is making gains on the Euro, causing FXE to fade lower, but it is approaching near-term support.
A surge in treasury rates caused the bond (fixed-income) ETFs to crumble last week. Obviously, these "defensive" ETFs are not a good place to hide right now. We are not seeing rotation out of the equities markets and into the bond markets. Don't forget that cash is always a valid position. Even a short-term, 3-month CD may be good to ride out the instability.
An unusual situation occurred in the Canada ETF (EWC) last week. At 9:56 AM EST on Friday. June 8th, trading spiked significantly lower, then recovered just one minute later. If you got caught and were stopped out, we suggest you contact your broker and ask them to "bust the trade." Every broker has their own guidelines, but this is one of the reasons there is a 3-day settlement period on transactions. Customer service at the better brokerage houses is often very accommodating.
Alert of imminent reversal to the upside:Click to receive your free 1-month trial to the ETF Trend Tracker (limit one free trial per household), which will be e-mailed to you every week, along with intra-week updates on an as-needed basis.