June Gloom

We Southern Californians living near the coast experience an early summer weather pattern of heavy morning fog that sometimes burns off by mid-afternoon. We call this pattern “June Gloom.” Unfortunately, this pattern not only applies to the weather but also to the current market climate. Not only do I see gloom written all over the charts of the major indices but I see potential doom, too, at least in the short term. My wish is not to bum you out especially in front of the first weekend of summer, but to make you aware of internal conditions so you won’t be caught in a downpour without an umbrella.

Indications of impending inclement weather
The market had been staging a nice recovery since mid-March but a pall began to form over it on May 19th when two things happened. First, the VIX staged a turnaround. Since then it has been making a series of higher highs and higher lows, with each low bouncing off its 20 day moving average (dma). The VIX is a measure of uncertainty and runs contrary to the overall market so that when the VIX moves higher, the market moves lower. Whenever the VIX moves and stays over a value of 20 is my signal to lighten up on long positions and initiate short ones. (The VIX is currently trading over 23.)

May 19th was the turning point for the major stock indices, too. The large topping tails shown by all of them, including the Dow Transports, signalled that buying interest had dried up. When there’s no one left to buy, the only direction left for the price to go is downward. But how far might it go?

A gloomy prognostication
Charts of the major indices all show a similar pattern. As an example, let’s look at the weekly chart of the Dow Industrials to see if it can tell us where we might be headed.

The chart shows two head and shoulders patterns:* One is an inside pattern that ranges from April to December of 2007, and the other is a larger pattern that ranges from October 2006 to today. Once the right shoulder is broken, one can expect the price to decline by roughly the distance from the neckline to the top of the head. For the Dow, the first price target given by the inner pattern is calculated like this:

Price at the top of the head = 14,000
Neckline price at the right shoulder = 13,000
Total distance = 14,000 – 13,000 = 1,000

Therefore, the first price target is 12,000 (13,000 – 1,000) which is exactly where the second neckline formed. The second price target, calculated from the outer pattern, shows a support level at 10,000. Doing similar calculations for the S&P and the Nasdaq yields the following support levels:

S&P 500
First support level: 1300
Second support level: 1080

Nasdaq Composite
First support level: 2200
Second support level: 2000

The Dow is breaking through its right shoulder as we speak and the S&P is not far behind. The Nazzie, however, is doing better. It’s touching on 2400, a support level, and if it breaks through that the next stop is 2200. The techs have been doing fairly well lately so maybe they’ll help keep this index afloat.

A Ray of Hope
There’s no silver lining to be found in this thunder cloud, but if there is one ray of hope it will probably come from a turnaround in the banking and brokerage sector. Today isn’t the day, however, as both the financial spyder (XLF) and the regional bank holders (RKH) are hitting new five year lows. Sure, the high price of oil and other commodities are contributing factors, but I truly feel that the clouds won’t be clearing until investor uncertainly dissipates concerning the fate of the credit crisis. The Dow Transport Index is regarded as a leading indicator of market direction, but I think this time we need to add the XLF and RKH to our radar screens. I believe these charts need to stabilize first before we see the market turn around. But until the sun comes out, the best place for conservative investors is in cash or cash equivalents.

Don’t let the market rain on your parade!

*See Cooking Tools #1 (March 5th blog) for a discussion on how to interpret head and shoulders patterns.

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