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Head And Shoulders: A Lot of Dandruff Out There


With the proliferation of hedge funds over the past decade and amount of crowded trades out there, the potential for sharp moves is increasingly higher.

Futures were sharply lower this morning as credit concerns are back to the forefront with a large European bank getting "surprised" by liquidity drying up and therefore having to suspend three funds.

Before I move on to discuss some head and shoulders topping formations I've seen in several markets, let's take a look at the S&P 500 and what is going to look like failure at key retracement levels. The S&P 500 topped out just above 1500 and the high almost perfectly coincided with the .618 Fibonacci retracement level. It just so happens the 20 day moving average happened to be right there as well, which in a trending market, pullbacks to the 20 day are often opportunities to reinitiate positions in the direction of the trend (in this case down). I think the key level to watch in this ensuing pullback will be the 1452-1460 support band which is the 200 day moving average (1452) and the February highs (1460). A close below 1450 opens the door to further downside.

Click here to enlarge.

Now for the dandruff. Below are some charts where I'm seeing some potential Head and Shoulders topping formations, as well as a few that look to have already confirmed. First off, let's look at the potential setup in the Dow Industrials. We have a left shoulder in June topping near 13,700 and the head in late July topping at 14,000. This latest bounce has the potential to carve out a right shoulder. Watch out for a move below the neckline at 13,300 (and confirmation with a close below the August 1st low of 13,132) which would project down to 12,600. Note how this target would coincide with the first break of the 200 day moving average in over a year.

Click here to enlarge.

We've all heard the rumors swirling around some of the bigger investment banks lately so I don't need to mention any names, but just look at the XBD (Broker Dealer Index) and you can see what might be one of the more bearish setups we have going right now. Here we have a downward sloping neckline on the XBD occurring well below the 200 day moving average. It is also looking like this could be a fairly small right shoulder which would emphasize the weakness in this group. I don't see this Index gaining much traction above 240, and a conservative target breaking the neckline would be 175.

Click here to enlarge.

With the news yesterday that China is threatening to use their "nuclear option" and dump some 1 trln worth of U.S. bonds, we need to look at the TLT as well as the dollar index. The TLT is a great example of fractals and seeing similar patterns in multiple timeframes. Look at the bigger picture head and shoulders starting back in 2003. We have a neckline around 83 and with the top in 2005 near 96, a break would project down to 70. Ouch! This would mean much lower bond prices and much higher rates, not a good combination in the current market environment.

Also notice the right shoulder where we have a smaller head and shoulders. This broke down around 87, and we bottomed right around the target of 83, which I have discussed in prior posts and Buzzes. Notice how bonds bounced right back up to the neckline during the "flight to safety" and rolled right back over at that level. Respect the resistance. Looks like the next leg lower is underway.

Click here to enlarge.

The Dollar Index is last but certainly not least, and we have talked extensively about this bearish long term setup. Notice the potentially smaller right shoulder just like the broker index which is a bearish omen. Sentiment is certainly negative on the U.S. Dollar and it could get a bid off another "flight to safety", but the trend is your friend and this trend is down.

Click here to enlarge.

The fact that we are seeing multiple topping formations in several different markets I think underscores the fact that a lot of these markets are much more highly correlated than investors think. With the proliferation of hedge funds over the past decade and amount of crowded trades out there, the potential for sharp moves is increasingly higher. Enter increased volatility. A lot of funds have made a ton of money betting on low volatility over the past five years and those models work well until they don't. I think we are entering a period of increased market uncertainly and the one factor you want to bet on increasing is volatility.

Be careful out there, it is going to be a very interesting second half of the year.
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