Friday, May 28, 2010

Is a Head and Shoulders Top Forming in Stocks?

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

The U.S. markets are trading like some highly volatile emerging market, just as they did during the Credit Crisis in 2008.  Yesterday, the move was up with the small cap Russell 2000 gaining 4.2%, Nasdaq 3.6%, the S&P 500 3.2% and the Dow 2.9%.

While big gains make investors happy, they are not a sign of a healthy market if they alternate with big losses. Stocks opening with big gaps, prices much higher or lower than the previous close, are also not behavior bullish investors would like to see. Nasdaq gapped up approximately 58 points on Thursday - a huge amount. Ironically, Nasdaq traded to fill a gap made on the downside on May 20th (as I predicted would happen in a previous article).

At this point, U.S. investors should be looking for the formation of known topping patterns. These can occur in just one, two, three or all four of the major indices. In the 2009 March low for instance, the Nasdaq made a clear double bottom, whereas the other indices had sloppier action. Right now it looks like the Dow Jones Industrial Average and the S&P 500 are trying to form a nice even head and shoulders top (the pattern would have a somewhat higher right shoulder on Nasdaq). The head would be the market top in late April and the left shoulder the high in January. The bottom of the pattern is the market low in February and the recent market low on May 25th.

Technically, the Dow and S&P 500 are the weakest of the four indices. Even after yesterdays powerful rally, they still closed a tinge below their simple 200-day moving averages. Nasdaq gapped up above its 200-day and the Russell 2000 has yet to close below its 200-day, although it did pierce it intraday. Volume, as usual, was not supportive of the bullish price action. It was slightly above average on the Dow and barely average on Nasdaq. Volume was noticeably higher on both indices during the previous two days of selling.

Investors should also be paying attention to the action in the euro (FXE) and the trade-weighted U.S. dollar (DXY). The euro is putting in a short-term double bottom and the U.S. dollar is putting in a mirror image short-term double top. The techical indicators support the view that the euro will rally and the dollar will sell off at this point. Whether this move becomes something more intermediate-term remains to be seen.

The choppy action that is taking place in the markets is likely central bank driven. This was also the case during the Credit Crisis as well. The results of the liquidity games central banks play are more damaging than helpful in the long run. It is known that the ECB pumped huge amounts of liquidity into the global financial system on Monday, May 10th. A huge rally with a big gap up in stocks consequently took place since liquidity injections show up in trading immediately. The ECB then attempted to drain this extra liquidity several days later. The markets then traded to a lower low. Yesterday's huge move up in prices was almost certainly another liquidity injection from a major central bank. We will have to see how long they can keep the pump going this time.

Disclosure: No positions.

Daryl Montgomery Organizer,
New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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