What Went Wrong in the SPX? From a Constructive Up-Trend Channel to Disastrous Head and Shoulders Top Formation

by Dan September 28, 2011 6:52 pm • Commentary

Yesterday’s late day collapse, with today’s inability to hold the morning gains only to collapse for the second afternoon in a row may be the nail in the coffin for this trading range we have been bouncing in between for the last 6 weeks.  In a lot of ways the news in the U.S. on the economic front (today’s durable goods) and some earnings (JBL & ORCL) don’t speak to the flat out disaster that the European equity and credit markets are signalling, but as I have said on many occasions of late on this site, the notion that the U.S. could somehow decouple from Europe is essentially a fairy tale.  It has not happened in any economic crisis in the last few decades and there is no reason to believe given our increasing reliance on foreign demand to keep our economy humming that it will not be any different this time.  

The S&P500, the Dow Jones Industrial Average and the Nasdaq are essentially the best performing indices of all developed nations, ranging from down ~5% to down ~8.5% ytd vs most European, Asian and South American indices down ~15-20%.

I have been of the mindset that this relationship is not likely to last and that given our large multinationals’ exposure to Europe and Asia and the recent rally in the dollar vs. the Euro, that profits may have their peak earnings for this cycle in Q2.  Earnings have most definitely been mixed as last week we saw a high profile beat and raise qtr out of ORCL and a miss from FDX, both causing significant movement in the underlying stocks.  I have expressed this view with a DIA oct put butterfly.

Looking at a chart of the SPX (below), there was a very definable range since breaking the key 1200 support level back in early August……the market has essentially made 4 sizable moves since bottoming on Aug 9th between 1121/1150 and 1200/1220.  The chart had been making a wedge pattern that in a lot of ways was fairly constructive making a series of higher lows and higher highs……until yesterday.  Yesterday’s close below the up-trend line from the Aug9th low, and today’s ugly reversal and close on the dead lows clearly signals a retest of last weeks closing low of 1129 and most likely of the Aug 9th low of 1121.

[caption id="attachment_5048" align="aligncenter" width="300" caption="4 Month SPX chart from Bloomberg"][/caption]


On Thursday’s close after an almost 8% sell off from the Tuesday’s highs, I covered half of my trading shorts and started to add some beaten up longs (generally through vertical call spreads to define my risk)…this has been a good strategy as I wanted to run a more balanced trading book while looking to technical levels to lay out broad market shorts…..Unfortunately for most investors/traders who don’t have the time to stare at the intra-day charts all day, one of the only things that has been working is technicals as evidenced by the chart above.

The up-trend channel has also given way to what technicians call a head an shoulders formation with the left and right shoulders forming on either side of the head (in this case there is two heads that were peaks above each shoulder) and the neckline sitting at what is now a huge support level of 1150.

[caption id="attachment_5049" align="aligncenter" width="300" caption="2 month SPX chart showing head and shoulders top from Bloomberg"][/caption]


It has been a difficult environment to make money due to the historic levels of correlation between individual names, but momentum and technicals have been working on a more macro level. The bank stock short has been the gift that has kept on giving and it has been my preferred short on any rally, expressed through JPM Oct put spread, BAC Jan put spread and XLF Oct put butterfly.  I am convinced the bank trade is going to end with a big thud and I am determined to be there for it.

So I guess the point of this post is that the chart above is increasingly looking toppy, where just a week or so ago it looked like a very constructive up-trend……I have been fairly convinced that Aug 9th wasn’t the bottom, and becoming increasingly convinced that there is nothing that comes out of Europe over the next week or so that is going to signal a prolonged fix to their debt issues.  So I remain cautious, I continue to short almost every rally, but importantly I am adding longs, usually of beaten up names where I have dreamed up potential catalysts, AAPL, HPQ, RIMM to name a few.  So the point is, remain convicted, trade without being too stubborn but reserve the right to change your mind, that is where the big money is made, catching the turn, not exactly the bottom, but the turn.