The Gilmo Report

August 14, 2011

August 14, 2011

The S&P 500 Index’s 6.66% drop on Monday didn’t turn out to be the “sign of the beast” some might have expected. In fact, the indexes ended the week down less than 1%, masking the wild volatility inherent in a week where we saw the Dow Jones Industrials Index move over 400 points one way or the other four days in a row. And as the dust settled on Friday we were left with a market that is, objectively, in the midst of what is so far a four-day rally attempt off the intra-day lows of this past Tuesday. Meanwhile, active money managers have run to cash, as the National Association of Active Investment Managers sentiment survey shows them to be invested to be invested a little over 21%. The Investor’s Intelligence Survey of Investment Advvisers over the past two weeks has shown little change in the percentage of bullish and bearish advisers, something that would appear a bit odd given the extent and velocity of this current market break. While sentiment is unclear, the daily candlestick chart of the NASDAQ Composite Index, below, shows a four-day wedging rally with a “doji” at the peak of the rally so far on Friday hinting that perhaps the rally attempt will run out of gas before it can reach logical resistance at the 2600 price level. Thus we wait and watch.

NASDAQ Composite Index Gilmo Report Chart

While sentiment surveys may or may not show a surge in fear over the past two weeks, the major market indexes certainly tell a story of fear. As well, the rush of money into Treasuries, the Swiss Franc, and gold all speak to a spike in fear as stocks get the “hot potato” treatment. The daily candlestick chart of the SPDR Gold Trust (GLD) shows the sharp rise in gold this past week on the heels of the S&P downgrade of U.S. debt and heightened European sovereign debt issues. In the short-term this looks somewhat climactic, and gold may need a little bit of time to let its 10-day moving average catch up. Meanwhile, the SLV, not shown, remains dead in the water but is still holding above its 50-day moving average. Note, however, that the GLD picked up some support off of its intra-day lows over the past two days as it was pulling back, and it is possible that it could resume its moves to the upside if this four-day bounce in the general market fails and stocks get dumped in another bout of forced selling. Gold remains a hold, for now.

SPDR Gold Trust (GLD)  Gilmo Report Chart

The main issue I see with the long side of this market right now is that even if we did get a follow-through day (FTD) in the next week there is absolutely nothing in position to buy. Most leading stocks have been pummeled on the recent market break off the peak, and thus have done little more than stage bounces off their recent lows and rally up into areas of logical resistance. Even leading stocks that have held up better, such as (PCLN), shown below on a daily candlestick chart, are in some cases teetering in a precarious position. As I have discussed in previous reports, PCLN is starting to look like a potential late-stage failed-based (LSFB) short-sale set-up after breaking down through its 50-day moving average last week. This was then followed by a one-day wonder rally after announcing earnings which quickly dropped back below the 50-day line again. PCLN has still not been able to get back above the 50-day line as volume declines, indicating a decline in buying interest as I see it. If the general market fails on this rally attempt, PCLN may very well be shortable here using the 50-day line as a guide for an upside stop. (PCLN) Gilmo Report Chart (AMZN), another online retailer similar to PCLN, is showing a similar type of late-stage failed-base set-up as it also broke below its 50-day moving average last week after failing on a gap-up break out of a short flag formation that occurred three weeks ago when it announced earnings. As we can see on the daily candlestick chart of AMZN, below, buying volume has waned as the stock bumps up into its 50-day moving average which now serves as near-term resistance. In this regard, AMZN and PCLN illustrate what is wrong with this market, and why a follow-through day, even if it did occur, might be very suspect: There is no leadership setting up in proper bases. When the market is about to turn to the upside after a correction, such a turn is usually supported by numerous clues in the form of pocket pivots and constructive basing action among potential leading stocks, an element that is clearly missing in the current environment. Thus, while the markets could rally, taking the NASDAQ up into resistance at the 2600 level, it may not be supported by any material leadership. Thus AMZN may be potentially shortable here using the 50-day line as an upside guide for a stop. (AMZN) Gilmo Report Chart

The key to any successful short sales here will be, without question, a failed general market rally. Therefore, if we continue to see the indexes push up higher from here, even on weak volume, expect that broken-down leading stocks will likely drift up with the market, so any short-sales should be timed with a rally failure. The daily candlestick chart of Netflix, Inc. (NFLX), below, tells a common story among former leading stocks. NFLX gapped down on big volume after announcing earnings, traded a little “doji” pattern the next day and then rolled over, breaking down below its 50-day moving average and moving lower until it found support at its 200-day moving average on Monday of this past week. The rest of the week saw the stock wedge up into its rapidly falling 10-day moving average which the stock has followed on the way down off of its mid-July peak above the 300 price level. This also coincides with resistance at the prior breakout level as I’ve highlighted on the chart. NFLX could continue to rally up to the 50-day moving average at 265, I suppose. But if the market rolls over it may not get past the 250 price level before rolling over and testing its 200-day moving average again. At best, NFLX is another grossly “out-of-position” leader.

Netflix, Inc. (NFLX) Gilmo Report Chart

Flipping through my charts and screens this weekend, I find a lot of patterns that look like Rackspace Holding, Inc. (RAX), shown below on a daily candlestick chart, which has rallied on weak volume back up into its 200-day moving average. They aren’t limited to former tech leaders, either, as I see agricultural stocks like POT and MOS or retail stocks like JWN and LTD, for example, running into resistance at their 50-day or 200-day moving averages. With so many stocks looking like this, it almost looks like a “target rich” environment for short sales if this general market rally attempt fails. As we can see with RAX, it suffered a massive price reversal and breakdown after announcing earnings last week and running into its 50-day moving average near the 41.50 price level. That break took the stock well below its 200-day moving average before the stock found support at the 31 price level at the top of a prior basing area which is out of view to the left on the chart. RAX has now rallied just above the 200-day moving average on wedging volume, which is not uncommon for beaten-down stocks as they often will slide just past and above a key moving average on a reflex rally. This doesn’t have to roll over right away, as it could hover around the 200-day line for a few days before breaking down, but it bears watching. I would use a 39 stop on any RAX position taken here around the 200-day moving average.


Rackspace Holding, Inc. (RAX) Gilmo Report Chart

Among retailers, one of the weakest patterns I’ve seen is the late-stage failed-base set-up in Under Armour, Inc. (UA), shown below on a daily candlestick chart. Again, this is a common pattern that I see in this current market environment, and the implications of this, as I see it, is that a lot of former leaders still would need to do a lot of healing before they could ever be considered buyable again. I saw UA as a shortable LSFB set-up last week, but normally a failed late-stage
breakout will first break the 50-day moving average and then rally back up to or just above the 50-day line before heading lower again. In UA’s case, once it broke the 50-day moving average it split wide open and dived well below its 200-day moving average. Now we see the stock staging a weak-volume wedging rally right up into resistance at the 200-day moving average that is marked by a little “doji” on the candlestick chart. Notice also that the 10-day moving average has met up with the stock on the downside as it just crosses below the 200-day line. This is potentially shortable here, as I see it, using the 65 price level as an upside guide for a stop. Given the extent of the downside break this is not much of a bounce, but that may be telling you how weak UA is, For now, resistance at the 200-day line is in force until it is materially breached.

Under Armour, Inc. (UA) Gilmo Report Chart

While the market isn’t showing me a lot of classic head and shoulders type of formations, it is showing a great deal of broken down patterns and late-stage
breakout failures that have hit leading stocks very hard over the past 2-3 weeks. In this sense the market also reminds me of the market top and break in the spring of Year 2000 when so many leaders just blew apart off of their peaks and descended rapidly. The difference is that 2000 was the end of a parabolic move in stocks that gained notoriety as the “dot-com” bubble and today we are in a different positon after a three-year secular bull phase that began in March 2009 but which has roughly remained within the sideways, choppy pattern the general market has formed since Year 2000. Does it portend a serious bear phase in the offing, and what will it take to save this market?

There were some rumblings in the news this past week that investors are expecting that the Fed will soon come riding to the rescue with QE3, and that this will send stocks back on their merry and bullish way to the upside. Some believe that “QE3″ is not likely, but “QE 2.1″ might be. My only response to this is that when we start referring to artificial spurts of liquidity coming into the markets courtesy of the Fed’s bottomless balance sheet (a.k.a. money printing press) as if they were new versions of an ill-fated Windows PC operating system we may be getting nearer to the point where QE in any form merely becomes the final bid for sellers to hit. Certainly, the final burst of QE2 in the last two weeks of June that created the sharp market rally off the 200-day moving average (also taking the NASDAQ Composite Index to a higher high) turned out to be one Fed QE “bid” that was certainly hit by sellers as we see in the NASDAQ daily chart below.

NASDAQ Gilmo Report Chart

The bottom line is that while a follow-through day remains a possiblity, it is also a fact that intermediate- or longer-term corrections/bear markets usually have a couple of failed follow-throughs, so it’s not as if such a signal would come as a surprise. Such failed follow-throughs also generally mark the start of another wave of selling that takes the market to lower lows. Have we seen the end of this current sell-off and are we looking at a “generational buying opportunity?” Somehow I don’t think so, and with no leadership in position to buy, my tendency is to think that any follow-through day would have a difficult time holding up. The market could continue to drift higher on little volume, but my guess is that if this occurs then we will simply see more broken-down leaders rally up into logical areas of resistance at which short-sales become higher-probability propositions. Short-sellers may have to be persistent as they “feel out” the market and test short positions into the rally as it weakens, but that is the direction I am leaning towards at the moment, keeping upside stops firmly in mind.

Gil Morales

CEO & Principal, Gil Morales & Company, LLC

Principal and Managing Director, MoKa Investors, LLC

At the time of this writing, of the stocks mentioned in this report, Gil Morales, MoKa Investors, LLC, and/or Gil Morales & Company, LLC held a position in RAX, though positions are subject to change at any time and without notice.

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