The Gilmo Report

April 6, 2014

April 5, 2014

As I wrote this past Wednesday, I did not trust this current market rally “resumption” given that it had the look of a possible bull trap. And that is exactly what it turned out to be as the entire market finally took some serious heat on Friday, as we can see on the daily chart of the S&P 500 Index, below. The breakout to all-time highs got everyone excited about the market, including the financial cable TV pundits and talking heads, as the Friday jobs number was initially seen as a positive for the markets. But the ebullience on the move to all-time highs by the S&P 500 was short-lived as the NYSE-based index declined on heavier volume. At this stage the S&P 500 looks to me like it is set to test its 50-day moving average down at 1838.07. The snapping shut of the bull trap door implies a reasonable chance of a longer-term market top, in my view, and I think we can expect the market to move lower from here over the next few days.

At the very least, the long side of the market is entirely out of the picture for now. And while some might consider Friday’s selling to be some sort of capitulation, this is not necessarily clear to me with the S&P 500 having just failed from its breakout after logging an all-time high on Friday on an intraday basis. For all we know, Friday’s action is just the beginning of a deeper correction than we’ve seen for a while, and one factor that argues in favor of this is the extremely deleterious action in formerly leading stocks. Once the sell-off gets into panic mode, however, the odds of a sharp reaction bounce also increase. So if one is making decent money on the short side one should still stick to their price objectives as individual short-sale targets hit them, regardless of what the indexes are doing.




The NASDAQ Composite Index had an even worse time of it on Friday as it busted back below its 50-day moving average, splitting wide open on a 2.6% downside break. I still find it quite fascinating, if not downright shocking how formerly leading NASDAQ names like FB, NFLX, FB, SPLK, YELP, AMZN, BIIB, CELG, GILD, PCLN, GOOG, DATA, PANW, FEYE and others simply cannot get a bid in what has been a de facto bear market for these names over the past month. All the way down I’ve been expecting that we might see a logical reaction rally of some substance, but when any of these former leaders have tried to bounce, their rallies have been immediately sold into as selling volume on down days has remained extremely heavy. The urgency and persistence with which sellers have sought to exit these stocks strikes me as a very ominous development for the longer-term market picture. But I haven’t liked what I’ve been seeing under the market’s “hood” for at least the past month, as my reports during that period document quite well. As well, as I wrote on Wednesday, the clear rotation out of high-P/E high-flyers and into more defensive, old-line, low-P/E big-caps made me suspicious of the S&P 500’s rally into new highs, and that suspicion has proven to be correct.

So where do we go from here? Near-term I can see the S&P 500 meeting up with its 50-day moving average on the downside while the NASDAQ, shown below on a daily chart, might test its early February low, which I’ve highlighted on the chart below. At that point the market might move into some sort of short-term capitulation phase, which would then create a potential reaction bounce as the need to sell becomes extremely obvious. On the other hand, the market doesn’t have to do exactly what I think it’s going to do, so the day-to-day price/volume action remains the bottom-line driver of my real-time decision-making. At the very least, I repeat that if you are making money short this market based on the short-sale set-ups I’ve discussed in recent reports, avoid getting “piggy” by keeping an even emotional keel and maintaining discipline. This means covering shorts and taking profits at the prescribed downside price targets.




Adding to the ominous tone of Friday’s sell-off was the fact that gold rallied back above its 200-day moving average, even as stocks were getting pounded, as we can see on the daily chart of the SPDR Gold Shares (SPDR), below. The move on Friday also took the GLD back above its declining 10-day moving average, but does not qualify as a bona fide buy point. I’m not really sure where gold will go from here, as I believe a continued sell-off in stocks will eventually drag everything down with it, including precious metals and other commodities. But with the yellow metal rallying on a day when stocks were getting pounded, I have to wonder whether it isn’t a clue that something is amiss somewhere. At the very least, the action in the stock market is telling you that something is not quite right somewhere. If one really wants to buy into gold here, then I would suggest simply using the 200-day moving average as your quick downside stop. Maybe it rallies from here regardless of what stocks do, maybe it doesn’t, but in my view it’s not that worthwhile of a set-up on the long side for me to want to get involved at this precise moment in time. Overall the action in gold vs. stocks might be telling us that some sort of “event” is coming down the pipe, but since I can’t predict the future in this regard I choose not to play – I prefer to work the short side of stocks instead.




When the S&P 500 was rallying back up towards its highs earlier in the week we kept hearing from certain newspaper writers and financial cable TV talking heads that the rotation into areas like financials and semiconductors was constructive. I’m not sure what those guys and gals were smoking, but as I wrote last weekend, financials and old-line semiconductors alone are not the stuff from which roaring bull markets are cast. Friday’s action put the kibosh on this erroneous concept as the daily charts of the Select Sector Financial SPDR (XLF) and the iShares PHLX SOX Semiconductor (SOXX) ETFs show below. Both of these took some serious heat on Friday as the XLF reversed hard on heavy selling volume while the SOXX broke down sharply off its recent peak on equally heavy selling volume. So much for the rotation into these sectors as evidence of a constructive development that speaks in favor of the short-lived rally resumption.






Looking at financials, most of their upside movement took place in early March as money cycled out of the high-P/E high-flyers, and this is evident on the daily chart of Goldman Sachs (GS), below. You can see the spike at the beginning of March where the stock jacked above its 50-day moving average, but this move was quite brief as the stock immediately rolled over, forming what now looks like the peak of a right shoulder in an overall head and shoulders formation. GS is expected to announce earnings two Tuesdays from today, but the stock looks shortable here as it moves below the 200-day moving average as selling volume picked up on Friday. If we don’t gap down on Monday morning, this looks potentially shortable to me using the 200-day line at 164.26 as a neat and tidy upside “hyper-stop.”

Further confirmation of the mythical “strength” in financials is provided by the daily chart of Citigroup (C), below. Last week C was already mired in a head and shoulders topping formation, as I’ve outlined on the chart, before gapping down on massive selling volume. Over the past six trading days C has simply set about forming a reverse “bear flag” formation and is probably heading lower, as I see. I consider C a short using the peak of this current six-day bear flag at 48.36 plus 2-3% as a quick upside stop. Ultimately, however, I would see any rally up into the 50-day moving average at 48.57 as an optimal short-sale opportunity. While some have lauded the “rotation” into financials the reality is that a number of financials are showing some pretty severe breakdowns within weak patterns, as the H&S-like formations in both C, below, and GS, above, quite starkly illustrate. For your reference, remember that C is expected to announce earnings two Mondays from today.




With the alleged “rally resumption” failing in short order, the short side of the market was very much in play over the past couple of days. Cree (CREE) gave short-sellers a nice entry opportunity on Thursday and again on Friday when it traded up to the 58 price level and the 20-day moving average, the first level of resistance as I tweeted to members on Thursday morning. After a brief move higher Friday morning that pushed right into resistance at 58, CREE came apart and closed lower on the day, as we can see on the daily chart below. Right now I’m using the 52.85 low from last November as my downside price target on CREE.




Pandora Media (P) also gave us a nice entry point on Thursday when it rallied a couple of bucks right at the open on news that subscriber listener hours had increased 14% in March. That sparked a rally right up into resistance just above the 33 price level along the prior lows from last month and the 20-day moving average at 32.90. I tweeted to members in real-time that the stock was well set-up on Thursday to enter on the short side on that news rally, and by the close the stock had completely reversed and closed down 5.06%, making for an 11.4% total reversal from the intraday peak. The weekly chart of P, below, shows the stock hitting its 40-week moving average, corresponding to the 200-day moving average on the daily chart. This was my first downside price target, and so I dutifully covered my position here, seeking to perhaps short any kind of bounce up and off of the 200-day moving average. You can see on the chart, however, that the stock looks to have completed the “head” in the head and shoulders formation and a rally from here, at least from the perspective of the weekly chart, would serve to form a right shoulder. That seems logical, but if the market blows apart next week P might just continue right on through the 200-day line to the downside.




Stratasys (SSYS) gave us a nice entry on the short side on Thursday on the news rally up to the 50-day moving average and just beyond the neckline in its head and shoulders pattern, as we can see on the daily chart below. As I wrote on Wednesday, this rally was quite shortable using the 50-day moving average as a quick upside stop. You can see in this example that SSYS actually broke down through its 200-day moving average before rallying back above the line and towards the 50-day moving average. This is not unusual behavior for a head and shoulders set-up, when the breakdown below the 200-day line also coincided with and undercut the prior low from early February when SSYS bounced right off of its 200-day line. SSYS stopped at the 200-day line on Friday, but my guess is that further market weakness will take it lower, and my short-term downside price target is the prior 100 low from last week.




LinkedIn (LNKD) broke down through the neckline in what I have considered to be a “rolling top” type of head and shoulders formation with multiple right shoulders, something I have discussed at length in the last few reports and as we can see on the weekly chart, below. My near-term target on LNKD has been the 160 price level, and it is only about 3% away from there at this point, which would also coincide with an undercutting of the prior base it formed between May and July of last year.




As I run through my screens, I see a lot of action in former leaders that looks like the initial formation of the right side of a “head” within an overall head and shoulders formation. For example, the weekly chart of Facebook (FB), below, shows the stock breaking down hard off the peak on very heavy selling volume. This action meets the definition of what you want to see on the right side of the head in such a pattern, and we might surmise that the stock is headed for its 40-week/200-day moving average, where a possible neckline could form. Thus FB has to go on my short-sale watch list for now, along with a number of other former leaders.




These former leaders would include Workday (WDAY), which crashed right through its 40-week moving average on Friday, as we can see on the weekly chart, below. The breakdown over the past five weeks has served to form a clear “head” in what could easily turn out to be a head and shoulders formation over the intermediate term.




Biogen Idec (BIIB) would also qualify as we can see the same type of formation where the stock has formed the right side of a “head” in a possible head and shoulders formation in the making.




Netflix (NFLX) is another former leader and one of the now headless “Four Horsemen” showing this type of “right side of the head” action as it moves down to its 40-week moving average on heavy volume.




Yelp (YELP) has also formed the right side of a potential “head” within a head and shoulders formation in the making, as its weekly chart shows below.




So as we can see, the weekly charts of many formerly leading stocks are showing this same type of action where they look to be forming the right sides of “heads” in potential head and shoulders formations that are in process. So far these patterns show a left shoulder and a head in classic textbook fashion, but they still have to build right shoulders to complete the patterns. Therefore I might extrapolate, based on the positions many leaders have within these H&S patterns in-the-making, is that at some point in the next week we will hit a near-term panic, exhaustion low, as these stocks move somewhat lower, maybe a little lower, maybe a lot. As we reach a short-term exhaustion low the ensuing reaction bounce will then lead to similar, oversold types of reaction rallies in these stocks that will serve to form right shoulders and complete the H&S formations.

What I’m seeing in so many leaders in this regard reminds me of the action right off the peak at the market top of October 2007. These breaks off the peak led to the formation of right shoulders as the market bounced around in 2008, with the final resolution to these patterns occurring in the latter part of 2008. There were some H&S breakdowns such as with Crocs (CROX) which blew apart in January of 2008. Members should refer to Chapter 6 of “Trade like an O’Neil Disciple – How We Made 18,000% in the Stock Market” where I showed numerous examples of topping patterns that formed after the October 2007 peak and during most of 2008.

We can study CROX from 2007-2008 to get an idea of how the “mechanics” of the H&S pattern might work in the current examples I show above. The break off the peak in CROX occurred at the same time as the general market top, which gained downside momentum over the next couple of weeks as CROX also went into freefall, taking the stock below its 40-week moving average. Right now we see stocks like FB, NFLX, WDAY, BIIIB, DATA, YELP, and numerous others moving down towards or right to their 40-week moving averages in similar fashion. What might happen is that they either push just below their 40-week lines as CROX did in late 2007, or if they are somewhat above their 40-week lines as FB currently is, for example, they might push right to the 40-week line before rallying to form a right shoulder and complete their H&S formations.

Notice that after bursting below the 40-week line, CROX rallied up into the line where it found resistance that created the peak of the right shoulder. As the right shoulder began to roll over, the 10-week moving average crossed below the 40-week moving average for a bearish “black cross,” and the stock rolled over from there on the way to lower lows. Notice that a couple of months later, CROX rallied up into its 10-week moving average in early February 2008 before rolling over again. In this manner we can see how the stock offers several short-sale entry points on the way down as it rallies up into the 10-week and 40-week moving averages. Note also that CROX’s right shoulder formed after the stock’s and the general market’s break off the October 2007 peak and during a general market reaction rally and bounce that occurred in early 2008.

As a short-selling model stock, CROX gives us a sort of “road map” that shows how some of these H&S patterns-in-the-making might play out over the coming weeks and months, assuming the market is in fact making a significant top.




What bothers me most about this market is the difference in how the current correction has played out with respect to the action in leading stocks vs. prior corrections over the past year. Since last March, I adjusted my methods in the spirit of what I like to call the “Ugly Duckling Theory” because of the way leading stocks would correct in shallow patterns and form “roundabout” set-ups as the general market pulled back and started to look uglier and uglier. Using bottom-fishing pocket pivots as leading stocks corrected and held tight along their 50-day moving averages in most cases and along their 10-day moving averages in a few cases, I was able to gain early entry before the general market turned (see my February 9th report, for example) and the profit as these stocks moved up and out of their patterns. Basically, the market would be coming down, but leading stocks would be setting up along their 50-day and 10-day lines. As the market found a floor, these stocks would be flashing pocket pivots or buyable gap-ups in the manner that I have described before where leading stocks tell you what you need to know before the indexes do.

This time around, leading stocks just keep crashing through all of these support levels, and for this reason I have been mostly bearish throughout the past month. This is what is quite different about this correction vs. others over the past year, and I think investors should take notice of this. As I wrote in my early March reports, leading stocks back then were telling you what you needed to know before the indexes as they began to top in earnest. A month later they all lay in tatters after sharp breakdowns.

My guess is that we are headed for some sort of panic low, and then we’ll just have to see what happens once everyone who is going to sell has already done so for the time being. I’d like to think that there will be some sort of tradable bounce given how oversold so many stocks have become. But as I’ve discussed before, sometimes an extreme oversold condition is simply telling you just how bad things really are. The persistent selling appears to me to speak to a general, secular exodus of money flows out of equities that could be the initial precipitate of a longer bear market phase.

However, since I cannot predict the future, I just maintain my discipline. This means that I stick to my downside price targets on my short-sale positions and cover as these targets are hit. Otherwise, I continue to seek to stay short or enter on the short side those names that have not yet hit my downside price targets, using logical rallies to “load up” as appropriate. If you find that the short side is not suited to your tastes, then the bottom line for investors right now is simply: Cash is king.


Gil Morales

CEO and Principal, Gil Morales & Company, LLC
Managing Director and Principal, MoKa Investors, LLC
Managing Director and Principal, Virtue of Selfish Investing, LLC

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