Things took a turn for the worse in the market on Thursday and this accelerated on Friday as the indexes gapped down to start the day off and closed near their lows on heavy volume, as we see on the NASDAQ Composite Index daily chart below. As I wrote in my Wednesday report, I was looking for another upside leg in the market “until further notice,” and the past two days have provided that further notice that the correction is instead deepening. All of a sudden the long side of this market looks very dangerous. The assumption is always that QE will come in to support stocks, but as we know from May 2010 and August 2011, that is not always the case, and downside spirals in a QE market can get out of hand very quickly. Given the market’s action over the past two days, if you are long this market you have no choice but to take at least some defensive action, although by Thursday it looked to me like the sidelines or short side were the best places to be as the NASDAQ closed just below its 50-day moving average on increased volume. In hindsight the stalling action on Tuesday, four days ago on the chart, was likely a clue of trouble brewing. Throw in Friday’s big-volume gap-down and to me it looks like that 2900 downside NASDAQ target I was talking about a couple of weeks ago is rapidly coming into play.
All of this ugly action just goes to show what happens when you try to make a silk purse out of a sow’s ear by calling a 1.36% move in the S&P 500 Index a “follow-through” day. As I said before, we need to see a follow-through in the NASDAQ Composite to give the market credibility on this rally attempt, and the last two days have all but quashed that possibility. While the market didn’t sustain a downside move after Thursday’s ADP Employment Change number, it did on the big jobs number Friday. But my best assessment is that it wasn’t the jobs number that the market didn’t like on Friday. Something else is afoot, and perhaps the answer is found in the fact that money is looking for a safety valve, leading to both the U.S. dollar and the precious metals, silver and gold, both rallying on the day. Gold picked up some buying volume as well, as the SPDR Gold Shares (GLD) came in with above-average volume on what was a pocket pivot volume signature. Unfortunately the position of the GLD underneath the 10-day and 50-day moving averages means it is not a bona fide pocket pivot buy point, but its action relative to stocks on Friday may be meaningful.
And of course what is this market without its “big-stock-cum-market stock,” Apple (AAPL), which couldn’t hold its 50-day moving average and on Friday violated the 50-day moving average, as we see on the daily chart below for the first time since it broke out in January of this year. As I wrote last weekend, if AAPL stabilizes the market will stabilize. AAPL now looks primed to test the 555 low of not quite two weeks ago. At this point with a 50-day moving average violation under its belt, in my view,AAPL is a sell, plain and simple. I know that the whole world is convinced that AAPL absolutely must go to $1,000 since it apparently has been ordained by the alignment of the stars and planets, and certainly if you go on any financial TV station you can see all the talking heads nodding in agreement that one “must own” AAPL. Let us, however, not forget our market history, which has proven time and time again that even the greatest leading stocks will top when everything is as rosy as it can be and the “story” appears bullet-proof. I tried buying a little AAPL off the 50-day line on Wednesday, but Thursday’s higher-volume reversal got me out of my long AAPL position and into AAPL on the short side. In my opinion, this stock is headed lower, period, as we look for it to undercut the 555 low in the pattern.
The only good thing happening on Friday was LinkedIn’s (LKND) supposedly “buyable” gap-up, as we see on the daily chart below. As I discussed in my report of this past Wednesday, a gap-up breakout on earnings seemed like a distinct possibility for LNKD, and perhaps the only irony here is that something I’ve been anticipating for a long time in LNKD finally happens on a day where the market is taking a lot of heat. While this may cause one to be justifiably hesitant in buying this gap-up move, I might chime in here that I am not buying this on the basis of a) the general market action currently and, more importantly, b) some of the subtleties in the daily chart, below, that bother me. For example, this is now the third gap-up move in LNKD’s pattern off the lows of late last year. Thus I tend to think this gap-up on Friday is just a bit too obvious, particularly since it comes off of a long prior uptrend off the lows of the base and therefore might be more of an “exhaustion” type of gap move on the breakout. Thus I am wary of LNKD here when viewed in context with the general market action. At the very least, I think one can watch this to see how it develops, but if one did buy this gap-up then one should adhere to the 115.51 intra-day low of Friday as your quick stop and exit door if this does not work.
From the short side of any market, as a bull phase begins to top, the first short-sale set-ups that start to appear are generally late-stage failed-base (LSFB) or Punchbowl of Death (POD) types of breakdowns. CF Industries (CF) is an example of both rolled into one. We see it has formed what might be termed a “POD-with-handle” formation with this week’s breakout attempt reversing and failing in rapid order on heavy selling volume. CF announced 59% earnings growth on Friday but it wasn’t enough to impress investors as the stock gapped down from its recent peak above the $200 price level and proceeded to blow to pieces, moving just below its 10-week/50-day moving average. A short little bounce from Friday’s close up into the 50-day line at around 186-187 would be eminently shortable, in my view, using a 3-5% upside stop, maximum. Of course, one could also simply hit the stock right here in the 184 area since it is well within range of the 50-day line. We do know that these types of base-failures will generally break the 50-day moving average first, moving sharply to the downside before rallying back up into the 50-day line, so it is possible that CF will offer one quick short trade down to the 200-day line before trying to rally back up into the 50-day moving average. I’ll be following this in subsequent reports as it continues to develop.
Another Punchbowl of Death (POD) formation in the works here is seen in Valeant Pharmaceuticals (VRX) on a weekly chart, below. You can see the massive-volume breakdown on the right side of the POD from last August, which was then followed by a steady movement back up the right side to complete the big “cup” or “bowl” formation. VRX was looking almost too perfect this past Thursday morning, however, as it gapped up on earnings and looked for all intents and purposes like a buyable gap-up. At that point, the long tentacles of the POD reached up and dragged VRX back down as the gap-up and breakout attempt failed spectacularly. One might say that VRX’s action prior to Thursday’s breakout was very tight and constructive, but one clue might have been that over the prior period mutual fund ownership of the stock declined from 894 to 826, a pretty sharp drop. A bounce up into the 53-54 price area would be optimal to short into, but there is the issue of upside resistance at the lows of the prior bases in the 52-53 price area, so this may be as far as the stock gets on any potential bounce from Friday’s close – that is something to keep an eye on here as this pattern develops. Based on the massive downside volume on Thursday’s reversal and on the weekly chart, it appears that at least a test of the 200-day/40-week moving average down around 46 is likely here.
With a few PODs starting to show up, my POD screens produce more than a handful of potential candidates that should be monitored in case they do begin to weaken. One of these is Salesforce.com (CRM), which can easily be seen to be at a point that could be considered the right side peak of a possible POD formation. The steep trend off the lows of late last year represents a very rapid upside move, and even in a market rally phase such a move needs more time to consolidate, hence I tend to think that CRM is not simply going to launch higher from here. CRM’s group has drifted from #7 eight weeks ago to #42 today, and its return-on-equity (ROE) has slowly eroded to 13.9% from a peak of 17.1% in 2010. For a “glamour” cloud-computing leader, such an ROE would not be acceptable for our purposes when it comes to buying the stock, and with earnings coming up towards the latter part of May one has to question whether CRM will be able to sustain its upside. High P/E ratios, such as CRM’s 95 times forward earnings, are great for companies growing earnings at 40-50% or higher, but it is not clear to me that CRM has the type of accelerating growth that can drive what is already a big right-side POD rally higher. Stay tuned as this one develops.
Aside from the PODs I am seeing begin to show up in this market, there are some of what I would term “second-stage” head and shoulders formations that are breaking down. Netflix (NFLX), not shown, has been one short like this that I’ve been testing since it gapped down last week after earnings, and so far that has borne some fruit. Green Mountain Coffee Roaster (GMCR), not shown, had a pattern similar to NFLX before it blew to pieces on Thursday, so we may be in a position where we see “second-stage” head and shoulders formations break down as well. Opentable (OPEN) is another one of these types of breakdowns as the stock gapped down on Tuesday after announcing earnings and so far the stock has held tight sideways in a classic “dead cat splat” situation. The high of this little inverted flag formation on the daily chart, not shown, is 37.99, so I would look to short the stock using that as my rough guide for an upside stop. If you go back and look at stocks like Crocs (CROX) in 2007-2009, there are at least two stages of major breakdowns in what starts out as a head and shoulders top. The first break usually occurs sometime after the stock breaks down through the neckline of the initial head and shoulders formation, after which it moves sharply lower and then begins a period of consolidating for several months before another leg down occurs. In this position, OPEN looks to be starting a second leg to the downside.
SodaStream International (SODA), a company that brings the production of carbonated beverages right into your home, all in the name of environmental friendliness and the promotion of “health and wellness,” is actually just starting to break down from a big head and shoulders formation it has been working on for about the past year. Looking at the weekly chart below we can see that the entire “head” that I’ve outlined on the chart is itself a head and shoulders formation, and the action since the stock hit a low in roughly November of last year has simply been a process whereby the stock has built a series of rolling right shoulders. A rally up into 32 as far as the 10-week/50-day line at 34-35 would be potentially shortable here, in my view. SODA was a high-flying IPO at one time, but since then its growth rates have turned negative, and the company is expected to continue to see its earnings growth remain negative over the next two years – definitely not the makings of a hot growth stock, as I see it.
I note this week in my screens that a number of semiconductor stocks are breaking down and/or rolling over, from Altera (ALTR) to Microchip (MCHP) to Novellus (NOVL) to even our once beloved but now scorned fabless semiconductor name Invensense (INVN), a once-promising new IPO that has since been “beaten Invensenseless!” The daily chart of the iShares Philly Semiconductor Index ETF (SOXX), below, illustrates this breakdown in the group quite nicely. While I don’t explicitly label it on the chart, it is easy to see how this is shaping up into a little head and shoulders type formation with a clear neckline, which I have indicated on the chart with a blue dotted line. If the general market remains weak, I would expect this to break down through the neckline. But if I were going to hit this on the short side by buying, say the inverse, three-times leveraged Direxion Semiconductor Bear ETF (SOXS) to play a further downside move in the SOXX, I would like to see just a little bit of a bounce in the SOXX into which to put on a position in the inverse SOXS. Otherwise, the bottom line here is that this rolling top that the semiconductors have been working on looks to be reaching its completion with a potential breakdown through the neckline becoming ever more likely, and this does not bode well for the market.
I would love to coo and giggle and tell everyone to not worry, that the market is fine and QE will come to rescue everything, but I just can’t help remembering May 2010 and August 2011, both short, sharp and brutal downside moves as a result of a temporary “QE vacuum” forming under the market. With no QE to support stocks, they don’t hold up very well in a QE-driven environment, at least based on past experience. That represents my greatest concern right here and now. Because if you sit all fat and long through another sharp QE break like we had in May 2010 or August 2011 you may get chopped up into chunky red salsa very quickly indeed.
On the other hand, such a break, should it occur in this market, represents a short-sale opportunity of very favorable proportions, and frankly that is what I’m looking at playing right now. It doesn’t necessarily have to pan out into a full-fledged bear market, but right now the odds appear to favor further downside, regardless of what it develops into from there. Therefore, I am not long this market, I am short this market, and the last two days of price/volume action in the market have confirmed my initial operations in this regard. I should emphasize, however, that one doesn’t have to go short in a market that may be running into some trouble on the upside. Cash is a perfectly acceptable vehicle to sit in while one waits for the rainclouds to pass, however long that may or may not take. Meanwhile, for those of you who like the excitement and danger of the short side, some set-ups are there to play, as I’ve discussed in this report. So choose wisely and remember, maximum 3-5% upside stops on short-sale positions at all times! Stay tuned, because this could get interesting.
CEO & Principal, Gil Morales & Company, LLC
Principal and Managing Director, MoKa Investors, LLC
Principal and Managing Director, Virtue of Selfish Investing, LLC