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Monday Morning Outlook: Which Head and Shoulders Will Come Out on Top?

Eyeing a few intriguing chart patterns forming for the Russell 2000 Index (RUT)

by 1/7/2012 10:40:50 AM
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It was an upbeat abbreviated week on Wall Street, as traders returned from the New Year's holiday in a buying mood. Rekindled euro-zone debt concerns stifled stocks' momentum as the weekend approached, but improving U.S. jobs data eventually helped the bulls prevail. As a result, the S&P 500 Index (SPX) notched together a four-day winning streak above its closely watched 200-day moving average. However, this week, Todd Salamone is taking a closer look at some intriguing technical patterns developing for the Russell 2000 Index (RUT), which could keep bulls and bears jockeying for supremacy over the near term. Meanwhile, Rocky White runs the numbers to find out what investors can expect during this election year. Finally, we wrap up with a preview of the major economic and earnings events for the week ahead, as well as a few sectors of note.

Notes from the Trading Desk: Short-Term Selling Could Precede a Bullish Breakout
By Todd Salamone, Senior VP of Research

"We head into 2012 with a mixed technical backdrop. The SPX is docked at a key resistance level, after trading above resistance during the past couple of weeks. Meanwhile, small- and mid-cap benchmarks linger just below major resistance zones of their own -- and, unlike the SPX, have not traded above these technical sticking points lately. While trading was thin last week, bulls might find it slightly encouraging that the market didn't experience a major smack-down, which has tended to occur on previous trips to current levels."

"The sentiment backdrop favors the bulls, after a year in which retail folks pulled $135 billion from equity mutual funds and short interest grew."
- Monday Morning Outlook, December 31, 2011

The technical backdrop turned slightly more favorable for the bulls last week, with the S&P 500 Index (SPX - 1,277.81) rallying from a trendline that connected its string of lower highs from July through most of December. Last week's advance pushed the index comfortably above its 2011-2012 breakevens in the 1,257 area and its 200-day moving average in the 1,260 region -- a trendline that had capped rallies since early November. In fact, the SPX has now closed above its 200-day moving average for four consecutive days. The last time the index put together such a string was late July 2011, right before the early August plunge related to the U.S. debt downgrade.

We looked back at previous instances since 2000 in which the SPX closed above its 200-day moving average for at least three consecutive days, after going a period of at least 100 trading days without three consecutive closes above this trendline. The very short-term implications were bearish, but the intermediate-term implications were noticeably bullish, which would suggest pullbacks could be buying opportunities.


SPX Returns Since 2000

Turning to the small- and mid-cap benchmarks, the S&P 400 MidCap Index (MID - 891.49) remains stuck below the key 900-920 range -- an area that marks the 2007 peak, 2011 breakeven and first-half 2011 lows, as well as its 200-day moving average. But all is not so bad in mid-cap land, as the MID closed the week above its 160-day moving average, which had capped rallies in October and December. The close above this trendline paves the way for a move into the 910-920 area in the coming months.


Daily Chart of MID since January 2011 With 160-Day Moving Average

Meanwhile, the Russell 2000 Index (RUT - 749.71) finally made a run at 750, its peak ahead of the 2010 "flash crash." The RUT ventured above 750 last week, but comes into the week trading slightly below this level. The index did close above its 160-day moving average at 742.09, after this trendline had capped a late-October advance.

There are a couple of potential technical patterns developing on the RUT that are worth noting. The first is a bearish head-and-shoulders pattern on a chart that goes back to the 2010 flash crash highs. Some skeptics are betting that a top could be in place right around the current "right shoulder" levels, with an eventual breakdown below "neckline" support in the 600 area. A consensus familiarity with this potential bearish pattern might explain why institutional investors, according to the most recent National Association of Active Investment Managers (NAAIM) survey, hold a relatively low allocation to equities -- even though stocks are up substantially from their October lows -- as they are hesitant to accumulate equities at these levels.


 Daily Chart of RUT since January 2010

But then again, this sideline cash could be the catalyst for a breakout above "neckline" resistance in the 750-770 area, as there are a couple of potentially bullish inverse head-and-shoulders patterns developing that would push the index up to its all-time highs in the 850 area. The early December low marks both a "shoulder" and a "head" in the two patterns, as seen on the chart immediately below.


 Daily Chart of RUT since July 2011

Given the sentiment backdrop, which appears to be a slow unwind of the climactic pessimism seen late last year, we would bet on an eventual bullish breakout. But with earnings season upon us, and another European summit and a Fed meeting later in the month, hedging your long exposure remains prudent. In fact, the CBOE Market Volatility Index (VIX - 20.63) closed at its lowest level since mid-July on Friday, and is trading in an area from which it briefly popped in late December, which presents a risk in the near term.

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