Head and Shoulders for the Utilities?

Aug 17, 2008: 4:55 PM CST

Is the Utility SPDR (XLU) on the precipice of a breakdown of a large head and shoulders pattern?  At a minimum, we need to keep a close eye on this index for a potential resolution one way or the other.  Let’s look.

XLU Weekly Chart:

Massive potential head and shoulders patterns such as this magnitude are rare, so when they form, it can be an excellent educational opportunity.  Traditionally – according to classical technical analysis – we would expect to see larger volume on the left shoulder, declining volume (and momentum) as the head forms, and finally the lightest volume as the right shoulder forms:  this is exactly the pattern we see here (notice the dotted declining arrow on volume).

Although I have not labeled the H&S pattern, it should be evident to you, in that the early 2007 swing is the left shoulder, late 2007 upswing (and “Measured Move” pattern – also not labeled) is the head, and finally the right shoulder formed in mid-2008.  Notice the roughly equal symmetry of the pattern, making it possibly too obvious to everyone to resolve as expected (‘perfect’ patterns often have a higher failure rate than ‘busted’ patterns).

Nevertheless, if we play the pattern out to completion, we take the height of the head and measure down to the neckline (blue horizontal line) and then project that downwards, should there be a closing break.  The Head to Neckline distance is roughly $7.00 ($43.50 – $36.50), thus a $7.00 subtraction from $36.50 projects price to a possible $29.50 target – if this results in being a true head and shoulders top pattern.

At the moment, price rests cautiously at the neckline (and thrice tested) support line, meaning also that a potential bounce/rally is possible as well (try not to be tied too much to a certain interpretation, and allow yourself to see other possibilities as well, so as not to be blindsided).

Let’s drop down to the daily chart to see if we can glean any clues.

XLU Daily Chart:

We see different momentum divergences preceding each price turn (swing) in the ETF, but we are seeing what I call a “Flatline Divergence” which is a weaker form of divergence than a pure positive or negative one.  The moving averages on the daily chart are in the ‘most bearish orientation possible,’ which does not bode well for the bulls.  The 20 day EMA has served as considerable resistance, thwarting any rally to it since July.

A major test of support is upon us in this key ETF/sector, and it will be important to note the resolution and aggressive traders may try to profit from a breakthrough (down) of these levels, or could alternately play a successful support test.  The key – whatever your choice – is that your stop will be close to entry and your target will be much larger than your stop.

Continue to watch this development as it unfolds, and we may have an answer as early as next week.

(Hat tip to Fresh Salt Water Blog for calling this structure a little earlier).

1 Comment

One Response to “Head and Shoulders for the Utilities?”

  1. Richard Says:

    The failure of the utility stocks is tragic for the retired fixed income investor who relies upon dividends and appreciating stock value.

    The minutes of the May 19th Bank of Japan meeting published by news services such as CEP News on Action Forex.com and other news sites, beginning in the third week of June 2008, mentioning inflation as an investment risk concern, caused disinvestment from the BRICS, EEB, and the Utility Stocks, VPU. That is to say the yen carry traders sold their stocks to take profit based upon the report.

    Like your chart above, the chart of the BRICs and utilities, shows EEB and VPU took a tumble together on June 23, 2008 — both lower on inflation concern.

    Rising inflation is stimulating risk aversion to stock investing world wide: stocks outside of the US, EFA, have been falling; while US Stocks, VTI, have been rallying on a rising dollar.

    Concern over rising inflation is seen in the fall of value of the inflation protected TIPS bond ETF, TIP, relative to TLT … TIP:TLT.

    The utility stocks are leading the way down; the Dollar Rally is ending as I write tonight, the USD/JPY is turning down, and the US Dollar, $USD, is falling.

    US stocks will be falling on Monday. I recommend short selling and gold; gold is a storehouse of value in inflationary times.