Warning Signs in the Charts: How to Survive a Late-Summer Shakeout
Key Takeaways
- Strong earnings can lead to gap-ups that quickly reverse, especially when technical warning signs such as negative divergences and bearish engulfing candles are in place.
- A period of consolidation or correction is likely, and traders should adjust expectations accordingly.
- Long-term investors should tune out noise, while short-term traders need to be nimble and technically aware to navigate the choppiness ahead.
It had been a long time since the stock market suffered through a week like last week. Quite honestly, however, the selling was overdue. To that point, I wrote to our EB.com members on Thursday, stating, "We're very extended in the short-term and we've seen no follow-through after a very strong open this morning. Throw in the fact that I'm not a big fan of AAPL's chart heading into tonight's earnings report, and it's safe to say I'm growing a bit more cautious in the near-term and have raised much more cash personally."
We saw absolute blowout numbers from Meta Platforms (META) and strong numbers from Microsoft (MSFT) as well. Both charts showed excellent leadership in terms of relative strength among industry peers, and they were set up to report blowout numbers. I had even suggested that META's chart setup looked like a gap-up was coming, and appeared poised for an open somewhere above 745. META had closed at 695.63 before earnings, but ended up opening at 775 on Thursday morning. Many of the high-growth names, especially the leaders, rallied strongly at the opening bell. Many times, euphoric rallies end with excellent news, a major gap higher, and then failure.
Check, check, and check.
I keep saying that when a negative divergence is in play, it's a sign of slowing price momentum. A reversing candle can add the exclamation point. Check out the following S&P 500 three-month chart that shows the extended rally, negative divergence, and reversing candle (bearish engulfing).
That was a nasty candle, and the reversal occurred with the heaviest volume in a month. I'm guessing that this will be an important top for the short-term and that we could see an extended period of selling/consolidation, which technically would be a good thing. On this three-month chart, I see support from the 50-day simple moving average (SMA), currently at 61.29, down to the latest breakout, which was closer to 6050.
Also, keep in mind that the previous S&P 500 closing high in February was 6144. Broken price resistance becomes price support, so that the 6144 level should be watched closely. Another reversing candle after a downtrend at any of the support levels mentioned could mark a significant short-term support and establish a summer trading range. Further selling won't be a good thing for portfolios, though. It also won't be a good thing for traders, who've likely grown accustomed to buying and just letting stocks ride higher. Traders will need to be much more nimble and not trade based on emotion.
Volatility Spikes
This is what will make trading more dangerous in the near term. Check out the Volatility Index ($VIX) chart below.
We've seen two prior spikes in the VIX since that April low, one at 25.53 and the other at 22.51. I suspect any further selling will see a top in the VIX somewhere in this 22-25 neighborhood. If it jumps higher, the selling could escalate very quickly.
It is not unusual to see the stock market struggle during the August-September timeframe and the VIX rise. Check out this seasonality chart on the VIX over the past two decades:
The average VIX gains during August and September are the highest of all calendar months. This is when fear builds, historically.
Furthermore, I've shared my seasonality research on many occasions. While the media routinely touts "Go Away in May", I correctly point out that the real "go away" period is from the July 17th close through the September 26th close. Those are facts. I don't have a cute rhyme for it, but I do have the facts on my side. I also know that there have been 14 bear markets since 1950, and seven of them have bottomed in October. These next two months require us to lower our market expectations. I believe long-term investors should turn off all the constant negative noise that we're likely to hear over the remainder of summer. Traders? Well, Jack be nimble and Jack be quick, and Jack watch out for the key candlestick (there's my rhyme).
The Good News
There will definitely be a silver lining in what could be a messy late-summer trading environment. Prices will get cheaper. I'm already building a list of the stocks we'll want to own in our portfolios over the next few months. We're enjoying another stellar month with our Model and Aggressive Portfolios, with the latter absolutely crushing the S&P 500. Here's where we currently stand this quarter to date (May 19 to August 1):
Our Aggressive Portfolio has outperformed the S&P 500 by more than 15 percentage points, which is simply ridiculous. Even our flagship Model Portfolio is beating the S&P 500 by nearly three percentage points. Portfolio managers would love to outperform like this.
Finding the Next Group of Winners
As I mentioned earlier, I'm already scouring hundreds and hundreds of quarterly earnings reports, searching for the next group of relative winners to outperform the S&P 500. We'll announce those stocks when we do our next portfolio draft in a couple of weeks.
In the meantime, we're hosting a free event on Saturday, August 9, "Invest Confidently: 2 Steps To Better Stock Picks". Fundamentalists do not know how to time entries and exits on stocks. Technicians don't understand why their stocks rarely have staying power. We combine both to find the best, high-quality trade candidates to own for the next quarter. I am going to show you how we select our stocks, and our "since inception" track record above speaks for itself. Our system works!
While the event is free, you will need to register with your name and email address. CLICK HERE for more information and to register! I'll see you on Saturday!
Happy trading!
Tom
