SPY BATTLES SUPPORT - RETAIL HOLDRS BREAK SUPPORT - REGIONAL BANKS REMAIN WEAK - REVIEWING THE 2002-2003 BASING PROCESS - PROJECTING PULLBACK TARGETS FOR SPY

SPY AND DIA BATTLE SUPPORT... Link for todays video. After sharp declines in mid June and early July, the S&P 500 ETF (SPY) and Dow Diamonds (DIA) are testing support from the May lows. Chart 1 shows SPY with a head-and-shoulders pattern extending back to May. After breaking below the May lows on Tuesday-Wednesday, neckline support is becoming elastic as the ETF attempts to firm on Thursday. While this may seem potentially bullish, the break below the May low forged a lower low all the same. So far, this looks like a consolidation or rest after a sharp four day decline - not a show of strength. Chart 2 shows the Dow Diamonds going through the same process. The ETF gapped down five days ago and broke below its May lows this week. However, neckline support is not going easily as the ETF attempts to claw its way back above 82. So far, this looks like small rest after a sharp decline. In other words, the technical damage has already been done.

Chart 1

Chart 2

XLY AND RTH ALSO BATTLE SUPPORT... The Consumer Discretionary SPDR (XLY) is also battling support around 22 with firmness over the last two days. Instead of a head-and-shoulders pattern, chart 3 shows XLY forming a double top over the last two months. The break below the intermittent low confirms the pattern and targets further weakness towards 19-20. Like SPY and DIA, it looks like the technical damage has already been done. The July highs now mark the first resistance hurdle for the bulls to reclaim. Chart 4 shows the Retail HOLDRS (RTH) breaking double top support five days ago with a gap down. Even though the ETF bounced back on Wednesday, this gap is holding and it should be considered bearish unless filled. As with XLY, first resistance is based on the July high.

Chart 3

Chart 4

BANK ETFS FIRM WITHIN DOWNTREND... The Regional Bank HOLDRS (RKH) and the Regional Bank SPDR (KRE) managed to firm on Thursday, but both remain in downtrends overall. Even though these ETFs represent the same industry group, they are clearly different when it comes to performance. RKH fell around 17% from its May high, while KRE declined around 27% from its May high. One stock makes the difference: JP Morgan (JPM). Right or wrong, this regional bank accounts for over 23% of the Regional Bank HOLDRS (RKH), but does not feature in the Regional Bank SPDR. Chart 5 shows RKH with a falling wedge over the last two months. The decline may be slight, but it is still a downtrend. RKH needs to break above the wedge trendline and June highs to reverse this trend. Chart 6 shows JPM with a similar pattern, which is hardly surprising considering its weighting within the ETF.

Chart 5

Chart 6

In contrast to RKH, the Regional Bank SPDR (KRE) consists of some 50 stocks and each weighs less than 3%. It seems that KRE is a better representative of the regional banking industry. More importantly, chart 7 shows KRE in a definitive downtrend. The ETF started showing relative weakness back in April as the price relative started moving lower. KRE soon followed with a peak in early May. With a decline below 18, the ETF formed a falling wedge and retraced around 62% of the prior advance. While this is a good spot for a reversal, the trend remains down and there is no evidence of real strength. A break above 19 is needed to reverse this wedge.

Chart 7

THE 2002-2003 BASE... Way back on April 17th, John Murphy suggested that a head-and-shoulders bottom could evolve in 2009. On May 14th I looked at the 2002-2003 bottoming process for clues on what to expect in the current market environment. With stocks weakening over the last few weeks, I decided to revisit the bottoming process from July 2002 to March 2003. As chart 8 shows, this process took around nine months and involved some big swings. After a serious bear market and new lows in July 2002, the S&P 500 ETF (SPY) surged with a big summer rally that peaked in August. There was another test of the July lows in October and then a surge to the summer highs (~87). From the July low to the December high (5 months), there were three swings that were 20% or more. But wait, theres more. A head-and-shoulders top evolved from November to January and SPY broke neckline support with a sharp decline in January. Hmmit seems that SPY also has a head-and-shoulders pattern working now.

Chart 8

THE 2003 SURGE ... Chart 9 shows the decline extending into early March with a move below the February low. In fact, SPY came awfully close to its July-October lows. Despite a low in July and successful test in October, SPY decided to test this support zone one more time in March. This test proved successful as SPY surged in mid March and broke resistance from the mid February highs. As noted above, the 2002-2003 basing process took nine months and involved two very deep pullbacks (Sep-Oct 2002 and Jan-Mar 2003). Now lets apply these insights to the current SPY chart.

Chart 9

THE 2009 HEAD-AND-SHOULDERS??... Chart 10 shows SPY from September 2008 to September 2009. I added 45 days to the chart. SPY forged a new low in March and then surged back to its January highs recently. Even though the surge was historical in percentage terms, it started without a base whatsoever. A basing process involves sideways price action with pullbacks and/or support tests. Without a pullback from current levels, SPY would be embarking on a V bottom. In fact, it would be the most amazing V bottom in market history. As noted last week, anything is possible when the stock market is concerned. With SPY breaking the May lows this week, it now looks as if a correction is upon us. The chart extends into September. A 50-62% retracement of the March-June advance would extend to the upper 70s. In addition, a bottom in September-October would fit with seasonal patterns. There is also a chance for an overshoot should the low of the right shoulder (~73) match the low of the left shoulder.

Chart 10