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Head and Shoulders Above The Rest

2020-10-15

 

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This blog post is a copy of the Investment Discussion I presented to my board Investment Committee today.  It was written for them, so please read it as such…Thanks!

Since we last met, the market has drawn out a inverse head and shoulders pattern (see graph above).

I’ve annotated the graph so you can see the three inverse head and shoulders moves.  You can also see the neckline of this pattern at 3429 (the horizontal green line I drew).

Typically this pattern is a bullish set up for a move higher in stocks.  Generally, your target higher is the distance of the neckline to the bottom of the head, or in our graph above its roughly 200 points on the S&P 500 Index.  That would give us a target of 3629 +/- (remember, it’s a target not a commandment that it will happen).

However, in the case where the pattern does not turn out to be bullish, then you have to measure your risk as well as your upside potential reward.  Here is how that works:

If we break below the neckline, then you have three targets that are easily seen on the graph:

  1. 33 points down you have the 50 day simple moving average at 3396
  2. 200 points down you have the bottom of the head at 3229
  3. 307 points down you have the 200 day simple moving average at 3122

We should not be surprised that the market pulled back after the fast and furious run higher from the late-September correction low (the bottom of the head).  You can see it ran straight up to resistance zone (highlighted pink) between the All Time High in the market and the beginning of the correction.

The chaotic nature of the news is driving the market right now.  We came off the bottom of the September low based upon news of an almost deal on stimulus and we have pulled back with news that it may be dead until after the election.

Right now?  We are trading in no-mans land – the blue shaded area between the neckline and the broken uptrend line off the bottom of the head.  Ideally, we want to see the neckline hold and the market move back above the uptrend line while heading toward the 3629 measured target of this pattern.  If it doesn’t, then we need to watch for a move to the 50 dma – fortunately, it is less than 1% below the neckline.  Holding that level will be key.

As far as strategy is concerned, remaining opportunistic is key for this market.  When the market bottomed in September, I put some of our cash to work in the growth, core and fully diversified strategies in small cap and value stocks which have underperformed the overall market.  If the neckline doesn’t hold, I will likely sell some growth stocks exposure in anticipation of a move down to the bottom of the pattern or even the 200 dma. I expect we will see increased volatility over coming weeks until the election is decided, so that could very well be the catalyst for a downdraft to the 200 dma that we were looking for prior to this pattern forming.

In terms of the shift into some small cap and value stock exposure in these three strategies, we will discuss that more in depth next month.  The markets have been primarily driven by beta allocations to the top weighted growth stocks in the indices – that appears to be changing, even if for a short period of time – and the lagging areas of the market will start to perform better.

Rising bond yields and a rising dollar both should result from the economy beginning to pull out of the covid shutdown recession which should favor the cyclicals and domestically focused small caps over the large cap growth stocks that outperform during falling interest rates and a slowing economy.

Note:  after I finished my meetings today I checked the market and the S&P ended nearly flat for the day after opening down > 1%.  Most notable, small cap value stocks ended up nearly 2% on the day, which makes me feel positive about the shifts we’ve been making to add value and small cap to portfolios. /msb/