Jon D. Markman: Mid-cap stocks were one of the hottest investments of the past year until recently. That is clearly exemplified by the iShares S&P MidCap 400 Index (NYSE:IJH), which jarred investors by sinking 2.3% over the past three trading days. The exchange-traded fund (ETF) had shot up 33% in the 12 months prior.
But the good news is that a reversal could be in the making.
That is, the sharp decline of the past few days may have helped to set the right shoulder of an inverse “head-and-shoulders” pattern. This is a classic reversal pattern that tends to occur at the end of major declines. You can see for yourself on the accompanying chart.
I have marked the left shoulder, head and right shoulder of the pattern that is unfolding in the chart above on the right.
This is exactly the pattern that has ended all major declines in the past two years. The most recent example was last summer right around this time. In that case, the market moved up briskly to a high in early August before coming back down to set a second right shoulder. That’s a well-known variation that could easily occur this time as well.
The psychology of a head-and-shoulders bottom is what is important: Shares move down to the left shoulder on bad news, rally to a “neckline,” then sink deeper than the first low on worse news to a “head.” Then they rally back to the neckline before sinking one or two more times on bad news to levels that are equal to the first shoulder and not as low as the head. Finally, a new cadre of buyers come in, believing that prices are finally low enough, and push the market back up to the neckline.
To “validate” this pattern, prices need to shoot back over that neckline on higher-than-average volume and not return. Technical traders argue that the index should follow up with a subsequent advance that is equal to the depth of the move from the neckline to the head.
In case of IJH, the calculation is 101.1 – 92.5 = 8.6. So then you add 8.6 to 101.1 to get a target of 109.7. That would be a 14% move from the current quote, which obviously would be welcome.
It’s hard to say whether a similar move could occur in the absence of any extraordinary monetary policy efforts by the U.S. Federal Reserve. But it gives you an idea of what could happen if earnings and outlooks are better than expected this month, or if the market gets a hint that a third round of quantitative easing may be on the way.
And of course, it is possible that the pattern will not be validated.
A move back down, under 96, would invalidate the pattern and set up a test of the 92.5 area. So watch the MidCap 400 carefully, and be prepared to act.
Just keep in mind that a move back to the neckline is not enough. The index needs to move emphatically through that level. If the old high brings out sellers that push the market back down, we’ll keep an eye out for the potential of a second right shoulder much like last year.
They never make it very easy on us, but if you stay on your toes and really watch these levels carefully you can pick up a lot of clues that will augment your returns for the year in a big way.
Jon D. Markman brings a unique perspective and unparalleled insights to his role as a Money Morning contributor. And with good reason: During the past two decades, Markman has worked as both a journalist/commentator and as an actual portfolio manager. In addition to his contributions to Money Morning, Markman manages The Markman Portfolios, and is the editor of two premium investment research services: Strategic Advantage and Trader’s Advantage.
From 1982 to 1997, Markman was an editor, reporter and investments columnist at the Los Angeles Times. In 1992 and 1994 he was a news editor on staffs that won Pulitzer Prizes, the top award a journalist can receive. From 1997 to 2002, Markman was managing editor of CNBC on MSN Money. Markman is the author of four books, including the bestsellers Online Investing (1999) and Swing Trading (2003). His fourth book – an annotated version of the widely read investment classic, Reminiscences of a Stock Operator – debuted in late 2009. Markman is also the co-inventor on two investment-software patents. A graduate of both Duke University and Columbia University, Markman is a regular guest on radio and television, and at investment conferences – sought out for his insights on stocks, credit and the global economy. Markman lives with his family in Seattle.