Reading the tea leaves
The Dow Jones Industrial Average ($INDU) has been tracing out a dangerous-looking "head-and-shoulders" reversal top over the past few months that could put late-2011 lows back in play. That would be worth a 21% drop from current levels -- the definition of a bear market.
A head-and-shoulders pattern often signals a market poised to weaken, perhaps substantially. The Dow's October peak is the head of the pattern. The shoulders came in May and early December.
On price alone, there is also the long-term head-and-shoulders pattern the Standard & Poor's 500 Index ($INX) is tracing that dates to the late 1990s. Theoretically, technical analysts would argue, the chart is saying the S&P 500 could fall to zero. The odds are remote, but merely a return to the early 2009 low would be a 53% drop from here.
There's more. Over the past two weeks, breadth has been narrowing as buyers find fewer stocks that interest them at these levels. Options traders are moving into put-option protection, pushing the CBOE Market Volatility Index ($VIX) up dramatically. Inflation expectations are falling as expectations for economic growth and the efficacy of a Fed stimulus are rolled back. And "safe haven" assets, like the U.S. dollar and Treasury bonds, are strengthening.
To be sure, there will be temporarily relief rallies along the way -- such as the one we’re seeing this week. Flurries of excitement will greet signs of compromise in Washington over fiscal issues. But there are bigger issues in play. Besides, even if Democrats and Republicans come to an agreement, that means only that they've found a mutually tolerable level of economic damage to dole out.
For conservative investors, the best option at this point seems to be pulling out of stocks and parking their money in cash and Treasurys to wait out the storm. For the more aggressive and nimble, there are profits to be had betting against key cyclical groups (like energy) while leveraging exposure to safe-haven trades.
Examples, already added to my Edge Letter Sample Portfolio, include the Direxion Daily Energy Bear 3x (ERY) and the Direxion Daily 20+ Year Treasury Bull 3x (TMF) exchange-traded funds. Other, less-leveraged, funds include ProShares UltraShort Oil & Gas (DUG) and iShares Barclays 20+ Year Treasury Bond (TLT).
It's unclear if this will be a multimonth pullback or if the weakness will run into 2014. It depends on whether Washington can tackle its long-term budget challenges related to out-of-control health care spending and underfunded entitlement programs in a quick, minimally dramatic way.
The way things are going, with the partisan warriors armoring up for a fight -- not only on issues like taxation and Medicare but also gun control and contraceptives -- I'm not hopeful.
Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at anthony@edgeletter.com and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.
