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Why Last Week's Rally Is a Bad Sign for Stocks

By Jeff Clark
Tuesday, June 23, 2015

The Dow Jones Industrial Average screamed 200 points higher at one point last Thursday. The S&P 500 jumped more than 20 points. And the Nasdaq was up 50.
It was a HUGE, broad-based rally that punished the short sellers and breathed life back into the deflated bulls.
But it was bearish.
Let me explain...
Last month, I wrote two articles about how to profit as stocks fall. We looked at a couple of different patterns that tend to mark the top of a market or individual stocks.
One of those patterns was the "Head and Shoulders Top" formation. This is a bearish pattern that often signals the end of a bull trend and the beginning of a bear trend. And it can lead to large and fast gains for folks willing to bet on the downside. (If you're not familiar with short selling, you can learn more here.)
Now, take a look at a current chart of the S&P 500...
Last Thursday's rally to 2,126 on the index (and yesterday's move higher as well) formed the right shoulder of a potential Head and Shoulders Top formation. It lines up perfectly with the left shoulder high back in April.
The neckline of the pattern is down around 2,078. A decisive break below that level gives us a downside target of about 2,038 on the index. (You can calculate the projected price target for an asset or index in this pattern by taking the difference between the top of the head and the neckline and subtracting it from the neckline.) That lines up with the March low.
It doesn't have to play out this way, of course. If the bulls can rally the S&P 500 to a new high above 2,134, then it will negate this bearish setup.
But with the high-yield bond market rolling over, the massive divergence in the Dow Jones Transportation Average (which peaked last December and failed to make a new high while the Industrial Average marched even higher), and the poor recent performance in market-leading stocks like Intel (INTC), there's a good chance this Head and Shoulders Top pattern will play out to the downside over the next several weeks.
Aggressive traders can take advantage of yesterday's big move higher by shorting the S&P 500 index near the 2,126 level with a downside target of about 2,038. Stop out of the trade for a small loss on a close above 2,134. That will give you an excellent risk/reward setup.
Best regards and good trading,
Jeff Clark

Further Reading:

"Short-selling is an important strategy for any portfolio," Jeff writes. "If you're only investing on the up moves, you're only taking advantage of half the opportunities." Get all the tools you need to make money on short trades here and here.
The "Head and Shoulders Top" formation is just one of many indicators Jeff uses to see where stocks are headed next. Brush up on some of his other trading tools here: Bollinger Bands, the MACD indicator, bullish percent indexes, and the "empty restaurant" indicator.

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