Can The Utilities Hold Up?

03/29/05 12:10:54 PM

by David Penn

As a head and shoulders top threatens the utilities HOLDRS, are utilities stocks experiencing a Hound of the Baskervilles moment?

Security: UTH
Position: N/A

In the story of Sir Arthur Conan Doyle's "Hound Of The Baskervilles," the Sherlock Holmes classic, the mystery was solved by the intrepid Mr. Holmes not by a clue he found, but by a clue he didn't find--or rather, something that should have happened, but didn't.

I'm feeling something similar as I look at the daily chart (Figure 1) of the utilities HOLDRS (UTH). From one perspective, the UTH recently gave a buy signal that, while not occurring on exceptional volume, was a true moving average convergence/divergence histogram (MACDH) reversal to the upside and did in fact push the exchange-traded fund back above the 50-day exponential moving average (EMA), which it slipped below for one day.

From another perspective, however, the utilities HOLDRS are showing some real underlying technical weakness. It may be more appropriate to say "potential" technical weakness in deference to the powerful bull market that utilities stocks have enjoyed since bottoming in late 2002 along with the rest of the market. In fact, while the broader market struggled through much of 2004, the UTH represented a sector that did as well or better than most during that period.

Figure 1: Utilities HOLDRS. Head and shoulders top or buyable dip en route to new yearly highs? Had the March lows taken out the February lows and the same stochastic pattern been in place, the utilities bulls would have had a powerful argument upon which to build their case for significantly higher prices for UTH.

Graphic provided by: Prophet Financial, Inc.

But the weakness, in the form of the dip below the 50-day EMA (which the UTH had not done on a closing basis since June 2004) and the running negative stochastic divergence, is real. And given the age of the bull market in utilities stocks, this weakness--like a chest pains in the body of an overweight 65-year-old--is worth paying some attention to.

Here's where the "Hound" comes in--or doesn't, as the case may be. The negative stochastic divergence is bearish, maybe critically so. There is a negative divergence between the early and late February highs, and another longer-term negative divergence between the February and March highs. While negative divergences sometimes anticipate merely sideways markets rather than ones poised to move sharply downward, it seems to me that often enough the possibility of a significant reversal is real enough that traders and investors should remain, at a minimum, open to that possibility.

In this case, in order to counter the bearishness of the running negative stochastic divergence, it would have been helpful to have a lower low in March (relative to February) but a higher low in the 7,10 stochastic. Had this occurred, there would have been a potentially telling positive stochastic divergence embedded within the otherwise bearish head and shoulders top.

This is precisely what can be gained by combining indicators and chart patterns. As I wrote in a recent article for Traders.com Advantage ("The S&P 500's Intraday Diamond," March 24, 2005), indicators can often help provide directional clues for breakouts in chart patterns. In the other case, stochastic trends helped buttress the argument for a downside break in a directionally ambiguous diamond consolidation. Here, the stochastic is failing to provide support for the bullish, reversal-to-the-upside case.

The stochastic hinted back in February and March that a correction might be around the corner. For better or worse, nothing the stochastic has done since has changed that picture. And, like the hound of the Baskervilles that did not bark, the "silence" in the stochastic at present might be no less suggestive.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Can The Utilities Hold Up?

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