Sector's Failed Breakout Points to More Downside Ahead

StreetAuthority Network

The iShares Dow Jones Transportation Average (IYT) has rallied in a strong fashion since the beginning of 2013, and staged a particularly impressive streak since the November 2012 lows. After a break past 12-month resistance in December, there was no stopping it, and traders heeding the transports' call were well rewarded being net long the broader equity indices.

But with the recently failed breakout to new year-to-date highs, IYT quickly reversed lower. Although potentially oversold in the immediate term, there looks to be plenty of downside ahead, so any bounce in the near future may be a good short-side entry opportunity for traders. 

Like many U.S. equity charts at the moment, IYT's chart is a tale of two tapes. On the one hand, we have the multi-year weekly chart, which has behaved well and still looks good from a technical point of view. On the other hand, the closer-up daily chart is flagging a much needed pause that may come by way of a mean-reversion move lower.

As I usually do, let me start with a look at the longer-term chart, which spans all the way back to 2007.

After completing a classic double-top formation in May 2008, IYT plummeted into the abyss where it eventually found a bid in early 2009 along with the broader market.

After a massive rally, the transports again found resistance in July 2011, just north of the May 2008 double-top level, before correcting to a vitally important higher low versus the 2009 lows. This October 2011 low led to a renewed rally, which didn't quite make it for a retest of the 2011 highs, but rather settled into an almost 12-month bull flag formation (blue parallel lines). 

The breakout of the bull flag occurred in late 2012, and it set the stage for the big 2013 rally. By February, IYT broke past the multi-year resistance line (red), at which point upside momentum began to slow.

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IYT Chart - Weekly

On to the daily chart below, we can clearly note the waning upside momentum by looking at Moving Average Convergence/Divergence (MACD), which topped in February and has recorded lower highs ever since. 

All the while the price of IYT kept climbing, steadily recording higher highs and holding crucial support and its uptrend line (blue). As the saying goes, the market can stay irrational longer than most traders can stay solvent. But, ultimately, such negative divergences between price and momentum succumb to gravity. 

Through this lens, the breakout to a new year-to-date high in early August was nothing more than overshooting, as it quickly gave way to selling that has pushed IYT below the May highs. 

IYT continues to look and feel decidedly heavy, and in recent days, has begun to form what may end up being a bear flag formation (blue parallel lines). Furthermore, this formation is developing right smack in the middle of the 50-day and 100-day simple moving averages (not shown on chart). A break below the bear flag would therefore also result in a snapping of those two moving averages, thus confirming the bearish setup.

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IYT Chart - Daily

Recommended Trade Setup:

-- Short IYT on a daily close below $113
-- Set stop-loss at $114.75
-- Set initial price target at $107 for a potential 5% gain in 4-8 weeks

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