Market Summary

On Tuesday the markets got their wish that the Fed would not raise interest rates, but did not get the clarity regarding the Fed's future intentions that they would have liked. The accompanying statement left open the possibility of further rate rises as "some inflation risks remain". On the same day, the existence of these risks was reinforced by the Labor Department reporting that productivity slowed and labor costs rose in the second quarter. The waters were further muddied by a rare lack of unanimity on the Open Markets Committee, with one Federal Reserve president having voted to raise interest rates again now. Market, economic and geopolitical factors continued to conflict until Friday when all three major indexes closed down for the week with the DJI losing 1.35%, the S&P 500 dipping 0.99% and the NASDAQ Composite dropping 0.99%.

Investors are now hoping that inflation will abate as the economy slows and the Fed will see no reason to raise rates further. They also hope that the as yet unfelt impact of past rate increases, together with the slowing housing market and rising energy costs will not push the economy into recession. This delicate balance has investors in a heightened state of anxiety and we can expect continued volatility as each day brings news that affects the inflationary and economic outlooks. Additionally, we are in the dog-days of August and we are not likely to see any buying strength until September.

A 3 year chart of the S&P 500 shows that while we experienced a correction between mid-May and mid-June, the rally that began on June 14 is still intact and the index overall is continuing on its long term growth path. Although we still recommend caution, based on our market model for the NASDAQ indicating an exit, a move above 1290 would be bullish while a break below 1240 would break the long term support line and would be very bearish.

The number of breakouts fell to 15 this week but they did sustain an average gain by week's end of 1.44% - a significant improvement over the performance of the major indexes. Two breakouts from cup-with-handle bases made double-digit gains. These were Rent-Way (RWY, gaining 14.64%) which benefited from a take-over offer and Ralcorp Holdings (RAH) which gained 10.44%. Browne & Co. (BNE) broke out of a flat-base and gained 5.71%.

Breakdown Day Volume not Significant in Head and Shoulders Breakdowns

Last week we announced that we would send email alerts when stocks on our head and shoulders pattern watchlist fall to their breakdown price and their projected volume is at least equal to their average daily volume. In fact, we did not place a limit on daily volume and sent email alerts as soon as the breakdown price was reached. Why the change? After the announcement, we looked at the volume patterns for a successful H&S breakdown and concluded that the volume was not a significant factor.

The chart on the right shows a histogram of the number of breakdowns since 1999 against the breakdown day volume as a multiple of average daily volume. It is clear that there are many successful breakdowns when the daily volume is much less than the daily average (the daily average is at 1.0 on the horizontal axis).

This is very clear in the next chart which shows a cumulative histogram. It is evident that 50% of successful breakdowns occur at less than the average daily daily volume.

The question then arises as to whether or not the potential profit after breakdown is related to the breakdown day volume. If the potential return was greater on higher breakdown day volume then there would be justification in filtering the alerts by volume. In fact, we see that there is no relationship between potential return and breakdown day volume. The following chart is a scatter plot of the actual potential profit from each breakdown. You can see that substantial returns are possible when the breakdown day volume is well below the average.

We will consider a breakdown from an H&S pattern as confirmed if it closes below the breakdown price at the end of the alert day.

As always, we welcome your comments and suggestions. Please post them to the Breakoutwatch Forum.

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