Homebuilder's Chart Predicts It Could Plummet 23% -- Sell Now

Homebuilders bounced sharply last week thanks to a drop in interest rates on the back of Federal Reserve Chairman Ben Bernanke's latest dovish remarks. 

But not so fast. From a technical perspective, despite the bounce, the picture for homebuilding stocks -- such as today's trade setup, PulteGroup (NYSE: PHM) -- is not very pretty. 

Along with many other homebuilders, PHM broke its uptrend in April (despite a higher high in May). Furthermore, it is forming a classic head-and-shoulders pattern. Couple these two observations with the fact that interest rates broke significant resistance in the May-to-June period, and PHM looks to be setting up for a fall.

To better understand the technical picture for a particular stock, I always study the sector or group chart first. In the case of the homebuilders, the PHLX Housing Sector Index (HGX) works well for my analysis. 

HGX rose sharply off the 2009 broader market lows, and in early 2012, broke past a crucial resistance point, which can be seen on the multi-year chart below. In total, the index blasted higher to the tune of 160% off the higher low made in September 2011 (versus the 2009 lows) into the May 2013 highs. The May highs coincided with the 61.8% Fibonacci retracement of the entire sell-off from the index highs in 2005 down to the lows in early 2009. In other words, HGX found resistance at a crucial point.

Eventually, however, with the advent of higher interest rates in May, the index came crashing down, and by late June, had given up almost 20%. In fact, it retraced 25% (another Fibonacci number) of the entire 2011-2013 rally in roughly one month's time. 

Of course, such a sharp correction is nothing unusual because, as I often point out, stocks with slopes that are too steep eventually come back to Earth. More importantly, however, the recent sell-off was enough to break the steep uptrend dating back to 2012 on a weekly basis, and also traced out a large head-and-shoulders formation. HGX is now waving a sell signal.

HGX Chart

PHM has a daily chart very similar to that of HGX, and is therefore my go-to name for a short-side trade in the U.S. housing sector. 

Just like HGX's chart above, we can see the head-and-shoulders formation building. Another way to look at the topping formation is to view the May breakout to new highs as a fake-out sucking in the last few bulls at the top.

The neckline of the topping formation is around the $17.50-$18 area, and a break below there would be another feather in the bears' cap. Also note that the stock's 100-day simple moving average (blue line) acted fairly well as mini-support in the past. 

After the most recent bounce off the June bottom and neckline formation, the stock has once again bumped into this moving average. While I rarely use simple moving averages as hard levels to lean against, I am circling the $20 area as potential important medium-term resistance and the right shoulder of the head-and-shoulders formation.

PHM Chart

Recommend Trade Setup:

-- Sell PHM short at $19.50 or above
-- Set stop-loss at $20.50
-- Set initial price target at $15 for a potential 23% gain in 6-12 weeks

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