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The Dow Jones Industrial Average has successfully repelled the bears' latest attacks. But a closer look shows we should thank its technology components for the resilience, because many industrial stocks are hanging on by a thread.
One aspect of chart reading is understanding that certain price levels that acted as turning points in the past often serve as turning points in the future as well. Even though individuals may not recall what happened to cause people to sell at a certain level, the collective conscience of the market does.
Technicians simply call this resistance.
The chart of the Dow Jones U.S. Industrial Machinery Index offers a good example of this. The index stalled in August, right at an all-time high set in 2014, and then sold off sharply when it tried to trade there again in September. Currently, we can see this as a double-top pattern.
Various technical indicators show waning momentum and money flows in the index, so the odds now favor an end to the 2016 rally. However, I caution that, as with all technical patterns, we must wait for the actual breakdown before selling. For this index, that would occur with a move below its September lows at 434.
But there's one stock in this sector that has already completed its breakdown and is poised for a 10%-plus drop.
Illinois Tool Works (NYSE: ITW), a maker of diversified industrial products for the automotive, construction and food service markets, was one of the stronger stocks in the group. It cleared its 2014 high early this year and just kept climbing, hitting an all-time high in early September. But it's been all downhill since then.
Aside from setting a lower high and lower low -- the basic definition of a falling trend -- ITW also completed a double-top. (I'm not counting the spike high as only one trade seems to have taken place at that level, which seems to indicate a data error.)
On Thursday, ITW dropped below its September low to confirm the change in trend. Momentum indicators such as the Relative Strength Index (RSI) are clearly in decline, and we bearish divergences from price action ahead of the breakdown.
What's interesting about the breakdown was that it occurred right after the company announced better-than-expected quarterly earnings and even slightly raised the midpoint of its earnings guidance. Shares sold off 2.1% on the day, telling us investors were expecting more than they got and are likely moving on to greener pastures.
I'm looking for a double-digit percentage drop from current levels as the stock breaks down below the rising trendline that supported the rally this year.
Support rests at the bottom of the June correction at $98.32. This is quite close to a 50% retracement of the 2016 rally, as well as the top of the previous rally in 2015 in the $100 area. That makes our downside target quite compelling.
There is risk of a small bounce here. Since the stock is broken, though, I wouldn't wait around for that in hopes of entering a short position at a higher price. However, everyone's trading style is different, and if you'd rather be on the conservative side, there is a strategy that can increase your odds of success to as high as 90%.
Recommended Trade Setup:
-- Sell ITW short at the market price
-- Set stop-loss at $118
-- Set initial price target at $100 for a potential 12% gain in eight weeks
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