Boy, is the market humbling! As you will recall, late last year, I proclaimed the “end of the market.” Not really — but I did say in no uncertain terms that I thought 2006 would be a rough year for equities — and for most stock investors.

I guess the market hasn’t been listening. I say, “down,” and stocks go up. Doesn’t anybody listen?

The answer is no. And that’s why I believe so strongly in technical analysis. You see, it doesn’t matter what I think — because the market is always right.

That’s why I am so committed to using technical analysis. Technical analysis helps you distinguish trends from trading ranges, setups from breakdowns, imminent breakouts from impending collapses. It enables you to discern market trends in their early stages. And if you learn to master different technical analysis methods, you can utilize them to pinpoint the areas of the market where the profit potential is greatest.

Now back to my prediction of doom and gloom. The truth is I really don’t know what will ultimately happen to stocks this year. But I don’t trade based upon forecasts. Making forecasts is fun. However, deciphering trends — and then trading with them — can make you money. There is still a lot of time left in 2006, so we’ll see if my prediction of a rough year for equities comes to pass.

But whether my prediction turns out to be right or wrong, there is one piece of business I need to take care of today. That is the topic of this column.

Two weeks ago, I promised you Sleuthers that — in conjunction with my forecast of a difficult year for equities — I would point out one sector that looks particularly weak. So it’s time to make good on that promise. But given my negative outlook, it shouldn’t have been too hard to find a corner of the market ripe for a fall, right?

Well, despite a generally strong market in 2006’s first two months, I did find a sector with real potential — downside potential, that is. So here goes.

In a famous scene in the 1967 movie The Graduate, a family friend named Mr. McGuire (played by Walter Brooke) approaches Benjamin Braddock (played by Dustin Hoffman) during Ben’s college graduation cocktail party to dispense some career advice. Here’s how the exchange goes:

Mr. McGuire: I just want to say one word to you. Just one word.
Benjamin: Yes, sir.
Mr. McGuire: Are you listening?
Benjamin: Yes, I am.
Mr. McGuire: Plastics.
Benjamin: Exactly how do you mean?
Mr. McGuire: There’s a great future in plastics. Think about it. Will you think about it?
Benjamin: Yes, I will.
Mr. McGuire: Shh! Enough said. That’s a deal.

We don’t know whether Ben took Mr. McGuire’s counsel and charted a career in plastics. However, in the spirit of Mr. McGuire, permit me to whisper the following word in your ear: “Utilities.”

If you follow the market closely, you are keenly aware that the Dow Jones industrial average has been one of 2006’s stronger broad-based indexes — up 3.5% year to date and just off its highest level since June 2001. The Dow Jones industrial average is an index of 30 well-established, diverse companies.

But there are other averages created by Dow Jones. One of them is the Dow Jones utility average. This average — created in 1929 and reported on every day in financial newspapers and stock market Web sites — is not nearly as widely followed or broad-based as its industrial cousin.

But the Dow Jones utility average is an index of 15 large-cap, well-established companies. So while it can’t give you an inkling of the overall market’s prospects, it can give you a good indication of how things look in the utilities sector.

And you know what? Prospects in the utilities corner of the equities world don’t look nearly as bright. It’s my belief that when stocks are acting well, you want to own the best performers you can find. Conversely, the ones you want to short, buy puts on or sell if you own them are the ones that are struggling. Suffice it to say that — although utility stocks have rallied recently — the potential for large gains in the sector does not appear very great over the next several months.

Now, the sectors that lead the market do change. After all, buying interest does rotate from one industry to another. For example, not too long ago, oil stocks — along with my beloved gold shares — were all the rage among investors. However, both of these sectors have taken it on the chin lately, while financial issues have impressively zoomed to the forefront.

But when I looked at the daily chart of the Dow Jones utility average, I saw a lagging sector with the potential for continued weakness — despite its recent up move. First of all, the Slow Stochastics are in the overbought range. Now, for a stock or index in the midst of a strong rally, that’s bullish. Unfortunately, that’s not the case for the Dow utilities.

The Dow utilities just reached overbought status on a rally off their 200-day moving average. That rally has seen the average climb 4.7% in two weeks. While profits are always welcome to shareholders, let’s face it — the index became overbought in the absence of a major move. That’s not encouraging.

Even if the index should continue to rally, potential trouble looms for the Dow utilities in the 420-422 area. That’s where the index topped out in December. That December top is not the highest level the average has attained in recent months. Actually, the index got as high as 428.25 on Jan. 20.

But should the Dow utilities trade up to their 422.74 December high, the average will have traced out a bearish head-and-shoulders pattern on the daily chart — with the December peak forming the left shoulder, the current high forming the right shoulder and the January top marking the head. So whether the index stalls out here or stays overbought and runs a bit higher, significant technical challenges abound.

The index faces other technical obstacles as well. First, the Slow Stochastics, the 14-day Relative Strength Index and the Moving Average Convergence Divergence are all at lower peaks than they were at the index’s January swing high — significantly lower in the case of the MACD. That suggests that the likelihood that the Dow Jones utility average has just commenced a major bullish trend change is small.

Not only that, but the Dow utilities suffered a dramatic decline from their Oct. 4 zenith, falling 14.1%, to a low of 378.05 in just over two weeks. Since that time, the index has generally been grinding its way north — with a series of higher highs and higher lows.

Now, an index making higher highs and higher lows is usually bullish. But given the manner in which the index has traded, it’s not. That’s because those higher highs and higher lows have been relatively meager, with the index trading nowhere near its October high. In fact, since its Oct. 20 low, the Dow utilities have traced out a pattern known as a “rising wedge.” I won’t describe what a rising wedge is today — except to say it’s bearish.

As you can see, there are a lot of reasons to look at the current rally in the Dow Jones utility average with a jaundiced eye. What’s the potential downside? For starters, one could look for another move back down to the 200-day moving average — currently at 399.24. That’s where the index found support in October, November and earlier this month.

If the 200-day moving average should fail to contain any decline, a move to the November low, around 385, would likely follow, with a further drop down to the key October bottom, below 380, a distinct possibility. And if the overall market really starts to struggle, this index could be in the forefront of a severe downdraft.

There are a couple of ways to try to take advantage of weakness in the utilities sector. I’ll talk about that next time.

Trade well,

Mark Bail
February 28, 2006

I Just Want to Say One Word to You was originally featured in the Penny Sleuth.