#$^dwrtf

After breaking out of a massive cup-&-handle formation last month, REITs have returned to test that breakout level.

Early on in the week, a theme has definitely begun to emerge: “tests”. No, not the “back to school” variety but tests on the charts of financial markets. By chart tests, we are simply referring to occasions in which prices revisit former levels of significance and either confirm or reject previous action. If prices hold the level and resume course in the same direction as their prior encounter with the area, we say the test was successful. However, if prices move through the level in question, the test is a failure.

Over the past week, we have noted key chart tests of all varieties and durations. Utilities are testing their breakout level of last spring while, as noted yesterday, German stocks are testing their breakout of just a few weeks ago. Somewhere in between, we have a plethora of sectors and markets, e.g., the S&P 500, that broke out above significant levels in early to mid-July. Some of these groups are returning now to test those important breakout levels. Included among them are Real Estate Investment Trusts, or REITs.

On July 12, we noted that one of the main REIT indices, the Dow Jones U.S. Select REIT Index was not only breaking out to all-time highs, but it was arguably emerging from a historically uber-bullish chart pattern as well. The chart pattern is a “cup-&-handle” and typically leads to meaningful moves higher upon breaking out above its former peaks. After the breakout, the index was able to follow through to the upside by about 4% over the next 3 weeks.

Over the past 3 weeks, however, REITs have done an about-face, steadily pulling back to the point where they are presently testing the level of their July breakout.

As we noted in the July post, 2 of the largest REIT ETF’s in the market were essentially tracking the index step for step. That continues to be the case. Here is the SPDR Dow Jones REIT ETF (RWR):

And here is the Vanguard REIT ETF (VNQ):

Like other similar posts recently, the game plan ought to be pretty simple regarding such a test. Should prices hold the breakout level, longs should have the advantage. And considering, again, the cup-&-handle pattern from which this breakout came, with a successful test under the belt, REITs could have extensive upside potential. On the other hand, should prices be unable to hold the breakout level, we’d be looking at a false breakout. And as we’ve seen plenty of times in recent years, false breakouts or breakdowns can lead to just as powerful a move in the opposite direction.

One “wildcard” in this instance may be S&P’s reclassification of real estate as its own sector beginning August 31, 2016. The decision to move real estate out of the financial sector has led to plenty of speculation as to what will transpire. We’re not about speculating, though. We prefer to analyze the charts and the data and make investment decisions based on objective, quantitative strategies. Our belief is that all market pertinent inputs will necessarily be filtered through the data and through prices on the charts. Thus, investors need only to concern themselves with what is happening in the charts and data, rather than what supposedly caused the happening.

Thus, in this case, regardless of the impact of the S&P reclassification, the only thing that matters in the immediate-term is that REITs successfully hold the territory near their July breakout.

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More from Dana Lyons, JLFMI and My401kPro.

An index of U.S. REITs just experienced a potentially major breakout from a decade-long bullish chart pattern.

Following what we viewed as the popping of a likely real estate bubble in 2006-2007, our guess was that, after a dead-cat bounce, the sector would be dead money for some time. Almost 10 years later, apparently we thought wrong. Whether we are witnessing an echo bubble or whatever, real estate money is alive and well on some fronts. One such area has been Real Estate Investment Trusts (REITs). Now it is certainly arguable that REITs have been artificially propped up by the low-rate (or no-rate) environment and its accompanying affordability, access to deal financing and attractive dividends relative to fixed income instruments. Whether that’s indeed the case or not, though, we don’t care. All that matters to us is the fact that a major U.S. REIT index has just hit an all-time high -- and in the process, has broken out of a potentially very bullish decade-long chart pattern.

The index is the Dow Jones U.S. Select REIT Index. The chart pattern arguably in force on the chart is a “cup-&-handle”. We have discussed this pattern in other posts in the past, including the fact that it typically is considered to be a bullish pattern. What does it look like and why is it bullish? The pattern involves 2 parts, generally showing the following characteristics:

The Cup: This phase includes an initial high on the left side of a chart (in the beginning of 2007, in this case) followed by a relatively long, often-rounded retrenchment before a return to the initial high (in January 2015).

The Handle: This phase involves a shorter, shallower dip in the security and subsequent recovery to the prior highs (last month).

The bullish theory is predicated on the idea that after taking a long time for a security to return to its initial high during the “cup” phase, the “handle” phase is much briefer and shallower. This theoretically indicates an increased eagerness on the part of investors to buy the security since they did not allow it to pull back nearly as long or as deep as occurred in the cup phase. Regardless of the theory, the chart pattern has often been effective in forecasting an eventual breakout and advance above the former highs. And indeed, the Dow Jones U.S. Select REIT Index has broken out to new highs over this past month.

So how far does the pattern imply the index might rally after the breakout? That is certainly more of an art than science, but various technicians argue for a 50%-100% extension of the range of the “cup”. In this case, the cup ranges from a high around 100 to a low of 21.60 in 2009. Therefore, the range is about 80 dollars.

Based on the 50%-100% rule of thumb, if successful, the recent breakout would suggest an advance of 40-80 above the top of the range. That would be an extraordinary move, especially given the latter stages of the market cycle. Speaking of latter stages, we have warned many times about the market’s recent propensity for “false breakouts”. This is something to watch for in the event that prices do drop back down to (or below) the breakout point near 100.

Incidentally, it is not just the index that is breaking out above a potential decade-long cup-&-handle. Two of the most popular REIT ETF’s also share that same look as the Index.

First off, here’s the Vanguard REIT ETF (VNQ) breaking out of a post-2007 cup-&-handle.

Similarly, the SPDR Dow Jones REIT ETF (RWR) has just broken above its own potential 10-month cup-and-handle .

So what is the bottom line? While we remain leery of the aging equity bull market in the longer-term, in the near to intermediate-term, there is nothing more bullish than new all-time highs. Thus, until prices fall back below the breakout level, expect REITs to remain constructive -- and perhaps blow the roof off.

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More from Dana Lyons, JLFMI and My401kPro.