Monday's Market Surge: Head-Fake or the Start of a Real Turnaround?

Whether Congress's proposed temporary bailout of Detroit, combined with Obama's stimulus plans to create jobs by repairing our aging infrastructure, was the engine that fueled yesterday's broad-based rally is immaterial to market technicians who, like me, are getting excited over the forming chart patterns. Not only are Monday's break-outs and bullish gaps displayed by many individual stocks (most notably the best-of-breed companies in the infrastructure and basic material sectors such as water transport, coal, construction, and steel as well as some tech stocks and electronic stock exchanges) but for me, the most exciting and possibly telling pattern could be forming in the the S&P 500 index itself.

Below is a daily chart of the SPX. To me, it sure looks like it is in the process of forming an inverse head and shoulders pattern. For the chartologically challenged, a head and shoulders formation is a very powerful chart pattern that is coveted by many traders because it is so successful. (For a closer look at these patterns and some examples, see my March 5th and 6th blogs.) Let's look at this chart more closely.

You can see that the left shoulder was formed from the beginning of October to the beginning of November. The neckline, or the new level of overhead resistance, is at 1000. The top of the shoulder is at 850. The head was put in two weeks later and occurred at the 750 level, one hundred points below the shoulder. The last several trading sessions have touched the 850 level again and yesterday's gap up is a strong indication that a right shoulder is beginning to form.

If this pattern is indeed in the formation process, what can we expect from here? As my arrows on the chart indicate, we should expect to see the SPX retest the neckline level at 1000 in the next week or so. The index will then reverse, and head back down to the 850 shoulder level probably some time in the beginning of January. If this level is successfully retested, then the only thing left to complete the pattern is for the S&P to rise back up again to the neckline. If it manages to break through that on heavy volume, we can easily expect it to rise at least another 250 points, which is the magnitude of the distance between the neckline and the top of the head.

Of course, these are a lot of ifs. Trading mavericks can play each leg of this formation as it develops; for the gun-shy, I'd recommend waiting until the entire pattern is formed and then taking a bullish position if and only if the index decisively breaks through its neckline level which will most likely happen in the middle to the end of January.

If this pattern does play out as I've indicated, it would do a lot to boost the confidence and morale of the retail investor which, I believe, have been more badly beaten up than the market itself.

Comments

[harringd:]

Could you please add a link to the March 05 and 06 articles you mention.

Thanks

2008 Dec 09 08:20 AM

[je:]

Until it rises above the two most recent highs it is still in a declining range, which could be a bull flag... or take the last twelve days and that could be forming a bear flag. I have done what you have done here so many times only to be dissapointed.

You can jump in for quick trades or wait it out. I think the market wants a rally but I think it would pick up a lot more steam once it tests this most recent gap window for support and finds it. I think we could have a nice rally in to the options expiration theatrics of volatiliy.

2008 Dec 09 08:27 AM

[herbert hoover:]

If I've learned nothing over the years, I've learned to be very, very cautious when everyone is this optomistic. Two weeks ago everyone was a bear, now everyone is a bull. What changed? Nothing, in fact the economic news gets worse and worse yet every analyst is telling us that the market is turning. Be very careful people.

2008 Dec 09 08:50 AM

[rozer:]

wait till January 2009 holidays are over ,its a fake market ,manipulated by few like a oil market few months ago

2008 Dec 09 09:08 AM

[johnm:]

A lot of articles I read call for a bottom (some for the start of the bull)
yet at the same time they mention that the sentiment is very negative.
I thought that the contrary sentiment indicator meant that when all hope
for a bottom is lost is the time to buy.
Am I missing something?

2008 Dec 09 09:34 AM

[Smarty_Pants:]

I am cautiously optomistic at this point for the makings of a bear market rally. Tuesday's down open basically filled the gap and I took a cowardly small bullish position anticipating what I hope will be a breakout to the upside for the near term. You can bet I will abandon that very quickly if market action proves me wrong.

Good chart Doc. For those who are new it shows and explains a lot of information about how technicians operate.

2008 Dec 09 10:19 AM

[je:]

I think we could get a rally. I've been studying the pattern and I really believe that it is more of an ascending wedge at this point but it doesn't matter because they all have approx. the same target.

I think the biggest reason that it will rally is because of short covering. We have options expiration next week and it is the week before Christmas as well. There will be a lot of trades clearing before then.

I would like to see it pull back to the 850 level wuithin th enext couple of days. I think you would not only have the shorts clearing but new trades as well coming in at that level.

Yes Jan will sell off.

2008 Dec 09 01:15 PM

[John Lounsbury:]

Kris - - -

I also look for head and shoulder patterns, but I have learned through many disappointments not to start looking at them seriously until past the second shoulder and approaching the neck line.

Also, I have a big concern regarding the rally that started November 21. I wonder if it is an anticipation rally, anticipating the formation of the Obama cabinet. If so, will the market sell the news when the cabinet is largely announced this month. Will we then have another anticipation rally approaching inauguration? Then will we see another sell-off? Buy the rumor and sell the news seems to be especially operative in times of high volatility. An example is the rally from late October to November 3, followed by declines to new lows on November 20.

2008 Dec 09 01:36 PM

[Crudeman:]

Kris..where you see and inverted h & s pattern, I see a W forming. I still think we'll get a full test of the 7400 previous low and then hopefully a rally. We'll still get the same result...mine will just take a bit longer.

2008 Dec 09 02:28 PM

[Smarty_Pants:]

Still waiting for the bowlegged camel formation to really pile on.

2008 Dec 09 02:35 PM

[Buddy Fox:]

As I peer into my tea leaves this morning the crescent formation of the leaf to the right indicates the market is likely to trend range bound within a 200point bound for approximately 2 weeks, as indicated by the number of upper leaf perforations. However my astrologer indicated the Spring orbit of Jupiter could potentially mark a rally as the alignment in the cosmos is affected by potential solar flairs. For the more cautious I'd wait until perhaps the west coast has several days of rain as the changing season should mark the start of another upward cycle.

2008 Dec 09 05:22 PM

[CLH:]

Forget the head and shoulders they mean nothing. The market has gone up 9 out of 11 days while bad news is everywhere. This to me means that the market has turned. The important thing is how long will it last?

I expect it to go up slowly with low volume (few sellers left) and people will not notice. As buyers appear slowly the rally will get better.

Last Monday looked like a correction in a bull market --a last gasp of the bears.

2008 Dec 09 10:37 PM