Head and Shoulders Rorshach Test

In case you hadn't noticed, there’s a big head and shoulders debate brewing. A bona fide bulls versus bear story.

One side (the bulls) sees the stock market world from a decidedly more optimistic perspective with the potential of an upside breakout and a stock market run to new recovery highs. This view is exemplified by the first chart with the neckline somewhere around the 950 level (S&P 500).

Then there is the more pessimistic crowd who see the glass half empty with the threat of a downside break below the 880 level and the potential retest of the lows of early March (second chart above). The same price data, but seen from different time perspectives.

In both cases, old school market technicians will tell you nothing can be concluded UNTIL the pattern is complete, meaning that the neckline has to be broken and the ensuing move underway. It is most interesting that all this is occurring just as the markets enter the all-important earnings season and the fundamental justification for higher (or lower) prices, the answers to which we will receive in the coming weeks.

Investment Strategy Implications

Anyone who has read the technical analysis side of my work these past years knows that I am not a big chart pattern guy. No doubt there are those who have found a way of producing a better than 50/50 chance of predicting future price actions via chart pattern analysis, however, I am not one of them.

In my experience, the vast majority of chart patterns are like a Rorschach test – you see what you want to see. Frankly, the only consistent justification that I have found for paying any attention to chart patterns is the simple fact that many others pay attention to chart patterns, which then moves chart pattern analyses to the behavioral science realm – the study of your fellow investment rats and how they run the maze.

From the more bullish perspective (which is where I sit), the completion of a market bottom would be signaled by an upside break above the neckline. As I have written several times before, that would be the sign for the old school technical analysts to ring the bottom-has-been-seen bell. BUT, as noted above, that cannot/should not be done before the fact.

Or, to quote that investment sage, Yogi Berra, “It ain’t over ‘til it’s over.”

Comments

[Larry House:]

If you're not really a technical person, then I guess you follow fundamentals. What is there about the fundamentals that makes you bullish? Personally, I think both approaches are bearish right now.

Jul 07 04:48 PM

[DWStein:]

From what I've seen, the best approach is a fundamental view with entry and exit chosen with the help of technical indicators.

On the technical side, I have found that, like most trends, the indicator that's been working usually continues to work best. With that in mind, I think the 200 day moving average has been a good indicator since at least 2003: once the market is over the 200 day, it tends to stay there and vice versa.

We recently popped back over the 200 day, tested it, and are now testing again. If we break back through to the down side in a convincing manor, we well could retest the lows.

Jul 07 05:55 PM

[Mad Hedge F...:]

I think its already in. OK, so I don’t really open beer bottles with my teeth and do my own tattoos. But my call that the “golden cross” in the S&P 500 on June 23 was a bogus one turned out to be a bulls eye (see my report), and the abuse I piled on the analysts who predicted an upside breakout was richly deserved. I have kept a laser like focus on the real technical picture that has been unfolding for the last two weeks, that of a bearish head and shoulders top. David Fry nicely does the scut work on technical matters for me though his excellent ETF Digest blog. His chart and comments below are about to force us all to become historians, for it is setting up a perfect replay of 1937. That was when Roosevelt buckled under pressure from conservatives disgusted with four years of record government spending and groundbreaking social programs, and balanced the budget, igniting the second down leg of the Great Depression. It is no coincidence that both Chair of the Council of Economic Advisors, Christine Romer, and Fed Governor, Ben Bernanke, are authorities on this era. Thanks to Thursday’s diabolical employment numbers, Mr. Market is now telling us that a “W” recession and the second stimulus package it will demand are on the table. There is room for a short play here on US stocks. Look at the ProShares Ultra short S&P 500 (SDS), which is down 54% since March 9, and is overdue for a rebound. It will give you a nice 200% short position in a falling market. Please pass the church key.

Jul 07 08:49 PM

[Bruce Pile:]

Head and shoulders my foot! You can't tell much from this pattern of body parts until it's too late. I've found that other geometry is much more predictive. Also more significant is the pattern of the broad market following of leadership groups. It's been consumer discretionary both into this decline in '07 and up so far in '09 as well as tech. Do you see an inverse head and shoulders in the XLY? No. In the Nasdaq? No. You do see a definite break of the consolidation channel of the last two months to the downside.

Jul 07 10:21 PM

[catbox32@ya...:]

Elliott Wave. Learn what patterns are really saying. They are waves of pessimism and optimism... modeled patterns of herding behavior and form. Fundamentals are the "snake oil" of the financial industry and the financial alchemy of lying CEOs. Fibonacci and the markets reflection of man's growth in the world. Consider this a special moment to learn the truth... elliottwave.com. Catbox.

Jul 08 12:34 AM