Richard Shaw's  Instablog

Head and Shoulders patterns are popular indicators of a trend reversal for both tops and bottoms. We may have one now suggesting high 800's as an S&P 500 price target. The folks over at StockCharts.com report that a Head and Shoulders may be upon us. Let's look at that logic a bit.

The interpretation of Head and Shoulders patterns includes a very general price projection method, which measures the distance from the Neckline to the Head, and then projects a further price move in the opposite direction of the Head from the Neckline. As with any projection method, whether chart-based or fundamental, it is only approximate, doesn't always work out, and should be taken in consideration of other indicators and factors for confirmation.

Let's look at a possible Head and Shoulders that may have recently completed, and also compare it to the reverse Head and Shoulders that occurred around the March 2009 low.

In this image of the S&P 500 index (proxies SPY, IVV and VFINX), we see a Shoulder at "A", a Head at "C", a Neckline defined by "B-D", and an Shoulder at "E".

The distance from that Neckline to the the tip of the Head was about 280 points long (the red vertical). Projecting from the Neckline at about 946 in the opposite direction of the Head (the green vertical), suggested a price target of about 1226. The high in April was 1220 --- pretty close.

In the immediate past, there may be a Shoulder at "F", a Head at "H", a Neckline at "G-I", and a Shoulder at "J".

The distance from the Neckline to the tip of the Head is about 172 points. Projecting 172 points in the opposite direction from the Neckline, we arrive at a plausible price target of 876.

Given that, what confirmation can we derive from other independent indicators?

Price probability cones, based on 21-day (1 month) and 63-day (3 months) historical volatility (standard deviation) projected forward 63 days, using 90% probability says that 876 is roughly within the 90% probably price range -- not that 876 is 90% probable, but that a price lower than roughly 860 to 870 is only 5% probable [5% probable above the cones, 90% within the cones, and 5% below the cones]. You can see those cones projected to September 30, on the right side of the price chart above.

Clearly, the last couple of months have been in a downward direction, so assuming continuation of that direction for a while is more reasonable, we think, than assuming an upward direction -- but, of course, we could be wrong.

The next chart (a box chart that is time independent and only plots new boxes when the average daily price range is exceeded), shows the general area of 1050-1040 as a repetitive support price in the past. Now that the support level is clearly breached, it may be logical to assume an "air pocket" with a further drop of 10% or so, which would tend to put the price of the index in the range of about 920.

Standard and Poor's projects trailing "as reported" earnings through September 2010 to be $65.83. An average kind of multiple on that would be around 15 or 16 (broadly 975 to 1050 as a target). A price target of about 876 would imply (assuming the S&P earnings estimate is reasonable) a P/E multiple of about 13+. That does not seem so unreasonable to us in what we see as a very weak and fragile (or at least highly uncertain) global economy. In any event, it is not a terribly unreasonable multiple in these times.

Some would argue that with such low interest rates, multiples should be high (reminiscent of the old Fed model of expected P/E equal to the inverse of the 10-year Treasury rate). That idea may have held water in prior periods, but these days such low rates and their continuing decline is not a positive sign, but rather a sign of worry about trouble ahead. In our view, P/E multiples should be depressed when trouble is expected.

For these and other reasons, we are on watch for a possible S&P 500 index level of about 900 -- down about 10% from here.

The opposite may happen, and we will change our view and behavior accordingly when and if that happens, but for now, we think the handwriting on the wall is for more down than up, and for a possible target of around 900.

We certainly hope we are wrong, because we'd like to be back in the game, and not sitting on so much cash. We'll just have to wait and see.

Holdings Disclosure: As of July 4, 2010, we do not own any securities mentioned in this article in any managed accounts.

Disclaimer: Opinions expressed in this material and our disclosed positions are as of July 4, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.

June 16, 2010

According to Vanguard projections (made 3/29/10 for, AAII Journal, June 2010, page 7) 10-yr Treasury rates are implied by the current yield curve to be 4.4%, 5.2% and 5.6% by 1 year, 3 years and 5 years into the future. The current rate (June 15) is 3.32%.

They don't do a great job of explaining just how they got to those projections, but given their huge bond asset base, we think they should be presumed to be well qualified to make the projections.

They certainly cover themselves well with a disclaimer. Basically, they say you've to make some projection, but the future often unfolds differently. Therefore, broad diversification among bonds is more likely to be satisfactory over time than a narrow focus, which can seem right now, but turn out quite wrong later. --- So their article and this discussion is probably better than doing nothing all, but, as with any forecast, shouldn't be taken as ultimate truth.

For perspective, they report that historical rates were 4.9% since, 1800, 4.7% since 1900, 7.3% since 1970, and 4.6% since 2000.

The price implication for 10-year Treasury rates, by our calculation, is for price declines of 9.6%, 16.5% and 19.9% by years 1, 3 and 5.

That calculation is based on multiplying the duration for the current 10-year Treasury (which is 8.67 years) by the percentage yield change (1.1 * 8.67, 1.9 * 8.67, and 2.3 * 8.67).

Considering the interest that will be received over the holding period (without reinvestment), the net of price change and interest proceeds would be implied to be losses of 6.3%, 6.6% and 3.4% over 1, 3 and 5 years.

Those expected interest rate changes are large versus short term history, as the 1-year chart shows..

However, this 10-year chart of the rates for the 10-year Treasury, shows Vanguard's projections to be very much in the range of rates that we experienced in the period from 2000-2007 (except for a dip below during the last major bottom in 2002-2003).

This 50-year view of rates for the 10-year Treasury, shows plenty of room for rate increases well beyond Vanguard's projections in times inflationary, stress as we had in the early 1980's.

Related ETF products: IEF and TLH.

Holdings Disclosure: As of June 16, 2010, we do not own any securities mentioned in this article in any managed accounts.

Disclaimer: Opinions expressed in this material and our disclosed positions are as of June 16, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.

May 27, 2010

Bloomberg reported today (May 27) that this has been the worst US stock market in the 70 years since 1940. That's pretty bad, BUT there are some individual stocks and some ETFs with strongly positive price performance.

We filtered four lists (S&P 500, S&P 400, S&P 600 and ETFs) to find those securities that show these five price conditions using daily closing prices:

• positive slope of the 1-year best fit linear regression trend line
• 6-month average greater than 12-month average
• 3-month average greater than 6-month average
• 1-month average greater than 3-month average
• price greater than 1-month average.

That makes for a solidly positive trend.

Here is how many past that test:

• S&P 500: 53
• S&P 400: 38
• S&P 600: 45
• ETFs: 36

That is too many to put into lists for this article. A single Excel file containing the name and symbol of those securities in a separate tab for each list is available for download.

(Download File)

Holdings Disclosure: As of May 27, 2010, we may or may not have holdings in some of the securities in those lists in some managed accounts. Nothing about the list of securities is in any way a recommendation to buy or hold those securities. The list is simply identification of those securities with a strong up trend pattern, as defined by the filter criteria disclosed above.

Disclaimer: Opinions expressed in this material and our disclosed positions are as of May 27, 2010. Our opinions and positions may change as subsequent conditions vary. We are a fee-only investment advisor, and are compensated only by our clients. We do not sell securities, and do not receive any form of revenue or incentive from any source other than directly from clients. We are not affiliated with any securities dealer, any fund, any fund sponsor or any company issuer of any security. All of our published material is for informational purposes only, and is not personal investment advice to any specific person for any particular purpose. We utilize information sources that we believe to be reliable, but do not warrant the accuracy of those sources or our analysis. Past performance is no guarantee of future performance, and there is no guarantee that any forecast will come to pass. Do not rely solely on this material when making an investment decision. Other factors may be important too. Investment involves risks of loss of capital. Consider seeking professional advice before implementing your portfolio ideas.