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Richard Shaw
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Richard is the managing principal of QVM Group LLC, a fee-based investment advisor based in Connecticut, with clients across the country. QVM also operates the site www.StopAlerts.com and the site www.RationalRisk.com. QVM manages portfolios uniquely designed for each client on a flat fee basis... More
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Perspectives on Return and Risk Management
  • S&P 500 Price Target From Head & Shoulders 2 comments
    Jul 4, 2010 10:07 PM

    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.



    Disclosure: Holdings Disclosure: As of July 4, 2010, we do not own any securities mentioned in this article in any managed accounts.
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Comments (2)
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  • Paul Hanly
    , contributor
    Comments (840) | Send Message
     
    Thanks Richard, The technical analysis of the probabilities was very interesting. For more on the relationship between the inverse of bond yields and stock PE's see:
    * The Relationship Between Stocks and Bonds: What Just Happened?
    seekingalpha.com/artic...

     

    Over the last few months we seem to have reverted to a much more conservative relationship as earnings have increased but yields have fallen. We are at the most conservative relationship since 1960 and at about the average relationship since 1871 based on Robert Shiller's data.
    5 Jul 2010, 12:45 PM Reply Like
  • SeekingTruth
    , contributor
    Comments (1329) | Send Message
     
    Richard, I think that you have compiled, and assessed the handwriting on the wall correctly.
    Unfortunately for us all, there are more things that can go wrong than right in our extremely fragile condition at present.
    If the clandestine forces and powers cannot force a rally, they may very well accept and exploit a strong downleg, which of course sets up the next rally , deserved or not.
    Necessity may be the Mother of invention, but preparation (with patience) is the Father of good fortune.
    5 Jul 2010, 07:25 PM Reply Like
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