GETTING TECHNICAL
The Next Big Technical Pattern
By MICHAEL KAHN
Could another technical pattern become so obvious to the public that it, too, will fail?
THE LATEST HOLY GRAIL IS starting to make its way around technical analysis circles.
When the market rallied off its July 8 low, chart watchers turned their eyes to a new kind of head-and-shoulders pattern -- one that would signal a long-term bottom if completed.
However, as I questioned the validity of the short-term head-and-shoulders topping pattern that appeared on most major indexes two weeks ago (see Getting Technical, "Whatever the Chart Pattern, the Bears Are Back," July 8, 2009), so, too, do I question yet another "too obvious" pattern in development.
A head-and-shoulders is a rather common pattern that forms during rallies as the market weakens and starts to fail. A central peak, or head, is surrounded by two lower peaks, or shoulders, and a line connecting the lows between them becomes the critical support. If prices move below that line, called a neckline, the pattern completes and the market is supposed to go down.
The long-term pattern now supposedly carving out a major bottom is an inverted version with a central low surrounded by two higher lows. For the Standard & Poor's 500, the left shoulder and head occurred in November 2008 and March 2009, respectively (see Chart 1). I disagree that the trough two weeks ago was a right shoulder.
CHART 1
In my experience, head-and-shoulders should exhibit both symmetry and proportion, and these two shoulders are significantly different in size. Compare this pattern with the inverted head-and-shoulders that formed at the end of the last bear market. The price troughs were much closer in size for a nicely proportioned pattern.
Similar talk of a big bottoming pattern for the current market also emerged in May. At that time, the rally from the March lows had hit its first real snag, and the tiny price decline was supposed to be the right shoulder. Clearly, that was a false assumption. But was the July selloff large enough to accomplish what it could not do in May? Again, I do not think so.
Two weeks ago, when the media and the public had fully accepted the short-term topping pattern as real, most people were thinking the same bearish thoughts. The market does not like such consensus and responded with a big move in the opposite direction.
If and when the public latches on to the supposed big bottoming pattern, it is entirely possible that a false breakout can occur here, too. Sentiment readings at that time will be critical in determining if the public has once again formed a unified opinion that will likely be wrong. Of course, if the proverbial "wall of worry" persists then we have a different situation.
Although I prefer to use the S&P 500 as my benchmark index, the Nasdaq has been the undisputed leader from the March low. Keeping tabs on the leader is always a good idea.
This index does not present so much an inverted head-and-shoulders but rather a double bottom (see Chart 2). This "W" shaped pattern has two lows -- November and March -- at roughly the same level. Resistance for the pattern exists at the temporary peak between those lows.
CHART 2
The Nasdaq broke through that resistance to the upside in April. Chart watchers can set a target price for the breakout by measuring the distance from pattern low (arguably at 1295) and high (1665) and projecting it up from the breakout point. In this case, we get roughly 2030.
This is just a guideline as other factors, such as chart resistance and the trendline from the October 2007 peak, come into play. Currently, the trendline is near 2000. Resistance from Oct. 3, when the market was in mid-collapse and formed a gap on the charts, is near 1947. In other words, that last mile for the Nasdaq may be very difficult.
This is not meant to be a short-term forecast but rather a framework for the bigger picture. As the S&P 500 trades toward its supposed neckline in the low 960s, I expect that more people will embrace another technical pattern that is really not there. A move above that level could have a similar, but opposite effect, and instead of creating a short squeeze it would create what a colleague has termed a "long squeeze."
When too many people think the same way, bad things happen.
Michael Kahn, mutual fund co-manager, author of three books on technical analysis, former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, also blogs at www.quicktakespro.com/blog.
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