Getting Technical
WEDNESDAY, AUGUST 25, 2010
Head-and-Shoulders Portends Double-Dip
By MICHAEL KAHN
THE STOCK MARKET APPEARS to be undergoing a major attitude adjustment.
Former expectations of a sustained economic recovery are giving way to talk of a double-dip recession. But after a stellar earnings season that helped fuel a market bounce in July, August has seen an unrelenting parade of bad news on the economy, notably on jobs and housing. That has dragged stocks lower despite a surge in mergers and acquisitions that normally is a bullish portent for the market.
Investors still are pouring money into bonds. With Treasury securities from two-year notes to 30-year bonds barely offering a positive after-tax yield, the stampede is telling us the economy is not on strong footing.
Moreover, the deflationary undertow on yields extends to Europe, where German and British government bond yields fell to record lows. The malaise also is evident in Japan, where the Nikkei 225 entered bear-market territory earlier this week when it fell below 9,000, down more than 20% from its spring peak.
On the charts, the Standard & Poor's 500 remains in a sizable trading range between 1130 on top, called resistance, and a wider zone between 1020-1045 on the bottom, called support (see Chart 1). After a rather rough August, the index was somewhat extended to the downside as it dipped into the support zone Wednesday. The bears looked as if they need a breather.
Chart 1
Do not confuse the need for a rest in the short term with a probable upside reversal. The definition of "trading range" is an area where prices move from top to bottom and back in a repeating cycle. Therefore, it is always possible that the S&P 500 will once again test 1130.
But given that the market is still working off the "recovery premium" that bullish investors priced into it during the July rally, a true upside reversal seems unlikely. At least, not without a slew of better-than-expected economic news to flip sentiment back to bullish.
Last week, one technical indicator that made its way into the headlines was the Hindenburg Omen. Its widespread coverage by financial media suggests that the mood on Wall Street is rather negative.
Last month, a far less abstruse technical indicator, a large head-and-shoulders formation (see Chart 1 above), again was being noted. This pattern is marked by a central peak, called the head, surrounded by two lower peaks, called shoulders. Declines after each of these peaks take prices down to a support level called the neck line. The theory is that if the neck line is broken to the downside, then the market has confirmed a turn from bull to bear mode.
In early July, prices threatened to break the neck line but failed. Looking back, we can see that the pattern did not have the symmetrical shape it classically ought to have with roughly equal shoulders in terms of both price and time.
Fast forward to late August and the shoulders are now much more similar. To me, the spirit of the pattern—failed rallies and stronger declines—is in place. The neck line—the zone between 1020 and 1045 on the S&P 500—is now the site of what could be the final battle between bulls and bears.
To be sure, that's being dramatic. But if prices dip to the July low and buyers are not enticed to take advantage of a second chance to buy at the bottom of the April-July "correction," we'll know something is very wrong.
For now, the market is near the bottom of both a trading range and a large head-and-shoulders pattern. How it bounces, if it bounces at all, will let us know very quickly if next month will be more of the same trading range or something far worse.
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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