Head and Shoulders

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Head and Shoulders Pattern

As we celebrate Labor Day with an official 9.7% unemployment rate, our Nation indeed appears to be headed for what some are cleverly calling a "jobless recovery." Politicians and economists glibly predict that the rebound will feature high industrial productivity with commensurate corporate profits but may also leave an increasing number of Americans out of work.

Besides being incensed by the insensitivity of these commentators' remarks, when I hear the phrase "jobless recovery" being bandied about ever more frequently, I have to wonder whether those "employing" it really fathom how profoundly foolish their notion is. It's just about as inane as hope for an economic recovery without the participation of the American consumer.

Since the consumer must first produce in order to later consume, and since any such production would naturally require that he or she have a job, any hope of sustained recovery in our economy seems fleeting at best. We should note by exception that the arduous task of making money out of thin air (or from other peoples' pockets) is best left to investment bankers and politicians.

In light of this hollow economic backdrop, fueled by ill-conceived bailouts, stimulus packages and cash-for-clunker programs, one might expect that we could be in the final stages of an extraordinary bear market rally. But even as we look for a technical target, which may already have arrived, many point to a peak some 20% above current index prices.

These analysts point to a prominent chart pattern that has appeared on both the DOW and S&P indices: that of an inverted "Head and Shoulders." Most often, the head and shoulders pattern is associated with a bearish outcome, but when it is inverted as in the chart below, the predicted result is bullish.


Besides bolstering their price target for the S&P index with mark-to-make-believe based earnings predictions, traditional technical analysts measure the distance between the top of the head (i.e. the March low at 666) and the neckline, which is roughly 300 points higher, and extrapolate that price differential as the target for the top of the pattern: 1250. This would suggest we have much higher to go before any meaningful correction would occur.

If technical charting based on such pattern recognition seems like reading tea-leaves, or if the prospect of a rally to 1250 seems far fetched, don’t lose your head! As for the tea-leaves, I must point out that many well-known charting patterns (head & shoulders, bullish falling wedge, broadening formations, etc.) can be constructed from harmonic functions such as sine waves, even using multiple frequencies observed in stock market data. Thus the appearance of these repeated patterns can be explained directly from observable cyclic behavior.

However, the likelihood of such a pattern eventually achieving its technical target may be another matter altogether. Chart patterns, especially those that are ill-formed, often fail to meet price targets. Even those that are picture perfect, such as the bearish head and shoulders pattern that was so well publicized in July, can fail. Notwithstanding the ostensible need for supporting fundamentals, the S&P may therefore fall short of 1250 for other reasons observed by market technicians.

1. First, the eventual price much reach its target within a time frame consistent with the rest of the technical pattern, otherwise the pattern will likely fail. Such "failures" in the head and shoulder pattern can also be simulated using the above mentioned wave reconstruction methods where the amplitude and phase of constituent waves are adjusted to yield an incomplete pattern. Noting further the S&P chart in the figure above, it appears that the right shoulder is slumping in what should presently be a parabolic rise to the 1250 target. Instead, the index is struggling to maintain the millennium mark.



2. Second, market technicians observe that when the head and shoulders pattern appears as a bottoming formation (i.e. inverted), it is imperative that the right shoulder breakout above the neckline on markedly increased volume. Instead, market volume has been light throughout the latter stages of this rally except on recent days involving heavy distribution.



3. Third, given the broad constitution of the S&P index, if it were to reach that high of a target, it would seem relatively unlikely that either the DOW or the NASDAQ would be left behind. While the DOW itself is also presenting a similar pattern, the NASDAQ appears to be forming a more bearish formation. If the NASDAQ index were to pace the correction in coming days, it would further jeopardize any S&P climb to 1250.

In light of the above observations, the S&P is unlikely to reach the 1250 target before the bear market rally has reached its apex, and meaningful correction intervenes. In fact, there remains a strong likelihood that the top is already in, although 1047 remains a possibility. Readers should continue to watch key resistance (1018) and support (976) levels for indication of breakout in either direction. Opportunities for maximum profit seem to be growing short.


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