The S&P Head and Shoulders Top
January 7, 2008
 
In most years, we would currently be enjoying the profits of a bullish 4th quarter.  The so called "Santa Claus Rally" did not materialize this year.  Financial stress has taken a toll on the equity markets, and we must now look to the new year afresh.
 

 
In the spirit of erasing bad December memories, I spent a lot of time recently studying the charts.  Like the great navigators in the Age of Exploration, I use charts to help guide me when nothing else is working. 
 

I always start with the general market chart, in this case the S&P 500.   I immediately noticed a very common, and potentially bearish pattern.  It is called the “Head and Shoulders Top” pattern.

 

The pattern is discernable by the 3 topping formations shown here as Left Shoulder, Head, and Right Shoulder.  The pink line at the bottom of the pattern is called the Neckline, and is the most important feature of the pattern.  In a nutshell, if the market trades down through that neckline, especially on higher volume, then a precipitous drop is likely.

 

  

 

What is the psychology of the H&S pattern?  Why does it often predict market reversals?  It’s actually quite simple, if you follow the chart pattern.  Starting from the left, we see a strong bull market from late 2005 to mid 2006.  A small pullback happened starting in May, 2006, but the market eventually went on to make new highs before the end of the year.  (Note:  if you squint your eyes, you can see an inverse H&S pattern in May-July, 2006, which was bullish at the time). 

 

Continuing into 2007, the market had a frightful pullback in February.  This was related to fears that China’s growth may slow, and other fears.  After this so-called Shanghai Swoon, the market once again made a new high, with strength.

 

Finally, we ran up to the July peak.  That was the month that 2 Bear Stearns Hedge Funds went under, and the Subprime Mess was born.  A sharp sell-off and rally failed to take out the July highs.  The psychology of this failure is that people were no longer willing to pay more for stocks than they had in July.  Bullish fever was cooling, forming what would become the head of the formation.

 

After another sharp sell-off into November, traders stepped back in at the support level set in August (see neckline).  The subsequent rally was dismal, and reversed back to the neckline immediately.  So that is where we are today.  I posted my analysis of this formation on the iVolatility.com website.  In that piece I predicted an eventual target for the S&P 500 of 1225, which is a very long way from 1400.

 
 
 
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