We use technicals as a key component of our market timing model. Although the charts very much color our thinking about where the markets are and where they may be going, we spend very little time discussing them in much detail, as we long ago have learned to recognize that glazed over look in people’s eyes when we discuss support and resistance, breakouts or retracements.
Today’s missive will focus on a developing pattern – the Head & Shoulders consolidation formation (see chart nearby). While it’s a technical no-no to buy or sell in anticipation of a pattern yet to be formed, it is valid to consider how the market might be developing.
With that caveat in place, lets look at how the S&P, Dow and Nasdaq have been trading. After the 2003 move up, the indices clearly established a major up trend. After peaking on January 26 of this year, the indices saw 3 major sell offs. The first two enjoyed a substantial bounce – each of which failed at the forming neckline. The most recent sell off appears to be testing the last bottom made on May 17th. Any subsequent bounce from here will complete a Head and Shoulders continuation pattern.
The seminal book on Technical Analysis (Magee and Edwards) notes: “Occasionally, prices will go through a series of fluctuations which construct an inverted head and shoulders picture, which in turn, leads to continuation of the previous trend.” If that is what is forming here, it is indeed bullish in the short term, as the market should follow the prior pattern, bouncing off these levels.
For the longer term, a high-volume penetration of the neckline bodes well for the intermediate term – about 6 to 18 months.
For now, the technical short-term downside risk, in our opinion, is at 1 to 3% (I tend to be a bit early). The upside is a possible bounce of 10% or better, towards that H&S neckline. I would limit my downside to 5% if you are buying indices here for a trade – in case we are wrong and we experience a cascade sell off.
Right here, I am looking for an oversold bounce, taking us back to the recent highs of late June and late April. If that neckline gets penetrated to the upside – a possibility, to be sure, but in no way a sure thing – we could see a full-blown year-end election-year rally. If in the event that occurs, upside targets would be 11,200 on the Dow, 1220 on the SPX and 2320 on the Comp.