« The Four-headed Monster, Called 'Technical Analysis' (Part 1 of 4) »

[This is Part 1 of a 4-part series. Follow the links for | Part 1 | Part 2 | Part 3 | Part 4 |]

In the latter part of August – yes, merely a couple of weeks ago – there was a cacophony of market calls for an impending collapse in the stock markets.

The growing consensus was that the economy was at a high risk of falling into a “double-dip recession” and the stock markets were primed to go along for the ride.

In fact, many market gurus who normally wouldn’t touch the intricate art of technical analysis with a ten-foot pole, were pointing to the development of what they believed was a ‘head and shoulders top’ on a number of major market indices and using the same as added proof that another market meltdown was in the works.

While the ‘head and shoulders top’ meme was rapidly making its way through the investment world, a small number of astute technical analysts – this author included – noticed the development of a handful of signals on the charts that pointed to the likelihood that the ‘head and shoulders top’ scenario envisioned by many was, in fact, misguided and instead a bullish reversal was on the cards…

Over the past two weeks, the view of this small group of chart readers has been proven correct, with the leading market indices having gained as much as 10%, since that critical juncture in late-August.

A climb of 7-10%, over such a short span of time, is an exceptional rate of progress by any measure. But, it might just be the beginning. If another set of confirmatory signals can be dealt with successfully over the coming week, a further rise of a similar or greater magnitude would be on the cards over the subsequent four to six weeks.

Certainly, by now you’re keen on getting some insight into the particular methods that the astute technical analysts amongst us used, in order to arrive at the conclusion that the falling markets were more likely to reverse course than to continue their downward trend, in the early part of September.

Over the course of the rest of this article, we’ll introduce you to a few of these concepts including how we noticed that the ‘head and shoulders top’ alleged to have been taking shape on the charts was actually a “false” pattern and, in fact, contained an ‘inverted head and shoulders’ or ‘head and shoulders bottom’ formation that called for a sharp rebound!

The Head & Shoulders Top That Wasn’t (The Pitfalls of a Myopic View of Technical Analysis)

Now, in order to get a better understanding of where the proponents of the bearish head and shoulders scenario went wrong, we need to take a look at the price action that lead into the now-failed pattern and try and decipher what lead the aforementioned market watchers to (mis-) identify the pattern as a ‘head and shoulders top.’

This is not an exercise in finger pointing, mind you, but rather an attempt to identify common mistakes made when market watchers have a myopic view of technical analysis – drawing only from one or two areas – as opposed to a broader view of the arena.

The accompanying chart in Illustration 1, shows the action on the S&P-500 index (SPX), as of the end of August. Now, traders who’ve read about the head and shoulders pattern in the past will notice that the price action between November of 2009 and August of 2010 looks rather similar to the textbook form of a H&S top.

A potential ‘left shoulder’ formed between Nov. ’09 and Feb. ’10. A potential ‘head’ took shape between Feb. and May/Jul. (depending on where you draw the second intervening trough). Finally, a purported ‘right shoulder’ developed between May/Jul and Aug… The height of the shoulders was within the realm of acceptability and so was the duration of formation of each of the shoulders. Furthermore, the ratio of the height of the head to that of the shoulders was also close to the textbook case.

Illustration 1: S&P-500 Index (SPX), as of Aug 31, 2010, highlighting purported 'Head & Shoulders' Top. 

So, aside from the fact that traders who actually followed the advice of the misguided analysts probably unfortunately ended up losing money or at least losing the opportunity to profit from the impending bullish reversal, one can almost bring oneself to forgive the well-meaning analysts for having raised the alarm as a result of their interpretation of the formation.

On the other hand, the astute technical analyst who has made the effort to study the intricacies of the art will have gathered, even from this basic chart, that there were a couple of inconsistencies between this potential case and the ideal case…

Rather than get sidetracked by a phantom pattern, he/she would have been able to garner a more holistic view of the chart, which would have painted a picture of a developing bullish reversal (rather than a bearish continuation), and would have been prepared to take advantage of the same.

In a moment, you’ll be shown how other areas of technical analysis (including ‘moving averages,’ ‘price envelopes’ and ‘momentum indicators’) would have unearthed even more warning signs that would have put this potential pattern into serious doubt, but for now let’s focus on what can be seen on the basic chart, which consists solely of price action (top pane) and volume action (lower pane), in illustration 1.

Duration of pattern: The typical head & shoulders topping pattern takes 3-6 months to form. At 10 months in duration, the purported H&S pattern being studied would have been considered a little long in the tooth and this fact alone would have been enough to doubt the validity of the formation.

Breach of neckline: The neckline of a head and shoulders pattern is, generally speaking, sacrosanct. Now, in order for the formation above to have been considered as a legitimate pattern, the neckline would have to be drawn at the 1045-level (because, as you can see, there are several minor lows, at that level). However, in doing so, the trader encounters a small but not negligible issue…

Notice the action that took place in late-June/early-July. The index broke through support (1045) and traded as low as 1010. While minor excursions through the neckline are permissible during the formation of a H&S pattern, such moves should, preferably, take place only on an intraday basis and not on a daily closing basis.

However, it is clearly visible that the index closed below the neckline on 3 or 4 trading sessions, during the aforementioned period. This occurrence along would have hoisted a warning flag, as far as the skilled technical analyst is concerned.

Volume trend: The accompanying volume often confirms or casts doubt on a given move in the markets. In the case of a textbook H&S top pattern, the volume that is seen during the formation of the head is lighter than that seen during the formation of the left shoulder. You’ll notice that this was not the case this time around; trading volume during the formation of head was in fact higher than that seen during the formation of the left shoulder.

Additionally, in the textbook case, volumes generally rise during the descent from the peak of the right shoulder. As you can see, in this case, trading volumes did not rise – if anything, they seem to have fallen slightly – during the completion of the purported right shoulder.

While a trader who had a proper understanding of the theory of ‘Chart Patterns’ would have found any one of the inconsistencies, described above, to have been something that could have been ignored if it were to have occurred in isolation, he/she would definitely have had serious reservations upon having noticed all of them taken together.

Four Indispensable Areas Within ‘Technical Analysis’

So far, our discussion of the price action leading into late-August has been relegated to the area of ‘Chart Patterns.’ Now, make no mistake about it, the area of chart patterns is important the well-rounded technical analyst but, as far as this author is concerned, it is merely one head of the four-headed monster that is ‘Technical Analysis.’

When a chart is analyzed thoroughly, the following four areas from the discipline of technical analysis are utilized:

• Trend Analysis
• Chart Patterns
• Moving Averages & Price Envelopes
• Momentum Oscillators

Certain specialists and niche players will tell you that there are a handful of other narrow areas within the realm of technical analysis (‘Elliot Wave Theory’ and ‘Fibonacci Analysis,’ for example), as well. That fact is true, but by and large, these other areas derive data from and/or build upon the four leading areas mentioned above and, as such, it is crucial for a trader to study these four areas and have a good working knowledge of the same.

So, you might now be wondering, did the other leading areas of technical analysis provide any clues regarding the likelihood of a further decline in late-August?

Yes, they did! And astute technical analysts who were awake to this fact, were able to position themselves for the impending bullish move and to profit from the same, when it arrived almost on cue…

[This was Part 1 of a 4-part series. Follow the links for | Part 1 | Part 2 | Part 3 | Part 4 |]

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