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

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

An Analysis Of Current Market Action

Two weeks have passed, since the formation that was misidentified by many as a ‘head & shoulders top’ has failed, and has instead made way for a sharp rally. Let’s now utilize the tools that have been briefly studied above, and wrap up this piece with a look at current market action.

As you can see, in Illustration 5, the S&P-500 (SPX) actually ended up finding support at the 1045-level at the end of August and rallying to resistance at 1128, over the ensuing two weeks.

That amounts to a rally of over 80 points or 7.7%, which is a pretty impressive rate of return for anyone who had bought into the rally at the bottom (not so much so, for anyone who shorted the markets or implemented bearish options strategies, at that point)!

But where are the markets headed over the next several weeks? Is the rally over? Or does it have legs?

The recent rally has taken the markets back to the level at which resistance was found back in June and then again in August. You’ll remember that we’d earlier mentioned the fact that support or resistance is to be given due respect until or unless it is actually broken. So, for traders to add to bullish positions right now would be premature, but if the index can break through the 1128-level (and, importantly, stay above that level), not only will an important resistance level be taken out and the intermediate trend (not just the minor trend) arguably be seen as ‘bullish,’ instead of just ‘neutral,’ but amazingly an apparent ‘inverted head and shoulders’ pattern will be complete.

Illustration 5: A complete analysis of the S&P-500 Index (SPX), as of Sep 15, 2010.

Think about that for a moment… Certain market watchers were calling for a significant head and shoulders top, a couple of weeks ago, but in a short span of time that pattern has proven false and a smaller ‘inverted head and shoulders’ or ‘head and shoulders bottom’ has potentially cropped up on the charts, instead!

If the pattern proves true, it will bring about a move to the 1220-1240 range (this projection is based on the ‘height method’ of price projection). In other words, if the pattern proves legitimate, we should see a further rally of 100+ points on the index, over the coming month or two…

Now, are we going to jump with both feet at this potentially lucrative opportunity? Not so fast. The form of the pattern is great – as you can see, the left shoulder and the right shoulder are rather similar in duration and are perfectly similar in depth and, moreover, the depth of the head is in a good proportion to that of the shoulders – but what about the other aspects of the chart?

One of the leading factors that need to be paid attention to when assessing the chances of a potential H&S is the volume trend, of course. In the case of the head and shoulders bottom, the textbook case calls for a decrease in trading interest coincidental to each successive trough (left shoulder, head and right shoulder) in the sequence. If you focus your attention on volume action (bottommost pane) in illustration 5, you’ll notice that this requirement has been fulfilled, in the case of this H&S pattern. In other words, the volume trend confirms this potential head and shoulders pattern.

So, can we now jump headfirst into bullish positions? “No, not as yet,” an astute technical analyst would say…

Remember it takes an actual breaking of the neckline, which in this case lies at 1128, in order for the pattern to be seen as complete and for the trader to consider entering a trading position in anticipation of a move towards the pattern’s target. So, at the very least, the trader will have to wait for a closing price above 1128, before taking a position. Ideally, there should be a massive rise in trading activity, coincidental to this breakout, or else the trader will need to be wary of a potential fake-out in the making and will need to ensure that an effective stop loss strategy has been put in place.

What about other facets of the chart? Do they support the potential for a breakout and for a sustainable rally thereafter?

As far as this daily chart is concerned, the following are aspects of the chart that an astute technical analyst would notice:

Chart Patterns: In addition to the potential H&S bottom that has already been identified, there is another potential pattern on the charts. A close look at the minor trend shows that a potential ‘bull pennant’ or ‘bull flag’ has taken shape on the chart, over the past three sessions. It will take a breaking above the upper pennant (or flag) line, which lies at approximately 1125, in order for the pattern to be complete and, if such a breakout can take place and be sustained, a move towards the 1155-1160 area should be on the cards. If instead there is a close below the lower pennant line (~1115), the pattern will have failed.

Moving Average: The 20-dMA currently lies at 1083 and it is rising. As long as the 20-dMA continues to rise and the S&P-500 is trading above it, the minor trend will continue to be seen as bullish. If the index falls below the 20-dMA, the minor trend will no longer be seen as bullish and instead might shift to neutral or even bearish.

Bollinger Bands: The bands seem to be expanding, at present. This is a sign that volatility is expanding and that a strong new trend is underway. Furthermore, the upper band is rising and moving out of the way of the rising trend. If the upper band were to start to flatten out or to reverse course, a bearish reversal might be on the cards.

Relative Strength Index: RSI is showing a positive centerline crossover, which is a bullish confirmation signal. As long as RSI sits above its 50-line, the minor trend will continue to be seen as bullish. If RSI turns around and makes a negative centerline crossover, however, the move will be seen as a big warning sign and the bullish minor trend will be in serious doubt. Also note that RSI is currently still a good distance from levels that would be considered “overbought.” So, what that means is that there is still a good amount of room to the upside, before traders have to worry about the fact that this indicator points to a high probability of a corrective move.

Moving Average Convergence-Divergence: MACD has moved into positive territory, over the past week. This is ordinarily a strong bullish confirmation signal. Moreover, as with RSI, there is lots of room to the upside before this indicator reaches overbought levels. As long as MACD is above its 0-line, the bulls will be sitting firmly in the driver’s seat. Any move back below the 0-line, however, would raise the alarm.

So, to summarize, virtually every aspect of the chart shows that there is the potential for a continuation of the rally, but only if the index can break out above 1128 and stay above that level. If so, a move towards 1220-1240 will be on the cards.

So what will the astute technical analyst, who would have bought stocks at the lows, a couple of weeks ago, be doing at this point?

Remember that everything hinges on the resolution to the testing of resistance (and neckline of the potential H&S bottom) at 1128. If the index closes above that level, the persnickety - that’s a good thing in this business - technical analyst will then go all out and add to bullish positions. But even then, he will not let his guard down. There is always the potential for a false break, and in order to protect his trading positions, he will place suitable stop loss orders at a reasonable distance below the broken resistance level and allow price action to run its course.

If, on the other hand, the index is not able to break resistance at 1128 within the next few session, he will be trimming his winning bullish positions and waiting for the charts to show him the next big potential trading opportunity…

Conclusion

I hope that you have found this report to be an eye opener and to have provided you with an insight into the art of technical analysis done the right way.

In the coming week or two, I shall be writing a shorter follow-up piece that will provide you with an update on what has happened on the markets, in the interim. The upcoming phase should be an interesting one, because just like the juncture at the end of August, the markets are now at a cusp…

Will resistance at 1128 hold? Or will it be taken out? In the answer to that question lies the prospects of the markets for the next several weeks and, perhaps, for the rest of 2010!

I wish you the very best with your trading and hope that you find success in all your endeavors.

Sincerely,

Asher Pinto

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

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