Today's Market WrapUp 06.05.2008 Mon Tue Wed Thu Fri Goldberg Archive Market
Continues to Trade Multiple Head and Shoulders Reversal A logical pattern that fits the behavior of the S&P 500 is that of the multiple head and shoulders (HAS) reversal pattern. This article references the characteristics of the pattern as described in Technical Analysis of Stock Trends by Edwards and Magee, a book that should be a cornerstone of a technical analyst's library. As stated on page 75 of the 8th edition, these selected quotes help to describe the multiple head and shoulders reversal (emphasis added by Martin), “(multiple head and shoulders) patterns may be described quite sufficiently as Head-and-Shoulders Reversals is which either the shoulders or head, or both, have been double or proliferated into several distinct waves… ...They appear with fair frequency at Primary Bottoms and Tops, but more often at Bottoms than Tops. They appear less frequently at Intermediate Reversals. ...Still another, of which you will usually find several good examples at any Major Market Turn, consists of double shoulders on either side of a head which is itself composed of a small but quite distinguishable Head-and-Shoulders development. ...We have mentioned the tendency toward symmetry in the simple Head-and-Shoulders Formation. Patterns of the Multiple or Complex type show an even stronger urge toward symmetry – so strong, in fact, that it may be counted on in determining trading policy. If there are two shoulders on the left, there will almost always be two on the right of nearly the same size and formation until the right shoulder becomes evident. (Of course, one does not know that a Multiple is in the process of formation until the right shoulder becomes evident.) Except for volume, the right-hand half of the pattern is, in the great majority of cases, an approximate mirror image of the left. ...Up-sloping and down-sloping variants seldom appear in this class of patterns; necklines are almost always very close to the horizontal. Below is the proposed multiple Head-and-Shoulders pattern depicted in the weekly chart in early December. At that time, the pattern could only have been proposed since it had not yet been completed. The gray line in the chart below depicted the general price action that would have occurred in the future if the pattern were to remain valid. Volume guidelines are also shown in the chart. The forward price and volume action were based on the characteristics described by Edwards and Magee – including one head and two shoulders, symmetry, volume patterns, and horizontal necklines. Since the pattern had not been completed, it was a relevant question to ask the basis for suggesting this pattern.
In December, the pattern had not yet completed, but the case for the pattern’s existence was strong enough to warrant respect from a trading perspective. Respect is separate and different than hanging one's hat and most of one's capital upon the pattern and closing one's mind to the action that was actually taking place in the market. At the time, I stated, “as (and if) the year end rally progresses, it will be important that volume eases even more from the rather lack luster rally which occurred off of the August low. Year end volume tends to be relatively low especially around the Christmas holidays and this should continue to confirm the multiple HAS if the year end rally continues. Similarly, the volume following the proposed New Years swoon should be higher if the multiple HAS pattern is still in play. A new decisive high in the S&P invalidates the pattern as would any other major deviation from the grey line and volume pattern guidelines shown.” Moving to the current S&P 500 chart, we can see whether there was validity to the multiple HAS reversal by comparing the predicted pattern to the actual weekly action.
As you can see in the chart above, the symmetry aspect of the multiple HAS was violated by the two semi-panic debt crisis lows made in January and March. This may have invalidated the pattern. However, the height of the May shoulder does lend some degree of symmetry to the pattern because its height is approximately at the 1450 area of the early ’07 shoulder shown. Note also that even though it was violated on the debt crisis selloffs, the technical importance of the 1375 area was still maintained, thereby keeping the horizontal neckline of the multiple HAS pattern “in play.” Finally, you can see that the trading volume aspect of the multiple HAS seemed to have stayed true to form. The market swoons have been on high (even climatic) volume whereas the rallies have occurred with relatively low volume as easily seen in the weekly chart above. This is consistent with the multiple HAS characteristic. If indeed the multiple HAS still is a valid pattern which is nearing completion by a decisive and sustainable move below 1375, it would likely signal that a major top in October of 2007 occurred. A major top yes; but a rapid and punishing bear market would still be unlikely under the multiple HAS scenario. The case for leisurely movement of the S&P 500 to the downside is described by Edwards and Magee. “There is something about Multiple Head-and-Shoulders patterns especially pleasing to technical chart followers. Because of their symmetrical tendencies, it is fascinating to watch them evolve to completion. Once completed, however they may try your patience (!!) by their seeming reluctance to “get going” with a new trend. On that account, it becomes easy at times to jump to the conclusion that they have “blown out’, i.e., produced a false signal. Actually, except in the matter of extent of move (see below), which we have already discussed, they are fully as reliable as the plain Head-and-Shoulders. False moves are relatively rare with both. And in those extraordinary cases when a Complex Formation does go wrong, it still stands, like the plain Head-and-Shoulders, as a warning that the final Reversal is near.” Edwards and Magee describe the reduced “power” of a complex (many shoulders) versus simple (1 head, 2 shoulders) head-and-shoulder pattern (page 77). They propose that the multiple has less power and supports a leisurely move that meets the price objective, but does not exceed it to the downside: Curiously enough, the “power” of a Multiple Head-and-Shoulders Pattern is more apt to be over- than underestimated. One might think, in view of the length of time and amount of trading entering into its construction, that it would signal a move (in reverse direction to the trend preceding it) of greater extent than the simple Head-and-Shoulders. Yet, in its immediate consequences, at least, the Complex shows consistently less power. Minimum measuring rules for the two types of formations are the same and are applied in the same manner. The difference between the patterns appears in the price action after the minimum has been reached. The first downswing out of a plain Head-and-Shoulders Top, not counting any early Pullback pattern will frequently carry out of the minimum measuring implications of that pattern quickly and run well beyond it. From a Multiple Top, the first downswing is often more leisurely, and very seldom does it exceed the bare minimum – a probability well worth remembering when you are dealing with an Intermediate rather than a Primary Top. Of course, if the Complex does develop at a turn of a Primary Trend, prices will eventually go much farther, but even then there is usually a strong recovery from the “minimum” rule. This would seem to suggest that if the pattern is valid, the price objective of the multiple HAS pattern will take the S&P 500 to about 1225, but not below. This conclusion would be supported by the need of the government and Fed to avoid a severe stock market correction in the face of negative economic fundamentals. If they cannot keep the stock market correction “leisurely,” the feedback loop into the US consumer and the wealth effect will have a spiraling effect back to the US stock market and in turn, back to the economy and again back to the stock market. So if it is a multiple HAS, that wouldn’t be so bad for the long term stock market. Still it is troubling that the only technical characteristic that refutes the multiple HAS are the panic selloffs that accompanied the debt and banking crisis. And most evidence, including the technical charts of the financial sector, suggests that the market has not yet fully discounted this rare event. If the market is tracing a more ominous pattern than the multiple HAS, then the reversal may not be leisurely at all. Those January and March selloffs (refuting the multiple HAS) are troubling me in that they don’t support the leisurely pace of the next market correction. Martin Goldberg Copyright © 2008 All rights reserved. CONTACT
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