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TECHNICAL ANALYSIS: REVERSAL PATTERNS

Technical chart analysis has a widely debated reputation as a forecast tool for price behavior. Many, including this writer, believe it can serve as a critically important tool in combination with fundamental analysis. The study of a company’s array of product offerings, growing customer base, trend for product demand, cost structure, debt burden, equity offerings, and financial balance sheet all contribute toward its fundamentals. On the other side of the analytic workshop is the chart room, where price movement over time is examined for its chart patterns. It is my opinion that the best of forecasts employ both methods.

At this late summer stage, let us kick back and review some commonly recognized chart patterns, and bone up on our toolbag of reversal types. Each can be valuable to spot in the assessment of buy points, sell points, and setting expectations. Each pattern is evident in a major index or commodity in recent weeks or years. It will be assumed that support and resistance is understood. One should note that when resistance is broken on the upside, the old ceiling serves as the new floor. And when support is broken on the downside, the old floor serves as the new ceiling. The dynamic behind this phenomenon is forced short covering for a rising item, and forced liquidation sale for a falling item.

Many people have asked over the years, “What statistical models explain stock price changes?” Prices meander, according to some statistical theories, in such a way as to obey certain random laws. Nothing properly explains all stock movement, but one distribution has been shown by scholars to adequately explain movement in many situations. For those with some interest and deeper math abilities, read what follows. For others, skip to the next paragraph if you wish. Brownian Motion provides some workable models. It dictates that in very short term movements, prices change according to normal bell-shaped random distributions. For instance, the price change over a length of time Δt might obey the normal law with mean zero and variance kΔt, where k is some constant. In other words, the change in price varies proportionally with the length of time involved. The normal curve dictates a central tendency. In this model, over a small interval of time, in two thirds of the cases the price change will be within plus or minus the square root of kΔt. The movement of cigarette smoke particles in a still room tends to follow Brownian Motion over three dimensions.

Regardless of the precise laws governing motion, the paths of price behavior over time reveal much. When you step back and observe the pattern, it can reveal much. If a short-term chart is not clear, back off to a weekly chart for more clarity. A review of some frequently appearing chart patterns might be valuable. For now in this essay let us cover reversal patterns. Many advocates of technical analysis believe that imminent fundamental dynamics, such as changes to profitability or introduction of new products or the win of new contracts or dilution to shares, are all factored into the chart pattern. Nothing is foolproof. Certain events are not easily factored into charts, like court rulings, product failures (e.g. FDA product rejection), and retirement/death of executives. For certain, chart analysis can be a valuable tool for investors, both professional and individual. Almost every major mutual fund house employs a highly revered, highly respected, and highly paid staff of shared technical analysts who work “the chart room.” Fidelity surely did during a brief consulting stay of mine. In all charts which follow, the logarithmic scale is shown. So what? Well, that means a price rise of a constant growth rate (or a trend rise) will appear as a straight line. The moving averages displayed are 50-week and 50-day types, visible in blue.

HEAD & SHOULDERS

Reversal patterns are downright cool, whether in upright form or inverted form. They are by far my favorite patterns, bar none. They enable the analyst to make a bold public statement with a measure of fanfare. The clarity of the pattern and its message can be emphatic, yet hardly appreciated by the unwashed masses. When they are detected in advance, they offer a massive profit potential, provided the investor can be patient near the breakout. They require a keen comprehension of underlying fundamentals, which must provide a basis for the reversal itself in order to justify it. A gigantic battle usually is waged near the breakout neckline, sometimes lasting weeks or months. In most cases, some external event or some internal dynamic triggers the eventual (but never inevitable) breakout. In the H&S pattern, the market is essentially saying it might have gotten the story wrong, and has found it necessary to correct itself. Nothing moves on a dime though, so a reversal must take place which is orderly. Before the need to correct is noticed, or the reversal is ordered, oftentimes a bump impulse is seen, then a deeper bump impulse is pushed to the extreme, followed by a third bump impulse much like the first. These bumps outline the left and right shoulders, and the head. Critical to the pattern is the neckline which identifies where the breakout occurs. Extremes are reached from momentum players going out of control, perhaps lured by cold hardened professionals.

Late in the summer of 2003, many analysts dismissed the Japanese recovery story. They believed a decade of deflation embodied far too much suffocating stench in bad debt and overvalued assets to overcome. They overlooked capital flows, trade surpluses, and the emerging effect of substantial bilateral surpluses enjoyed by Japan over China. One of the clearest H&S reversal patterns in my recent years was with the Japanese yen, in inverted (upside down) form. In the late spring and early summer of 2003, the pattern came to my attention and was mentioned in my writing. The yen kept weakening, showed the shoulders and head, and had trouble mounting a rally despite incredibly strong fundamentals. The Bank of Japan has pursued a myopic strategy for years, to hold back the rise of the yen in order to preserve their brisk export trade with the United States. Their zero rate policy enabled Japan to “buy time” while they worked out from under a bank insolvency problem. Although the BOJ does the Federal Reserve’s bidding in a subservient role, Japan still commands far more power from their surpluses than was properly assessed. Mountains of trade surplus USDollars have been accumulated. For months and years, those surpluses have been sanitized with equivalent yen printed on paper, much as the Fed prints its paper. The newly minted yen are then used by the BOJ, who sopped up USDollars from the many exporters, to purchase USTBonds. Presto, no yen appreciation in the exchange rate and their export trade proceeds.

The new wrinkle last year was the massive trade surplus Japan built with China, whose currency does not float. Thus, the fundamentals dictated constant pressure on the yen to appreciate upward. After the Qatar G-7 Meeting, the yen took upward flight after finance ministers gave an indisputable clear signal for the USDollar to find its true (i.e. lower) value. In May of this year, a previous Monday essay, entitled “Forecast: Japanese Yen Parity by Year End” discussed a forecast which still stands, that the Japanese yen will reach parity at the 100 level by end of year. The forecast may miss on when, but it is written in stone that parity will be reached in the coming months and quarters. The most optimal usage of chart analysis comes when fundamentals and technicals are used together, and NOT in competition. The target of parity comes from measuring a height from the head at 74 to the neckline at 87, which is 13 points. Add those 13 points to the 87 neckline to reach the 100 target. See the four-month old chart.

It bears mention that the resolution of the breakout above the neckline, past the right shoulder, showed itself as a bullish triangle. The neckline was its flat top of resistance. Its 7 points of impulse power indicated a 94 target, reached quickly. The power was awesome in the FOREX market.

FILLED GAP

Price movement from spring to the present day in the same Japanese yen is generally uninteresting, a meander below the 95 attained target. Digesting the advance beyond the multi-year barrier at 86-87 was required and necessary; it took time. The powerful burst past the resistance level came with a worldwide dose of short covering, enough to jettison the equilibrium price quickly to 91 in three weeks. In the process, a gap from 86.5 to 89.0 was created. Gaps are like soft earth which fails to support a back porch deck on stilts, due to air pockets unable to bear the weight. An amazing phenomenon shows itself from time to time. Gaps tend often to be eventually filled. Although the thin threads of the entire gap were not filled, the actual jumped gap was indeed filled, a full eight months later !!! In the back of my mind, all through the early months of 2004, the long-term target of 100 parity was in the forefront of my mind. Like an itch in need of a scratch, like a tug of the shirt from behind, forward progress could not continue without due respect paid to the gap. The gap called. The gap was filled in May of this year.

CUP & HANDLE

A smoother, more orderly reversal process can be evident in the Cup & Handle pattern. Perhaps professional and public recognition of a trend change is more widespread and gradual, leading to a smoother price movement. A fine example is the long-term gold chart. The 2000 stock bust was followed by a recession and a change in Fed stimulus policy. Monetary expansion became an exercise powered by financial steroids. Negative real interest rates kicked the process in gear. Gold reversed off a long slow bottom. Of course some spikes can occur, as in 1999 when the Washington Accord triggered a huge short covering response and considerable gold volatility. The “cup” is clear in the chart below. In fact, two cups present themselves, one over five years, another over eight years. In a typical C&H chart, the potential rise following breakout is the height of the cup itself. A “handle” designates the area where the battle is waged on breakouts. This is where previous resistance levels are at work, motivating sellers. It keeps failing as before until it just doesn’t any more. Support is found from those who sense the fundamental story, widely viewed to be favorable. Note the handle in summer 2002 in the 310-330 range. The target of 405 can be calculated from the 330 cup edge plus the 75 point height off the 255 base, easily reached in late 2003. As to why the target was blown away, refer to the Qatar G-7 Meeting of finance ministers, whose released comments rolled out a red carpet for FOREX traders to send the USDollar down, and down hard. Incredible momentum ensued.

A new Cup & Handle chart of greater size has the same base at 255, retained curvature symmetry, and a cup edge of 420. The potential of 165 points forecasts an eventual breakout target of 585. We see a much greater battle at the handle to this larger C&H pattern, still in progress. A move above 430 would signal a convincing breakout underway. This pattern, unlike the previous discussed Head & Shoulder pattern, gives wings to more smooth sustained momentum. The new trend is more accepted, however, its full potential is continually debated.

ROUNDED TOP

Stock indexes seem at times to move in the slowest patterns. Reasons to attach are the subject of opinion. Perhaps greater public participation gives them more amateurish twists and turns. Perhaps USGovt intervention with the Plunge Protection Team rescues far too often. Perhaps hope at a national level colors the real picture. Perhaps brokerage firms and the Wall Street media machinery lose their ability to sell (if not deceive), but time is required for the strings to fray and the gravity of reality to win out. When the public embraces what they believe is a new bull market, when margin account money is cheap, when the banking leaders cheer on an intentional reflation initiative, a bounce off long-term lows takes a long time to fade. The best explanation might be poor analysis of what brought about a significant decline. The forces behind the long-term decline might still be intact, with no change, only different failed policies. Hope perhaps gives way to reality. The Nasdaq composite index shows such a failure in progress. Bounces tend to occur at levels where big turns took place in the past. Note how 1750 was a difficult resistance level in July 2003, now to lend support. Resolution of the rounded top could be outright failure, and recognition that the long-term stock bear is still clawing at valuations. Or it could give way to a new support.

FAILING WEDGE

A rarely seen pattern surfaced this spring, one not seen so vividly or frequently, a real treat. Sometimes the market holds the notion that a long-term correction has been completed, that changes have taken root, and a new period has been spawned. Price movement becomes overly aggressive off a bounce, excited at the fresh wind of promising changes, as a lasting trend seems to have begun to yield to something new. A reversal like above cited patterns could be exhibited, but the forces of inertia are too entrenched. Much like an airplane which attempts too steep a climb, a failing wedge can provide similar pathways which lead to a failure. It is just too aggressive, too much fueled by animal spirits, quickly addressed and corrected.

Such is the case in the USDollar, as seen in the DXY index. The DXY is a trade weighted index for the US currency, whose weights date back to the 1960 decade in truly arcane fashion. If it were really weighted properly, the components would direct much higher values to the Asian currencies where tremendous trade takes place, far greater than in past decades. That is a discussion for another date. When the DXY failed in late May, it did so dramatically. Its rise was too quick, probably aided by short covering on a worldwide scale. The prospect, totally false in my view, was that a grand US Economic recovery had begun. Its foundation was purely statistical cheating in the jobs reports, and in GDP overstatement. The DXY index has stuttered since, locked once again in the recovery battle versus the deflation battle.

Special thanks to www.StockCharts.com for their wonderful charting tools.

NEWS TIDBITS

Consumer spending grew in July by 0.8%, as the public continues to outspend their incomes, which grew by 0.1%. Wages in July grew by 0.4% as well. Ford Motor said it has stopped production at its assembly plant in Georgia, which employs about 2200 people,  for at least a day because of lack of parts. Union Bank of Switzerland is expected to buy Charles Schwab's institutional research and trading unit for about $265 million, a source familiar with the matter said. The purchase price would be about one-sixth less than the $321 million that Schwab paid for the SoundView unit only eight months ago. Canada's current account surplus widened in the second quarter to C$10.4 billion ($7.88 billion), from a revised C$8.25 billion in the first quarter, even though a big US acquisition by insurer Manulife led to large capital outflows, Statistics Canada said. The World Trade Organization's top trade court rejected a US appeal against a ruling exonerating the export policies of the Canadian Wheat Board, diplomats and trade sources said. Its appellate body upheld the findings of a WTO panel of trade judges in February that the Wheat Board's exclusive right to buy and sell western Canadian grain for export, and its right to set the initial price, did not break world trade rules. Shares in Gabriel Resources (GBU.TO) rocketed over 40% after news that the world's biggest gold producer Newmont plans to buy a 10% stake in the small Canadian miner.

The antibiotic Simplicef originally marketed for human use won approval to treat skin infections in dogs, the US Food and Drug Administration announced.

Oil prices fell $1 on continued profit-taking as producer-group OPEC eyed increases in the coming months in its tight spare capacity, countering worries over stumbling Iraqi oil exports and a new southern Iraq explosion. According to traders, edge funds are unwinding their speculative long positions. Despite last week's slide, prices are still about a third higher than at the end of 2003 as producers pump close to full tilt to match soaring demand. The OPEC producers are estimated to be pumping close to 30 million bpd, its highest level since 1979, in an effort to dampen this year's price rally. Russian oil company YUKOS said it would be able to cover only half of its $3.4 billion back tax bill by its deadline at the end of August but it would continue making payments in September. Gasoline at the pump rose by a half cent in the last week, to an average $1.877 price per gallon.

The Athens Summer Olympic games concluded, in a tremendous two weeks of international brotherhood and cooperation, not without controversy from drug doping and fixed judges. My favorites were Phelps and the men’s swimmer relays, Coughlin and the women swimmers, Ian Thorpe and Jodie Henry of the Australian swimmers, sprinters Gatlin and Crawford and Wariner with men’s track, Moroccan El Guerrouj in distance track, Lauryn Williams in women’s 100 meters, Holmes from Great Britain in women’s distance track, Bulgarian Jovtchev in gymnastic rings, Carly Patterson in gymnastics, Cael Sanderson in wrestling, women’s soccer, volleyball generally, and Canadian Despatie in diving. In movie box office, “Hero” led with $17.8 million, followed by “Anaconda” with $13.2M and “Without a Paddle” with $8.7M in another very tame week.

TODAY’S MARKET

Today the Dow Jones Industrials wrapped up at 10,123 (-72), S&P at 1099 (-8.6), Nasdaq at 1836 (-26), TENS yield 4.188% (-3.9 bpt). Currencies closed with Euro at 120.49 (+0.29), JYen at 91.02 (-0.24), Can$ at 75.77 (-0.35). Metals finished with gold at 407.8 (+4.6), silver at 670.5 (+12.2), copper at 126.2 (+0.3). Energy ended with crude oil at 42.22 (-0.96), natural gas at 522.5 (+3.6), unleaded gasoline at 113.8 (-3.3). Prices are at major futures contracts.

Jim Willie CB

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