Is the Dow Forming a Huge Head and Shoulders Pattern?

Tue, Apr 12, 2011 - 10:04am
"In all my years of investing, I have never seen an asset hit record highs, as gold has done recently, with less fanfare. There were no front page stories in the Wall Street Journal or Financial Times, heralding the new milestones." Fred Hickey, editor of the High-Tech Strategist and a member of Barron's Roundtable.

A leading analyst writes to tell me that we're seeing "the formation of the greatest top in stock market history." The "top" he's referring to is seen on the chart below. And sure enough, on the chart we can see the outline of a monster, multi-year head-and-shoulders pattern, with the head at the 2007 high and what appears to be a right shoulder now in the process of formation.

I've got to admit that this looks like a very formidable pattern. But I have a serious objection to its classification as a head-and-shoulder pattern. Normally, head-and-shoulder patterns are patterns of distribution, and they tend to be confined to periods of a year or less. The formation we see on the chart has formed over a period of 13 years or more. Spanning a period of a decade, the economic situation, whatever it started out to be, changes, and depending on what the situation was back in 1998, it is different today. Thus, after a number of years, the rationale for a head-and-shoulder top pattern changes. Therefore, the situation which existed in 1998 is probably no longer a factor today. By the way, in the classic book (Technical Analysis of Stock Trends) by Edwards and McGee they note that distribution patterns that extend over many years, lose their rationale. I agree.

But suppose we accept the costly decline of 2007 to 2009 as a deceptive secondary reaction. Then the rise since 2009 becomes merely an upward correction. If the Dow now turns down and violates its 2009 low, and if confirmed by the Transports, this would surely be classified as a turn in the tide and the signal for a primary bear market.

Conclusion — A primary bull market is in progress. If the Industrials and Transports turn down and violate their respective February 2009 lows, a bear market will have been signaled.

Note — The last consolidation-correction can be seen on the Industrials at around the 10000 level. A decline from here should find support at around 10000. Anything below 10000 would be cause for concern. Action to take at this point -- watchful waiting on the stock market.

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