July 11th, 2009

Market Future is in Eyes of the Beholder

I confess, chart reading is somewhat of an art form, something that improves with practice. Chart patterns are clearly in the eyes of the beholders. Take 5 chartists, stick the same chart in from of them and you’ll probably get 5 different responses. The criticism isn’t as much about delineating and defining the patterns carved out in the price movement of stocks or indexes, as it is about the interpretation of what those familiar patterns portend for the future. And perhaps it’s not even so much the interpretations as it is in how precisely the conclusion is articulated and communicated.

That’s what drives most fundamental analysts crazy and why they place technical analysis on a par with astrology or tarot car reading. Take for example all the discussion over the past couple of weeks about the head and shoulders pattern seen in the action of the S&P 500 since May:

We’re all familiar with it by now. It seems so obvious: the head and shoulders formation portends a decline of around 8% from current levels to approximately 820. The Bears point to this chart as reflective of the cascade of bad economic and financial news that continues piling up here and around the world. One look at the headlines (see RealClearMarkets.com) about an impending commercial real estate meltdown, the new taxes for healthcare reform or energy usage looming or the budget crises in state and local governments and you’re sure this head and shoulders might be the last you’ll ever see again.

But here’s a view that you probably haven’t seen before:

When it served their purposes, the Bears trotted out one of their favorite patterns, the rising wedge. Towards the end of 2008, before we knew there would be a March meltdown, much was written, correctly I should add, about another leg down after the Lehman bankruptcy in September followed by talk of the auto industry collapse that would carry the market to the the mid-400’s on the S&P and 4000’s on the Dow (I’m not sure I have the numbers correct but it was a pretty scary time).

When the market rallied off a “bottom” in March, most were calling it a suckers’ rally, a bear trap. The Bears pencilled in a second rising wedge portending another final decline to their ultimate and illusive goal of Dow 4000 (see MarketWatch video of Peter Eliades predicting 4000). And the Fundamentalists call technical analysis reading tea leaves?

But something happened in April and May. There was all the “green shoots” talk, the market firmed and the decline to 4000 was averted – or delayed. If you look at the most recent period you’ll see I drew in a bullish flag, a downward-sloping channel cutting across the previous uptrend. The flag straddles the 200-day moving average indicating an unwillingness for the market to give up that easily on having crossed above that indicator. I don’t believe I’ve seen anybody else picking this up yet but they will if the head-and-shoulder above fails to deliver the anticipated decline.

And then there’s my favorite, the longer term inverted head and should pattern that stretches back to those awful days last winter:

This is the one the bulls like. It clearly supports the notion that most of the bad news has already been priced into the market, the rate of decline has moderated, comparisons against prior year are improving and that the effects of the economic stimulus package (a.k.a., massive government deficit spending) will start showing up even though there’s a lot of debate on the need for a follow-up, second package (because the first one was poorly designed and isn’t working).

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