September 4th, 2009

Summo Wrestlers: Inverted H+S vs. Wedge

I would be dishonest if I didn’t show you a new pattern in the S&P 500 I have been noticing over the past several week but haven’t yet mentioned. It’s important to talk about because of all the debate as to whether the market is going to decline as the economy goes into a W-shaped recovery or bust out to new high territory as the US economy follows what appears to be recovery in Germany, France and emerging markets.

I’ve been thinking a lot about the question Jesse, a frequent commenter here, asked the other day when he wrote “At what point would you become a bear? What are you looking for in the market to convince you of this?” Innocent enough question but one that I may have brushed off to quickly by answering:

“A 20% move to 800? I don’t think I would ever predict that from this vantage point. Why should I? That would mean I’d have to dump all my stocks and go into cash and there’s no evidence to do that now. Move to 50% cash? Still not enough evidence.

In the same way that I wouldn’t invest 100% until the Index crossed above the 200-DMA, I wouldn’t go into 0% stock/100% cash unless the Index dropped to 870. That’s where the neckline of the failed H+S was (May-July). I guess if the Index broke below 870, that’s when I’d become a bear.”

As you know, I was one of the earliest proponents of the inverted head-and-shoulders bottom reversal pattern and have written extensively about a new upleg starting soon after after Labor Day. Here’s that now familiar chart:

Stepping back for another long-term view, you see another possible outcome in the charts. Here’s the same chart with another pattern:

Take the same chart, draw different trendlines and you see a dramatically different story. A rather large sloping, diagonal triangle better known as a “wedge”. As described in chart school at StockCharts.com, a rising wedge:

The rising wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. In contrast to symmetrical triangles, which have no definitive slope and no bullish or bearish bias, rising wedges definitely slope up and have a bearish bias…..

The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely. There are no measuring techniques to estimate the decline – other aspects of technical analysis should be employed to forecast price targets.

So here we have two huge patterns competing against each other for supremacy and control for the stock market’s future course over the next several years. Sort of like two summo wrestlers going at it right before our eyes. One heavy-weight is the inverted head-and-shoulder reversal going back a year indicating that a bottom has been put in while the other is a year long wedge consolidation indicating that bears have more pain to inflict as this rest comes nears its end. It’s conflicting situations like this that give “stock charts” a bad name and reinforce fundamental analysis. It’s ambivalence like this that underscores charting’s inability to predict, and reinforces its status as an art and not a science.

Some of you are going to write “Chart Guru, which do you think will it turn out to be: head-and-shoulder or wedge?” If you’ve been paying attention you would have known my bet is on the inverted head-and-should. But, I’ll let you in on a little known stock charting secret: we won’t know for sure until it’s over and then it won’t truly matter.

A chartist knows that patterns tell you when supply and demand are in equilibrium, when bulls and bears are fighting it out to control the trend. Trends tell you which has won and is in control. The best that charts do is act as timing mechanisms that alerts you that a new trend might has begun. While there’s equilibrium in the market, charts can’t predict what the outcome might be.

After you’ve read charts for awhile, you learn you need to remain flexible in your interpretations or run the risk of costing youself a ton of money. In this particular case, we’ll learn the answer very soon. If the herd of buyers succeeds, their demand will push prices convincingly above 1040, the inverted head-and-shoulder will have succeeded and the uptrend will continue to the next way-station. If, however, sellers begin crashing through support levels (crossing over moving averages, breaking below resistance trendlines) we’ll quickly learn there’s going to be more market trouble ahead and we’re gong to have to become cautious again and move back into cash. Again, I’m routing and betting for the bulls.

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  • Ed Dinovo

    Agreed, however the divergence of price w/ price oscillators has been alarming. Divergence of price w/ oscillators that include volume is even more alarming.

    I haven't done any kind of historical analysis, but I'm guessing trading-off these odd imbalances (and perhaps retesting the neckline) is necessary for the inv. H&S to continue.

    For me, until that occurs, I am looking at this as a rising wedge and an over-extended market.

  • Anonymous

    Do you see the head and shoulders developing?

    http://screencast.com/t/uTaiVky75t

    Mike M.

  • Anonymous

    Guru,
    Watch the credit market, I usually let the credit market tell me where the market going…so far it seems to be still ok!!

    oildigger

  • Anonymous

    Reverse Head and Shoulders should take us to 123 range on the S&P and then reverse, thus fulfilling both analyses.

  • Jesse Caris

    thanks for a little balance and for the shout out! lol
    the battle continues, but I think that there has been clear weakness for the bulls on display since Aug 24th. This market will tip over real soon. It will be painful for whoever is not on the right side.

    cheers

  • Minnesotalee

    Throw out the charts for a moment and look at what may come at the end of 3Qtr earnings. The sequential and especially the yr-to-yr comparisons are going to look great. Why? The comparisons will be easy due to lousy year ago earnings.

    Enough said, get back to the real game. Charts!!!

  • Jesse Caris

    Lee, you're blinded by dollar signs! I'm only messing with you sorta

  • Manoj

    Hi Guru
    I came to know canadian oil service trusts like PWE. It has 10%+ dividend yield. Where does technical analysis
    tell about it?

    Thanks
    Manoj

  • Guru

    Manoj, I'm beginning to see many of the oil & gas exploration stocks looking like they're about to make a run at the May-June highs. And this time they very well could go higher than those levels, much higher. Your PWE is in that category along with WHX, PVX, HERO, BPZ, GIFI, CEP, PDC and many more. However, there are few that have as nice a dividend as PWE.

  • Anonymous

    guru,
    I am a little concerned about thet IBD ranking for oil & gas exploration stocks (126)…thta is not very good.

  • Jesse Caris

    history – 9/9/29 was the high of the market before the big crash

  • Guru

    You're correct about the IBD ranking of O&G Industries, they don't look so hot. That's why I said some of these stocks look like "they're about to make a run at the May-June highs. And this time they very well could go higher than those levels, much higher."

    I surely would wait to get a confirmation that this is happening (like seeing the groups move up in ranking) before putting money into the stocks.

  • Jesse Caris

    the markets at year highs today. sounds like a good day to buy?!?(sarcasm)silly wabbit

  • Anonymous

    guru, labor day is here, so what the market is waiting for, supposed to shoot up to 120??

  • Guru

    Don't know what "120" you're referring to but perhaps it was 1120 and I don't mean for that to be hit in a week. That's the target by year-end so give it a chance.

  • Minnesotalee

    Well the bullish BUY signal on the S&P 500 happened a few minutes ago on the P&F charts at 1040 reemphasizing the bullish trend remains in tact. Where does it go from here: 1295 is the price objective from a "triple-top-chart formation". The statistics for this to be a genuine BUY signal is 7 out of 8. What does this mean? $$$.

  • Guru

    I'm looking for 1125-1150 and then a market consolidation which could run up to 9 months. That level would represent a 50% retracement of peak to trough. Beyond that, it's anyone's guess but a follow-up move to your 1295 is possible and welcomed. It just won't happen until 2011-12.

  • Minnesotalee

    Guru- respect your thoughts. We agree on movement but the charts I use also indicate timing of the price objective. The 1295 PO on the S&P500, should occur within 6 to 9 mos. I am a messenger who follows charts in a little different manner whereby the x-axis is not based on time like most every other chart system I've looked at. The x-axis moves to the right based only on momentum reversals not time. These reversals form patterns and the author has associated certain patterns with statistics. Of course these patterns can be bearish too and predicted the turndown since July '08. The more bearish or bullish the patterns the more they can be believed. If you pick 8 stocks, the best 8 you can find with the best chance of success, you can make money 7 out of 8 times. These very best patterns will then reach the PO within 6 to 9 months. Sounds like a "V". Remember that if you toss out the precipitous drop to 666 from 1000(throw out the high and throw out the low), then we are only up a measley 4%. This drop in my opinion was the lack of supporting LEH. Just a thought. I find your charting methods a solid reference for my decisions!!!