May 18th, 2010

Elongating the Head and Shoulder Top

If this doesn’t look like a reversal in the making then nothing does. That’s not a comment about how far down a reversal will take the market or how long it will last. It’s better read as a statement that the bull market that has been running from the March 2009 low to when the market began really struggling to make new highs in December seems to be about to turn into a Bear Market (defined as a decline of 20% or more).

This isn’t a new event and shouldn’t come as a surprise to anyone. This March, in “Is The Market’s Tilt Changing?“, I described how the slope of the market’s ascent had notably flattened. In that post, I summarized how Paul Lim of the NY Times characterized the challenges of the second year of a bear market recovery; it’s worth rereading.

I first introduced the notion of a head-and-shoulder top in the making on February 27 in “The Market Offers Something For Everyone“:

“If you’re a longer-term trader counting on bigger moves then you understand that significant reversals don’t happen is such short a time frame. This “inverted head+shoulder” [i.e., the bottom of the January 7.5% correction] could actually be part of a larger pattern….If the market does form the inverted head+shoulders described above and crosses above the neckline, it likely could stall out as it approaches the downward sloping 50-day moving average, an ominous sign leading to the completion of a right shoulder of a larger pattern. That right shoulder could eventually be followed by a cross under the longer pattern’s neckline. The target for the decline that follows would be around 950.”

The chart inserted there is reproduced here (click on image to enlarge):

Rolling the chart forward we see that what looked like a potential head+shoulder top has been elongated and distorted but produces the same conclusions:

  1. A complex head-and-shoulder top is possibly in the making.
  2. Even though the peak of the new head is 5% higher than the previous, the target decline could still wind up at around 950 due to the slope of the neckline
  3. That target support area happens to be the neckline of the now famous classic inverted head-and-should bottom back in 2009.

I know this is all supposition and conjecture but it does make me very cautious and sets the framework for a near term plan of action. Should a bear market actually materialize, my Instant Alert Subscribers and I will be in a position to take advantage of the new opportunities that will be presenting themselves.

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  • Anonymous

    Guru, what is your best ETF sector ranking ? IYR, IYE, IYK, IYFangle???

  • Joe

    Interesting choices. My ranking for appreciation to the end of the year (sorry, that's the sort of time horizon I like to work since it neutralizes all the short-term random noise) it would be:

    1) IYE (because it's the next best store of wealth after gold)
    2) IYR (because members in the group offer the highest yield in a low interest rate environment)
    3) IYF (because it offers upside potential as a turnaround situation
    4) IYK (by default)

  • Anonymous

    IYE sit under 200 ma, IYF sit @ 200MA, IYR between 50 & 200 ma

    IYR may have to come down to test 200ma? what do you think?

  • Joe

    Bottom line, I don't think any of them will move contra the market. It's really a matter of relative movement.