August 18th, 2010

Head and Shoulder Reversal Chart Pattern?

As the week began, everyone was talking about the Hindenburg Omen. Granted, it’s a clever choice of name but probably indicates little else. Anyone creative enough can come up with a bunch of disparate, unrelated and rather arbitrary metrics and by way of testing its efficacy over some time period in some contrived combination and prove that they work, they signal a subsequent market decline and unspecified time in the future.

In my opinion, the back-testing results of the HO (it’s now well enough known so that it has its own acronym, akin to MACD, OBV, BOP and RSI …. let’s see how long that lasts) is about as meaningful as the Lunar Cycle indicator. If the Lunar stats I’ve present here effectively represent a 14 month back-test with a 71% accuracy (much better than the HO, by the way) then why don’t more people give it any credence? Because if the Lunar Cycle indicator were tested over 30 or 40 year (i.e., 400-500 lunar cycles) its level of accuracy would probably drop to a 50/50% proposition.

On the other hand, there’s momentum investing. I came across an interesting article entitled Momentum Investing, Finally Accessible for Individual Investors written by Tobias Moskowitz (link obtained from the Dorsey Wright Money Management site). Moskowitz is the Fama Family Professor of Finance at the University of Chicago Booth School of Business which, coincidentally and ironically, is named after Eugene Fama, the professor who popularized the Efficient Market Theory and compared technical analysis to astrology.

Granted, the paper focused on the fact that Powershares has now introduced three ETFs ostensibly constructed around stocks with momentum, PIE, PDP and PIZ [I overlaid the these ETFs onto a graph of the S&P 500 and didn’t find a significant divergence in performance]. For me, however, the key point is that an academic paper concluded that “Momentum is a powerful investment style, nearly unmatched in its predictive strength and robustness.”

For there to be momentum stocks, however, there needs to be some momentum …. somewhere …. and it turns out that the supply/demand situation is in such perfect balance. There are as many buyers as there are sellers …. everyone is equally uncertain about the future …. and many, if not most, stocks, industry ETFs, commodities, currencies are close to where they were 10 months ago. It’s tough trying to make money in this market. A common question on Fast Money of guests and panelists is “how are you trying to make money in this market?” and you get all sorts of answers like selling covered calls, buying high dividend stocks, jumping on the current bubble, fixed income securities.

I wrote about this struggle in Top or Consolidation, That Is the Question” last week; I hope we’re coming closer to a resolution. Just when it looked like our hopes were dashed, the market found its footing and bounced off the rising 300-dma.

Slowly, ever so slowly, the market is attempting to put in the right shoulder of a small but important head-and-shoulder reversal pattern. The pattern isn’t large enough to generate any sort of substantial upside move if and when completed. But every momentum move has to begin somewhere. An even more significant accomplishment would be if the market were able to cross above the upper boundary of that Consolidation Channel because that descending resistance trendline stretches all the way back to the market peak in 2007.

While you wait, what are you doing to make some money?

Subscribe below or click here to learn more about help for navigating turbulent markets.
  • Anonymous

    Joe,,read your site daily.Right now following the David Rosenberg SIRP advise.Steady Income at a Reasonable Price..This guy staying out of the stock markets until stocks have a %5 div..How low would the S&P 500 have to go for that to happen ? Also I feel the M&A action could heat up..Companies have lots of cash etc.

  • Joe

    Unfortunately, either the S&P would have to drop by 50% or the average dividend double because the yield today is 2.02%

    To see an excellent chart chart of S&P 500 yield since 1881 click here. Can't vouch for accuracy.

  • Jesse

    I can't help myself, like a bug to the zapper! lol
    My question is how can you see the "reverse head and shoulders" but miss the big picture of the large head and shoulders pattern thats telling us the markets going down? Also, you are a MA guy. How is it that you're not seeing or talking about the 1 week 20dma getting close to crossing under the 1 week 50 dma? that will determine the long term trend has changed to bearish. We are within 12 points of that cross. My concern is and has been that you have an overwhelming bias towards seeing the bullish case when the bearish case is playing out right in front of us.

  • Anonymous

    I like the looks of this inverse head and shoulders Joe!

    Also, the lunar calendar has been quite effective now! You're the only blogger who has done the math on its efficiency. I refer people to your blog constantly, b/c you back up this "theory" with numbers – – The numbers don't lie! Even this last turn – the right shoulder of the inverse HS – has turned RIGHT on the moon!

    Joe, I'm long – and using a weekly chart for the next few weeks to add to current position, making buy stop orders every Monday above the previous week's high. Will sell when weekly lower lows are created (might switch to daily charts if momentum wanes very clearly) – at that point, the sell should also trigger a conditional order to "sell short stop" – or essentially use a buy stop order on inverse ETFs!

    Thanks Joe for all your work!

  • Joe

    Thank you, dg. It's been rough trying to defend my position in the wake of the bear's criticisms but it's readers like you who reinforce my confidence.

    The Lunar Cycle in this phase has worked like a charm so far. It's not supposed to turn bearish until 9/9 so let's hope we can make some money over the next few trading days.

    I have a new interpretation of what this market has been going through over the past year but have to share it first with my subscribers.