November 28th, 2012

Head-and-Shoulders Patterns: AAPL and GLD Case Studies

In my book, Run with the Herd, I retell the coin toss experiment from Burton Malkiel’s book, A Random Walk Down Wall Street.  In it, he asked students to

“continuously toss coins with heads arbitrarily representing a move up in a stock’s price and, conversely, tails a move down.  All the price changes were assumed to be of equal magnitude and all were recorded in a line chart.  After an unspecified number of tosses, the students began to see patterns in the charts that looked similar to those of stock charts.”

One of the most talked about, recognized and perhaps most reliable stock chart patterns are the head-and-shoulders and its mirror image the inverted head-and-shoulders. What makes these patterns so important is that they fall into the reversal category (as contrasted with the continuation or trending patterns).  In these patterns, the price/value of the stock, index or commodity makes three different attempts to reverse the direction of the prevailing trend.  Characteristically, the price/value reaches approximately the same level the first two times and then falters; it succeeds in the third attempt and crosses the level reached the previous two attempts. The elements of the pattern include a shorter left “shoulder”, a longer middle “head”, and a shorter right shoulder; all are connected by a trendline at what is called a “neckline”.

As you might expect, as a chartist I believe that comparison between the randomness of coin tosses and stock chart patterns is a false one using the wrong logical argument (incorrectly using deductive reasoning rather than inductive reasoning).  But it is true, however, that the head-and-shoulder chart patterns are easier to perceive in retrospect and not as readily discernable in real-time.  Furthermore, when the pattern has evolved sufficiently in order to actually intimate its future likely outline, the practical question remains as to when might be the best (highest probability of being realized with the lowest risk of being failing) time to act on that perception.  Here are two cases in point:

    • AAPL: At the beginning of the month, I wrote a piece entitled “AAPL Gets a Cold, the Market Gets …..?” when the stock was at 563 in which I included a chart showing a partially formed head-and-shoulder pattern and wrote: “Has the stock hit bottom and is it poised for a turn around (a large Wall Street firm recently called on CNBC for AAPL to more than double over the next year)?  Double it might but in the near-term it’s setting up for another 25% decline below what might be consider the neckline of an emerging head-and-shoulder topall the way down to 390 (nearly 30% from current levels).”Compare the chart in that post with the one below and you’ll find that AAPL is closely following the course outlined there:

      Although Robert Weinstein of Cramer’s wrote today that investors should “Put Away the Prozac, Apple’s Just Fine”, this emerging pattern continues to look to me uncannily like an emerging head-and-shoulders top [Cramer's Action Alerts Plus service has been a long-term AAPL investor with a 90+% profit].  There’s no way to tell whether the stock will follow-through but it pivots and starts declining again, I would order a refill from the pharmacy.

    • GLD: I wrote a piece at the beginning of the summer entitled “When It Comes to Technical Analysis, Accuracy Depends on Time Horizon (GLD)” in which I included a chart of GLD with a pattern that looked like a descending channel and wrote: “I look at a possible breakout from my flag and see a long-term move equal to the preceding the neckline.  I see the possibility of a 75-80% move to the 250-270 level over a year or two.  It all depends on how much time you want to spend managing your portfolio and making trading decisions.”

Today that channel has morphed into what might turn out ultimately to be an inverted head-and-shoulder pattern.  The hesitation in calling it that is that the pattern is developing after a major bull run rather than at the bottom of a major decline.  Consequently, this inverted head-and-shoulder will further morph a consolidation pattern or some type of reversal top pattern.

Bottom line, no matter how good these chart patterns may look a year from now, unless and until they cross their necklines, there’s no certainty that they won’t fail to deliver.  While getting in early will produce a greater return, the trade entails more risk that the stock moves in the opposite direction.  [In fact, even after a trendline is crossed, the stock will often reverse and test the trendline in what is called a "Buyers'/Sellers' Remorse Correction".]


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