I recently read an article by one analyst suggesting the S&P 500 could be forming a Head and Shoulders pattern. If it completes the pattern and follows through in the typical manner, the analyst reasoned, we could see a market drop matching the height of the pattern.
If the S&P 500 breaks below the bottom of the Head and Shoulders pattern, that slightly up-trending orange trendline below, then we can expect a drop similar to the height of the H&S pattern. So 1950 could be a target.
Well, that may be a Head and Shoulders pattern, and it may break to the downside, and may drop a 100 points or so. In my opinion, the volume pattern doesn't point to a high probability H&S pattern with follow-through.
A good H&S pattern will set the left shoulder on strong volume. After a slight pullback, the stock (or index or ETF) marches to a new high – the ‘head'. But the volume should be lower, as the conviction of the bulls has decreased. While the sellers haven't stepped in yet, the number of buyers should be decreasing, hence the lower volume. The sellers finally step in and bring the stock down to the area of the previous pullback. They take their profits and let the optimists again bid up the stock.
This time however, the buyers don't seem to have much company. The buying quickly peaks, forming the right shoulder. Typically, the volume will drop off just as the right shoulder peaks and will be less than the volume of the previous two peaks. Following the peak, the volume may actually pick up as the stock drops back from the right shoulder.
If the stock breaks the trendline formed by the two pullbacks, astute traders watching this price pattern and the volume patterns develop will jump into short positions, betting the stock will fall farther. They will look to take profits when the drop from the trendline matches the distance from the trendline to the head.
Now when I look at the above chart I don't see much change in volume as this pattern was forming. So at first I didn't place much importance on this setup. We may see a break below the pattern base, but at least based on just this chart, I didn't think it would amount to much.
But wait, isn't there an ‘inverse' form of the Head and Shoulders pattern? When flipped over, the inverse Head and Shoulders pattern can signal an important bottom.
Let's take a look at the S&P 500 chart again. If we step back and zoom out a little, we see a drop into a low (a couple of lows actually) on high volume. Then in January/February we see another drop, and a bit lower this time. Volume is strong on down-days going into the low, but quickly subsides. Strong volume accompanies some of the up-close days coming off the possible ‘head'.
If the inverse H&S pattern indeed does form, and follows through as it should, then we could see a 15% gain of a breakout above the base of the pattern. This would be in the area of 2450 for the S&P.
It may be hard to envision that, after recent economic news and earnings releases. But if foreign markets weaken further, the U.S. may look like the best investment environment on a relative basis – the best table in the casino. So after a near-term pullback (to form the ‘right shoulder'), we could see a significant rally. That analyst with his Head and Shoulders outlook may not be thinking big enough. I'll have to come back in several months and update this article on how it turned out – just the small H&S, a bigger inverse H&S, or none of the above (a curveball we didn't see coming).
Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day. To find out more, please click on the following link: www.markettamer.com/seasonal
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