I wrote last time (7/1) on how reversal patterns can be misconstrued with a subsequent market prediction bandied about with little interest beyond pundits reporting something that's attention grabbing. The supposed Head & Shoulder's pattern 'seen' on key weekly index charts is probably a case in point. A Subscriber wrote me about my take on the DAILY index charts NOT supporting a Head and Shoulder's Top interpretation.

MY MAILBAG:

"Re a Head & Shoulder on a daily SPX chart:

YOU WRITE THAT THE DAILY CHART DOES NOT SHOW THE H&S PATTERN. I ALSO SEE THE H&S PATTERN IN OTHER DAILY INDICES CHARTS.

ON THE ONE YEAR CHART THE H&S IS EASILY SPOTTED WITH A NECKLINE AT ABOUT 1050, THE HEAD ABOUT 1220 AND THE LEFT SHOULDER AND RIGHT SHOULDER AT ABOUT 1150 AND 1120 RESPECTIVELY. THE H&S PATTERN IS CONFIRMED BY A VIOLATION OF THE 1040 NECKLINE TO THE DOWNSIDE."

MY INITIAL RESPONSE:

This pattern can be construed, although the Right Shoulder (RS) is a complex one. Usually a 'complex' H&S will have both shoulders’ being complex; e.g., two 'double' tops on either side of the Head.

I would normally expect the top of the RS in SPX should be about equal to the top of the LS, which is off by about 20 points, making it a bit more 'irregular'.

My main point is that the H&S pattern is usually something that gets traced out on a shorter-term basis, occurring over say 2-3 months and interpreted on the daily charts, and not over a 6 month period, like now. I don't currently interpret the daily chart as having a H&S top in terms of the aforementioned points. If a major top HAS formed, the forewarning by tracing out this pattern, even though stretched out, would show the H&S pattern occurring over a lengthier period than we normally see.

MORE ON WHAT A HEAD & SHOULDER'S IS AND ISN'T:

I know (groan) that some will find extended details on this topic as TMI (too much info), but since there are a number of our fellow trader-subscribers who will also find it a 'teachable' moment involving a key juncture where what looks like a major top may not be or probably isn't.

From a couple examples in my (Essential Technical Analysis) book, I'll next show what a 'typical' Head & Shoulder's Top pattern (there is such a thing as a H&S bottom formation too) looks like on a daily chart basis. As well as showing downside 'measuring' implications once there is a decisive downside penetration of the so-called 'neckline'.

This chart is of GM in better days obviously! This H&S top forms over a few weeks.

My next daily chart is of the S&P 500 (SPX) during a prior period of course, with the H&S Top occurring over a few weeks also. The measuring implication on a 'minimum' downside objective once the H&S 'neckline' is pierced, was worked out over many instances over many years. The same measuring 'rule' may or may not be valid or even close to the mark on a WEEKLY chart basis.

What looked to many like a major Head and Shoulder's Top has been commented on in recent week as seen in the Weekly Dow and S&P (500) charts. I'll use the S&P 500 (SPX) chart to highlight the possibility that the index has formed a massive H&S top, at least as was seen prior to this week's rally.

The neckline traced out in the weekly SPX chart was pierced last week on a Closing basis but not by much; more on this shortly. There has been of course a distinct lack of downside follow though on the recent trendline break, which is definitely NOT characteristic of a H&S Top, although the pattern looks close enough to the above charts to wonder why the recent market break' didn't lead to another big down leg.

Even a pattern 'failure' such as may be occurring per the SPX weekly chart above suggests important strategy points; pattern failure being the occasional H&S pattern that sees prices taking off again (to the upside) from at or near the 'neckline'. I haven't seen the H&S much on weekly charts, often enough to have profited from it on a daily chart basis. I thought some more on why I didn't see the pullback into last week's low as part of a big top. A tradable pullback, yes, fantastic put trade, but not part of a major top.

Drawing the outlines of a possible Head and Shoulder's top on a DAILY chart of SPX, it's clear that the 'neckline' was penetrated at 1040 as our Subscriber pointed out. However, I listed my reasons ON the chart below as to certain 'drawbacks' to seeing this as a major top pattern. You get to a point after you have witnessed so many market cycles that some 'obvious' chart pattern doesn't look like the real deal. As once legendary market guru Joe Granville said: "If (in the market) its 'obvious', then it's obviously wrong." Meaning, if the market was so 'easy' to figure out, we'd all be rich.

Another point her is about volume considerations in a possible H&S pattern. My data feed doesn't give me a daily volume figure that I can plug into a Volume histogram on my index charts.

Edwards and Magee, who together wrote Technical Analysis of Stock Trends, the 'bible' of technical analysis (now in its umpteenth printing), said that what volume does or doesn't do relative to a possible Head and Shoulder's Top formation is a secondary but key input. Knowing that if a significant H&S Top was forming in the indexes, the same pattern should also be seen on one of more bellwether stocks, I looked for an individual key stock also having an H&S top pattern.

A possible H&S top pattern in such a stock would 'confirm' or not confirm the same formation in an index like the S&P 100 or 500. Most importantly, we could see if the volume pattern was also doing the expected thing. A Head & Shoulder's top was considered by Edwards and Magee to be a distribution pattern, where rallies would be accompanied by bigger volume on the upswing and less trade on a subsequent pullback. Each succeeding rally of the 3-part H&S top would have less volume usually.

Finding that American Express (AXP) has the same apparent H&S top, what did AXP do as far as falling below its H&S neckline and what did its volume pattern look like? The volume pattern didn't follow the H&S Top expectation as seen with my notations below. Moreover the most recent decline rallied from ABOVE the so-called neck-line, thereby not 'confirming' the H&S top and has now broken out above its down trendline to boot.

If you want to know the chart pattern that really intrigues me, this is seen in my last chart and isn't related to the preceding topic. Just that I'm more intrigued by this non-obvious pattern; i.e., the market possibly 'setting up' for a next major upswing as suggested by a bullish falling wedge. Stay tuned for a bit more on this subject tomorrow (in my 7/10 weekend Index Wrap) and in future weeks.


GOOD TRADING SUCCESS!