Submitted by Mark Hanna
Courtesy of MarketMontage. View original post here.
Well it has been another interesting start of the year – almost a carbon copy of the previous two in terms of the market. It remains to be seen if the swoons of 2011 and to a lesser degree 2012 follow.
Way back when, off the mid November bottom there was a potential for a chart pattern called an inverse head and shoulders. That is the opposite of the bearish head and shoulders formation. Why is this latter pattern bearish? It simply denotes a market that makes a high (left shoulder), pulls back, makes a secondary high which is a new high (head), pulls back, and then on its third rally attempt fails to make a new high (right shoulder). By definition you failed to create a new high in this formation which can lead to poor results if the “neckline” (the bottom of the two shoulders) is broken.
But that’s the bearish formation – the complete opposite is the bullish “inverse head and shoulders”. All the same logic but it means a low is hit, followed by a rally, followed by a new lower low (the head), and then after the next rally attempt, the next low is not as poor as the previous one. Theoretically this would mean the sellers were washed out at the climax selling during the “head” portion of the formation. This is what happened in November as denoted in the chart below, although everything is far “easier” to see with the benefit of hindsight. What made this rally tricky is (a) after breaking over the neckline in mid December, the S&P 500 broke right back below it in late December due to the fiscal cliff talk breakdown and (b) the real move over the neckline came on the first day of 2013 in a stupendous +3% gap up move on the first of the year. See below:
(click on the chart below and then click again on the next page for a super size version)
Now when you try to find an ultimate target for either a H&S formation or an inverse H&S formation you have a simple rule of thumb; the trick is the application and finding a cogent “neckline”. I tend to use horizontal ones, other people use angled ones. But going with this simple horizontal line we had an ultimate bottom at 1343 in mid November and the top of the two shoulders was ~ 1434. Again that level was breached in mid December, but that ended up being a massive headfake, only for it to happen for real on the first day of 2013. So the distance between the neck (1434) and the bottom of the head (1343) = 91 points. Add that 91 points to the neck and you get a target of 1525.
Where did the market stall in mid February? 1525. Indeed, there was a 2 day mini spike over that resistance of a few points (1528ish) which led to the only viable correction of 2013… a 2.9% variety. Recall at that time safety sectors had taken over the reign of the market (utilities, healthcare, consumer staples), bonds had stabilized, and the ascending channel that I usually draw on such charts had been broken. Combined with the fact that 1525 was the target of the mid November inverse head and shoulders formation, everything seemed in place for mid February to be the end of this leg of a rally and a moderate correction to begin.
But alas, after a few week break the rally continued. More cyclical sectors took over the reigns again and off to the slow grind up we continued. Indeed we have formed a second inverse head and shoulders formation during that correction (which by the way at its worst was a 23.6% retracement of the Nov-Feb rally – Fibonacci fans take note). Using the same math as above we have a bottom at 1485 and a neckline at 1525 – that’s a cool 40 points. Using the symmetry of this pattern where does that target the S&P 500? 1565. This is within sniffing distance of today’s highs.
This is also within points of all time highs on the S&P 500, so it will be very interesting to see how things shake down in the next week or two. If the index just blasts right through the top of this formation and through significant resistance of multi year highs, a lot of technicians will be scratching their heads.
Disclosure Notice
Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund’s holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog
