Educated Conjecture – Multiple Head and Shoulders (HAS) Reversal in Progress
A logical pattern that fits the behavior of the S&P 500 so far is that of the multiple head and shoulders reversal pattern. This write-up references the characteristics of the pattern as described in Technical Analysis of Stock Trends by Edwards and Magee, a book that should be a cornerstone of a technical analyst's library. As stated on page 75 of the 8th edition, these selected quotes help to describe the multiple head and shoulders reversal,
“(multiple head and shoulders) patterns may be described quite sufficiently as Head-and-Shoulders Reversals is which either the shoulders or head, or both, have been double or proliferated into several distinct waves…
...They appear with fair frequency at Primary Bottoms and Tops, but more often at Bottoms than Tops. They appear less frequently at Intermediate Reversals...
...Still another, of which you will usually find several good examples at any Major Market Turn, consists of double shoulders on either side of a head which is itself composed of a small but quite distinguishable Head-and-Shoulders development.”
...We have mentioned the tendency toward symmetry in the simple Head-and-Shoulders Formation. Patterns of the Multiple or Complex type show an even stronger urge toward symmetry – so strong, in fact, that it may be counted on in determining trading policy. If there are two shoulders on the left, there will almost always be two on the right of nearly the same size and formation until the right shoulder becomes evident. (Of course, one does not know that a Multiple is in the process of formation until the right shoulder becomes evident.) Except for volume, the right-hand half of the pattern is, in the great majority of cases, an approximate mirror image of the left.
...Up-sloping and down-sloping variants seldom appear seldom appear in this class of patterns; necklines are almost always very close to the horizontal.
Below is the proposed multiple Head-and-Shoulders pattern depicted in the weekly chart. The pattern can only be proposed at this time since it has not been completed. The gray line depicts the general price action that would occur in the future if the pattern remains valid. Volume guidelines are also shown. The forward price and volume action are based on the characteristics described by Edwards and Magee – including one head and two shoulders, symmetry, volume patterns, and horizontal necklines. The pattern has not been completed; so it is a reasonable question to ask what the basis for even suggesting this pattern is. The basis for the proposed pattern is as follows:
(Click on Chart for Magnification)
Volume Patterns thus far. Note that consistent with a Head-and-Shoulders formation, volume on the left side during the uptrend was relatively high. Especially convincing is the higher volume on sell-offs and the progressively lower volume on the most recent two advances. This suggests a possible pattern of long term distribution.
The price pattern thus far is consistent of the multiple head-and-shoulders pattern (but early since the pattern has not been completed). We see two left shoulders and a head so far and the S&P appears to be in the process of making the inner right shoulder.
The preponderance of multiple head-and-shoulders patterns in individual stocks in the recent market, many of which have completed.
The very long term double top shown in the S&P with the first top being in 2000 and (perhaps) October of 2007 being the double top. Given the technical importance of the current S&P level near 1,500, if the market is topping, it is likely that the top is a major top as would be consistent with the multiple head-and-shoulders as described by Edwards and Magee. (The Wilshire 5000 is also showing similar long term technical characteristics as the S&P.)
A host of fundamental factors such as meager dividends on the part of corporations, valuations, corporate ethics, and inflationary trends suggesting a major market top. In addition, as in Edwards and Magee, the multiple head-and-shoulders pattern occurs at major market tops and bottoms.
While the pattern has not yet completed, the case for its existence is strong enough to warrant respect from a trading perspective. Respect is separate and different than hanging one's hat and most of one's capital upon the pattern and closing one's mind to the action that is actually taking place in the market. Yet the case for the pattern is strong enough, to perhaps execute a few trades based upon its existence. The trades must be placed with a clear understanding of pattern characteristics that determine appropriate levels of risk tolerance which translate into appropriate stop loss points. Stated simply, you don't want to risk going broke or suffering pain by trading on a pattern that has not been completed. If the price and volume patterns don’t stay consistent with the pattern, the basis for opening the trades will have disappeared and the trades should be closed.
As (and if) the year end rally progresses, it will be important that volume eases even more from the rather lack luster rally which occurred off of the August low. Year end volume tends to be relatively low especially around the Christmas holidays and this should continue to confirm the multiple HAS if the year end rally continues. Similarly, the volume following the proposed New Years swoon should be higher if the multiple HAS pattern is still in play.
A new decisive high in the S&P invalidates the pattern as would any other major deviation from the grey line and volume pattern guidelines shown.
