Trader’s Narrative

You’ve probably already noticed this since the pattern completed in late July and early August. In case you haven’t, the Philadelphia Banking index (BKX) has carved out a fairly decent reverse head and shoulder formation:

Of course, the technical pattern in the above chart mirrors the one visible in other sectors as well as the general S&P 500 index itself. No surprise there since most stocks take their cue from the major index, rising and falling like the tide.

The one fly in the ointment is the left shoulder (see red exclamation mark on chart). Although the left shoulder is fully formed, I’d prefer to see a more symmetrical one to the right shoulder. That would have only been possible if the year end rally would have taken the Banking index a bit higher to reach the neckline. So it isn’t a picture perfect inverse head and shoulder pattern.

Back in June I mentioned that the financial sector was losing relative strength and the baton had been passed to the Semiconductor Index (SOX). Since then the banks have continued to lag the S&P 500 and the tech sector has been the engine of the stock market.

We’ve got considerable resistance ahead at the 50 level (on the BKX). But the measured move target is 74 - which takes us to the next significant support/resistance level. Needless to say, the reverse head and shoulder formation is the quintessential reversal pattern in technical analysis.

No, really. How high can this market keep going?

That’s the question a lot of people are asking. It isn’t surprising that once the S&P 500’s perfect head and shoulder pattern failed, prices rocketed higher - almost non-stop. We’ve had 12 consecutive trading days closing higher. That kind of streak is not only extremely rare, it is an unmistakable sign of surging momentum.

Now, many are pointing to a head and shoulder bottoming formation (on a larger time frame) and expecting prices to keep rising. Actually, I commented at the beginning of June 2009 that we may see a flag formation and then a break to the upside: Comparing Flag Formations: Then & Now.

Amazingly enough, we seem to be replaying the same price action that we had when we came out of the last bear market. The similarities are uncanny as I’ve mentioned more than once. So what’s next?

Below is a short video that briefly summarizes what the market has done and then finishes by looking ahead to what we may see next week and next month.

Click to watch video:

While everyone’s attention was on a head and shoulder pattern completing on the Standard & Poors 500 index, another head and shoulder formation was taking place in gold. As the magical $1000 marker acted as strong resistance several times, a consolidation pattern emerged below it.

Here’s a good video update of the recent price action. Click the chart below to watch the video:

While head and shoulder formations are usually considered to be reversal patterns, they can also act as continuation patterns. This is less common and fewer technical analysis students know about it, which makes it more likely to complete. As we’ve all noticed by now, the head and shoulder formation in the equity indexes was noticed and watched closely by everyone and their uncle. Which is why it turned into a bear trap.

The other possibilities are that we could get an irregular head and shoulder pattern. This is a variation where the shoulders are not symmetrical. For example, we could have two shoulders form in the right hand side. The whole pattern would still be valid but it would take longer to play out.

Also, we could see a sideways trading range which would then suggest a large cup and handle pattern instead. Either way, if the price of gold continues to trade within a short distance from the $1000 resistance, the probability of it breaking up increases.

Finally, we can look at the K-ratio to get a sense of the gold market. This is a ratio of the gold equities compared to the price of gold itself. It was first proposed by the technical analyst Jay Kaeppel and I estimate it by using the Philladelphia Gold Index (HUI) and the futures price of gold - instead of the original formula of Barron’s Gold Mining Index and the Handy & Harmon price. There is a minor difference in the two but the important thing is keeping things consistent by picking one method and sticking with it:

According to the K-ratio, the best time to buy gold stocks was in late October 2008, when they were almost as cheap as they were back in 2001. Of course, we now know the 2000-2001 era as a generational opportunity to buy gold - just as the majority were preoccupied with the technology sector. You can also see that the 200 rate of change for the ratio was confirming the buy signal. Right now they are both in neutral territory. This presents a bullish opportunity because if the price of gold breaks through the long term resistance, the K-Ratio still would have room to move up before becoming overbought.

Last Call
You can still get in on FREE week over at EWI’s commodity junction. All you need is an email to get in - but do it right now because it is only available til July 22nd. If you’re interested to trade commodities or are an experienced trader and want to learn about how Elliott wave analyses these markets, this is your chance to get a sample of their work for free.

Wayne, an experienced options trader sends along this note:

“The S&P 500 is up 7.0% so far this week. Over the last 30 years, if the S&P 500 is up over 4% for the 4 days going into an expiration, the market is 8-2 on that Friday.

Here are the 10 individual cases, when they occurred, the 4 day gain as well as the final Friday performance:

Start Date 4 Day Gain Friday’s Gain

• 1982/08/20 — 5.11 — 3.54
• 1989/10/20 — 4.04 — 0.01
• 1991/01/18 — 4.04 — 1.30
• 1998/10/16 — 6.42 — 0.85
• 2000/03/17 — 4.54 — 0.41
• 2001/04/20 — 5.93 — (0.85)
• 2002/05/17 — 4.10 — 0.76
• 2002/10/18 — 5.25 — 0.59
• 2003/03/21 — 5.11 — 2.29
• 2008/10/17 — 5.25 — (0.62)

Markets tend to go where there is the most business to be executed. Tomorrow that is the 950 strike price where option sellers will either have to buy or sell depending on the settlement. Also June’s 953 highs will act as magnet as well. I have been trading option expirations for 20 years and history has taught me many times, that if you are on the wrong side, don’t expect the market to do you any favors.”

While the statistical case isn’t really iron clad from the above, I agree with Wayne’s assessment. The S&P 500’s 950 level corresponds to not only the magnetic pull of the recent options expiration but also the top of the range trading we’ve seen for the past while. We’ve clearly seen a failure in the head and shoulder formation but I doubt that we have enough to juice it above the previous resistance levels.

I know that 10 instances over 30 years is a trifling sample but just for kicks, I took Wayne’s starting dates and then calculated ahead by 2 months (60 trading days). The best two month walk forward was for the 1982 date with a return of 23.46% and the worst was for May 17th 2002 for a -18.33% return. The average performance of the S&P 500 over that time for all 10 cases was only 4% - nothing to write home about.

In the even that we do see a decisive break above 950, we could be looking at a rally that demands respect. Not only will it have broken through the resistance that has pushed back prices since late last year, but it will have done so after a an incredibly strong push higher with extremely positive breadth, not to mention, with the wind at its back provided by the 200 day moving average (trading below price), the Golden Cross, as well as the upturned Coppock Guide.

A ‘head and shoulder’ formation is one of the most famous technical formations in price charts, probably because it is one of the most common formations. The name comes from the way that the chart formation looks like the sillouette of a person’s upper torso.

The head and shoulder formation consists of a rally (the head) separated by two smaller rallies (the shoulders), preceding and following it. As with all technical formations, the fractal nature allows for it to occur on a variety of time lines, from minute charts to weekly and monthly charts.

The slope of the neckline can also vary, being horizontal, downward or upward sloping. In all cases, the effect is the same. Upon completion, the expectation is for lower prices:

Volume is also an integral part of this pattern. Typically volume is heaviest during the left shoulder, or first tentative rally. Then during the more successful rally that follows (head), volume recedes. And the final, smaller rally has equal or lower volume. As you can see from the chart of the S&P 500, the head and formation that has printed recently follows these volume conventions exactly.

If the Head and Shoulder formation completes, then the target would be 820 for the S&P 500 Index (SPX). I got that by taking 885 as the neckline and 950 as the top of the ‘head’ and then projecting the difference downward. Depending on how you drew the line you may have gotten a slightly different number but I’m sure it would cluster around the same level.

Although instantly recognizable to the trained human eye, this chart formation is extremely challenging to quantify. But there have been more than a few who have taken a crack at it. Over the years I’ve read a handful of research reports that show the results are surprisingly positive. Even those who are skeptical of the efficacy of technical analysis in general, have accepted that a head and shoulder formation is very reliable.

Interestingly, this technical pattern is printing not only in the important Standard & Poors 500 but in the Russell 2000 (small caps) and the Dow Jones Industrial. But not in the Nasdaq Composite as the tech sector’s high relative strength has powered this index to higher highs. On the other hand, you could argue for a double top pattern in the Nasdaq which is equally bearish.

The important thing right now is to watch for the completion of the head and shoulders pattern. If it breaks the neckline, then the projection stands. However, such a formation is not guaranteed to complete. If we have a head and shoulder failure - that is prices break the neckline but do not go lower, then usually what follows is an explosive rally as many people who expected lower prices are caught on the wrong side and have to cut their losses.