Trader’s Narrative

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.

The market is full of cycles. Some are fast and others like the inter-relationship between the small capitalization and the large capitalization subset play out at a glacial pace:

The stock market seems to go through these slow, vast cycles between large caps and small caps and they usually last about 5 years. Most surprisingly, they resemble a sine wave - with some noise thrown in - which is surprisingly orderly and predictable.

But we seem to be in a rare exception right now when the market can’t make up its mind who is winning and who is losing. Since 2005 we’ve been in a holding pattern with the ratio of small caps relative to large caps around the same level as 1994.

This is around the area where small caps have given up the fight and large caps taken over. Going back 30+ years the ratio topped out higher than this level (approximately 0.80) in 1984. So based on historical precedent, we should see large caps take the stage for the next few years.

The real question though is what does it mean? I’ve turned it over but I can’t detect any edge from this slow back and forth cycle. Especially for timing the market.

Having an idea of where we are in the over all scheme of things may be helpful if you’re going to go long one and short the other but it doesn’t seem to be all that helpful when you’re simply asking if it is a good time to short or go long either market by itself.

For example, while 1991 was a trough, it corresponded to the start of a period of years where the S&P 500 did quite well. But in 1994 where the ratio topped, that was arguably also a good time to buy. And then finally, in 1999 and 2000 when the ratio was pushed down again, that was not a good time to be invested in the market going forward.

Looking at the percentage of stocks above their 50 day moving average is a quick and dirty way to find out where the market stands in the medium to short term. Looking at the percentage above 200 day moving average provides a much broader perspective.

Line In The Sand
The 200 day moving average is like the proverbial “line in the sand”. If a stock can’t hold above it, technically speaking, things are really rotten. But while that may be negative for one individual stock, when as a whole the market crosses that threshold, it usually is a sign that things have reached an extreme and are about to return to normal.

Right now, the percentage of stocks above their long term moving average are at levels which in the past have seen a resumption of the bull market. The index that got the most oversold was the Nasdaq Composite (COMPQ) which reached 34%. The next one was the S&P 500 (SPX) which got as low as 43%.

Large Cap vs. Small Cap
But there is an obvious dichotomy. Whereas the broad indices (containing a mix of small caps and large caps) show an extreme low reading for this indicator, the large caps are almost unscathed. The Nasdaq 100 (NDX) index, for example, has 60% of stocks above their 200 day moving average while the S&P 100 (OEX) has 62%.

This is no surprise since we all know that the small caps have gotten crushed in this correction. A cursory look at the Russell 2000 (RUT) shows it correcting about 12% (from recent high to recent low) - almost double that of the large caps.

Unless for some reason you believe that we are heading into a new bear market, this is as bad as it is going to get. I reiterate that this is a buying opportunity if you have a medium to longish time horizon. Especially the financial sector.

Here’s the chart for the NYSE and the S&P 500. Notice the difference between a bear market bottom and bull market inflection points:

The Commitment of Traders (COT) report is issued by the Commodity Futures Trading Commission (CFTC) and shows how small speculators, commercials and large speculators have placed their chips in the futures markets.

In contrast to other indicators like sentiment, it is an invaluable source of market information because it objectively lays out how the three separate players are positioned. The only caveat is that it comes with a 3 day delay (so insiders can still have an edge) so by the time you look at the target, it may have already moved.

Nonetheless, as long as our time horizon is medium to long term it can still be useful.

The latest report COT was released last week on Friday May 25th 2007. It showed a remarkable change in the behaviour of the commercial hedgers (known as the “smart money”). They not only reversed their recent short run bet against a rally, but are now sitting on one of the largest aggregate net long positions in the past 10 years.

The S&P 500 COT report shows the commercial hedgers as net long as they were in the early part of 2003 while the “dumb money” small speculators are still as short as they were at the March 2007 market bottom. In short, they are equally bearish even as the market has shaken off the dip we had in late February and early March 2007.

Over at the Russell 2000 (the small caps) things are quite lopsided as well. The small speculators are net short as much as they were at the bottom of the market in the summer of 2006.

Here are a few examples of previous times the commercial hedgers were close to this net long:

October 2005
January 2004
March 2004
May 2004
September 2003
August - October 2002
September 2001

With the exception of the 2004 instances, this was a fantastic tell that the market was headed up (on an intermediate to long term time horizon).

It is unusual to see such a lopsided bullish position by commercials after the market has risen considerably. Usually they step in and scoop up the market when it goes on sale due to panic selling (September 2001, for example).

I would be more confident buying along with the commercials when the market has been spooked lower but under any circumstances, it is too risky to bet against them. That is what you’d be doing if you short this market right now.