Potential Head-and-Shoulders Patterns

Updated from July 22

I've been watching a developing pattern: the head-and-shoulders consolidation formation.

The Pattern The chart is from Stockcharts; the markings are mine

Click for full-size image

While it is always a technical no-no to buy or sell in anticipation of a pattern yet to be formed, it is valid to consider how the market might react to a developing formation.

The S&P 500, the Dow Jones Industrial Average and the Nasdaq all show similar development. After peaking on Jan. 26, the indices saw three major selloffs. The first two enjoyed a substantial bounce, each of which failed at the forming neckline. The most recent selloff appears to be testing the last bottom made on May 17. Any subsequent bounce from here will complete a head-and-shoulders continuation pattern.

The seminal Technical Analysis of Stock Trends by John Magee and Robert Edwards notes: "Occasionally, prices will go through a series of fluctuations that construct an inverted head and shoulders picture, which in turn leads to continuation of the previous trend." If that's forming here, it is indeed bullish in the short term, as the market should follow the prior pattern and bounce off these levels.

Furthermore, the textbook notes that the consolidation head-and-shoulders pattern, unlike the reversal top (or bottom), tends to be "flattish." In a typical head-and-shoulders top, the head is always higher than both shoulders. That indicates the bulls are running out of ammo during tops. The failure to make a higher high is often the last gasp of a trend move running on empty.

On the other hand, in a reverse head-and-shoulders bottom, the head is always lower than both shoulders, showing bears getting tired during bottoms. The failure to make a lower low, then, usually signals the end of the trend.

However, this consolidation pattern is somewhat different: The reverse head-and-shoulders pattern has been on light volume, with indecisive action. It throws off enough confusing signals that both bulls and bears end up frustrated. That eliminates weak hands, exhausts sellers and eventually allows the market to break out of its range.

The tiring action of the most recent selloff since June 30 is the third major drop this year. It sets up the third possible bounce since 2004 began. But it also creates a deeply oversold condition, as well as a "sellers' vacuum," above these levels, allowing a bounce-back to take place relatively easily.

A high-volume penetration of the neckline bodes well for the intermediate term -- about six to 18 months.

For now, the technical short-term downside risk, in my opinion, is 1% to 3% (I usually tend to be a few days early). The upside is a possible bounce of 10% or better toward that head-and-shoulders neckline. So I'll scale in, using further drops as an entry for indices.

Regardless, I would limit my downside to 5% if buying indices here for a trade. If I am wrong, the alternative is a vicious cascade selloff. I am willing to lose 5% to a stop-loss here and redeploy the capital. Indeed, my working assumption is always that I am wrong, so I work backward from that point to protect capital.

As mentioned yesterday, I am looking for an oversold bounce, after a retest of Thursday's lows. The bounce might take us back to the recent highs of late June and late April -- 2040 on the Nasdaq and 1140 on the S&P 500. If that neckline gets penetrated to the upside -- a possibility, but in no way a sure thing -- we could see a full-blown year-end election-year rally. If that occurs, upside targets are 11,200 on the Dow, 1220 on the S&P 500 and 2320 on the Nasdaq Composite.

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Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback and invites you to send it to [e-mail].

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