Tracking Head-and-Shoulders Patterns

Helene Meisler looks at the latest one in the Dow.
Author:
Publish date:

OK, raise your hand if you haven't seen the head-and-shoulders pattern in the

Dow Jones Industrial Average

. It's there. I can't imagine anyone missing it. Heck, just open up

The Wall Street Journal

, and it's staring you in the face on a daily basis. And if you don't bother reading the

Journal

, then you must've heard it discussed on

CNBC

. I sure did.

It's so obvious that even if you know nothing about chart patterns, you couldn't possibly miss that head-and-shoulders top the Dow has managed to build. I've certainly received my share of emails asking if I've seen it.

So, if you haven't seen it, here it is. The left shoulder was formed back in April at the Dow high just over 11,100. The May correction came down to the neckline, around 10,400. The July rally made a marginal new high in the Dow at 11,200. That's the head. The recent decline came back to test the neckline but stopped a bit higher, around 10,500. This recent rally now appears very much like a right shoulder. The pattern would be completed by a break of the neckline, around 10,500.

For those who don't know how to measure a head-and-shoulders pattern, it's really quite easy. Take the price high of the head (11,300 in this example) and subtract the price low of the neckline (10,300). Subtract that number (1,000 in this case) from the number where you actually break the neckline (10,500) to get your target price (9,500).

So how bearish is this? I must admit it's not a bullish pattern, and this one appears to be right out of a textbook. If I had to draw a hypothetical head-and-shoulders pattern for an example, this is exactly how it would look. However, I would also say that my experience has been that typically when we see a head-and-shoulders pattern in the Dow, it is so obvious that it tends never to come to fruition.

Does that mean this one won't work and the market will be saved? While I like to keep an open mind about the market (i.e., this head-and-shoulders pattern might actually complete itself), I have always preferred to use the internal market statistics as a guide to market direction. And for now, I have noticed a distinct difference in the selling pressure this week than just a few weeks ago.

To begin with, the market is still not overbought. And the oversold level we saw 10 days ago was very extreme. It is now quite possible that when we get overbought next week and the oscillator comes back down, it will hold at a higher low. That would be positive.

In addition to that, the number of stocks making new lows is not expanding at nearly the same rate it was back in July. Let's take a closer look at how this works for a minute. I'm going to use

eBay

(EBAY) - Get Report

as an example, even though it's not really the best example. The low in eBay on Aug. 5 at 70 was quite extreme. Since then, the stock has rallied to 129. That's nearly 60 bucks! Now eBay is selling off again, down 13 or so on Thursday. I would say it's highly unlikely that a slide in the markets will take eBay all the way back down to that 70 price we saw two weeks ago. Does that make eBay a great chart? No. But it does give us a higher low in the stock, which is the first step. And that, in turn, will translate into fewer stocks making new lows, which, in turn, makes for a more positive tilt toward the market.

We must also keep our eye on the advance/decline line. Once again, we saw some improvement in that statistic yesterday. With the

S&P

down almost 10 points, the a/d was a net negative 250 issues. To put that into perspective, on Monday, Aug. 9, the S&P ended the day down only 3, but the a/d did not recover -- it still lost nearly 600 on that day. This tells us some stocks are beginning to hold into declines. Just as we had to wait for the top to form when the averages were up at their highs and the stats were losing ground, we must wait for a bottom to develop as the averages go down and stocks begin to hold. This will not happen overnight, and sometimes what holds today gives way tomorrow, but if the progress we've seen over the past few days continues, it will give the market a much more positive tilt.

And, finally, a word about those

Investor's Intelligence

bull/bear numbers. This week's drop in the percentage of bulls was considerable. We have now gone from a high of 61% in April to 45.8% this week. This 45.8% reading is the lowest number of bulls we've seen since the lows last October! It seems sentiment is finally moving in the right direction, too.

Of course, the biggest challenge I have is finding bullish charts. They are still few and far between.

Disney's

(DIS) - Get Report

move off the bottom (has it moved from the huge success of

The Sixth Sense

?) is important. It should dip at some point, which will help flesh out the bottom that chart is struggling to achieve. I would buy it into such a pullback.

DuPont

(DD) - Get Report

and

3M

(MMM) - Get Report

are building nice big bases. Even

International Paper

(IP) - Get Report

, which I've been scoffing at, refused to go down and has begun to show signs of strength.

Outside the Dow, I find myself warming up to

Compaq

(CPQ)

for the zillionth time. I still like

General Mills

(GIS) - Get Report

and

Kellogg

(K) - Get Report

. And

Schlumberger

(SLB) - Get Report

is tempting in the oil-services group.

On the negative side,

Coke

(KO) - Get Report

just fizzles down.

Merck

(MRK) - Get Report

has too much resistance overhead for my taste.

Elsewhere,

AMR

(AMR)

and

Delta

(DAL) - Get Report

are just down charts.

Limited

(LTD)

slips a little more each day.

Nordstrom

(JWN) - Get Report

is another retailer that does not act well.

Sara Lee

(SLE)

seems destined to become a teenager.

Sure, there are plenty of things about this market that are not very good right now. But it's our job to point out that not quite everything is confirming on the downside at this point in time. If the underlying improvement continues to creep its way into the market, the next trip down may just put this market into much better shape. And a successful test of the downside might just give me that "W" bottom I prefer.

Helene Meisler, based in Singapore, writes a technical analysis column on the U.S. equity markets on Tuesdays and Fridays, and updates her charts daily on TheStreet.com. Meisler trained at several Wall Street firms, including Goldman Sachs and Cowen, and has worked with the equity trading department at Cargill. At time of publication, she held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. She appreciates your feedback at

KPMHSM@aol.com.