Neckline or Neck Tie? (I Can't Tell)

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Good morning. While the market hasn't been much fun to watch lately if you happen to be holding any long positions, the explanation for the carnage from those being interviewed on the business shows certainly has been. For example, I can't tell you how many people have been talking about (and emailing me about) the potential head-and-shoulders top formation or the meaning of a cross of the 200-day moving average, or the violation of this or that.

In short, suddenly everybody on the planet is a full-fledged market technician and able to predict the future - all because of the movement of prices in the S&P 500 on Wednesday. Ask yourself, over the last couple of days, how many times have you heard about the downside projection that the much vaunted head-and-shoulder top formation is almost certain to produce? In case you have missed it, everybody and their grandmother are talking about 1160 as the next stop for the S&P. Yikes.

My problem here is I've been at the charting game since the early 1980's and one of the first things I learned was that the H&S formation is the most often identified as well as the least often completed formation around. (Back then, my friend Rick P. and I used to lay out the WSJ and the IBD on our desks and draw trendlines with our pencils and rulers. It was then that I realized that technical analysis was more art than science as we often argued about where the actual trendline was supposed to be!)

I will swear that I get at least 25 emails a year from people asking me if I've seen the H&S in this index or that stock. And the bottom line here is (a) most people don't understand the requirements for the formation and as a result (b) the projected downside rarely materializes.

Oh, and lest I forget, one of the key points to the H&S rule book is that a failed head & shoulders formation often produces violent reversals. So, what I learned about this formation years ago is that people see them all the time, they don't usually materialize, and then when they reverse, the security in question goes the other way - in a hurry! So, unless the setup is absolutely perfect (and you'd best read your Edwards and McGee on what that really means) it is best to ignore the formation and find something else to focus on. (Like the fact that the Portugal bond auction on Wednesday wasn't a disaster, or that the ISM Non-Manufacturing/PMI reports weren't as horrific as had been feared, or that Italy has a vital auction on Thursday.)

With that said however, I have witnessed some spectacular head & shoulders formations in the indices over the years. For example, the upside break of the neckline in July 2009 worked like a charm. Then the H&S bottom formation seen in late 1990 created some real fireworks. And if memory serves, the very first stock I ever bought was St. Jude Medical (STJ) and the reason for the buy was, yep, you guessed it; a H&S bottom formation.

However, the H&S top that appeared to be confirmed last summer turned out to be a great big fakeout. The bottom line there was that if you had shorted or gotten defensive on the neckline break, you would have called the bottom of the correction.

So, before you put too much of your hard earned money on the line over what could certainly be considered a H&S top on the S&P 500, you may want to look around a bit. For example, if you look at the NASDAQ, you might be able to argue that the formation is there, but there is clearly no break of the neckline. And then what about the DJIA - has the neckline broken there? Frankly, I'm not sure I even see the formation on the DJIA.

The point to my rather long-winded missive this morning is that chart formations and technical analysis are but pieces of the puzzle. Few, if any, investors ever use one single indicator to make big buy or sell decisions. Personally, I prefer a model-of-models approach in my efforts to stay on the right side of the important trends. The idea is to use the weight of the evidence to drive your decisions. It doesn't always work perfectly (what does?) but it does help me sleep well at night.

In closing, yes, I am making light of something that "everyone" seems to be talking about. And yes, I certainly do see and respect the H&S formation. But I have also learned over the years to take these "certainties" with a grain of salt.

Turning to this morning... Maybe there's something to this neckline break after all as the futures are heading south once again this morning. But this time the red ink is in response to soaring yields in Italy and a rising dollar, thanks in part to the Bank of Japan's overnight intervention.

On the Economic front... Initial Claims for Unemployment Insurance for the week ending 7/30 fell by 1,000 to 400K. The report was below the consensus estimate for 406K and last week’s revised total of 401K. Continuing Claims for the week ending 7/23 came in at 3.73M vs. 3.7M and last week’s 3.72M.

Thought for the day... Remember to think positive today :-)

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

• Major Foreign Markets:
  • Australia: -1.23%
    
  • Shanghai: +0.21%
    
  • Hong Kong: -0.49%
    
  • Japan: -0.94%
    
  • France: -0.94%
    
  • Germany: -0.17%
    
  • Italy: -2.14%
    
  • London: -1.09%
  
  
• Crude Oil Futures: -$0.95 to $90.98
  
• Gold: +$6.70 to $1673.00
  
• Dollar: lower against the Yen, higher vs Pound and Euro
  
• 10-Year Bond Yield: Currently trading at 2.586%
  
• Stocks Futures Ahead of Open in U.S. (relative to fair value):
  • S&P 500: -16.29
    
  • Dow Jones Industrial Average: -133
    
  • NASDAQ Composite: -31.8

 

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The opinions and forecasts expressed are those of David Moenning, founder of StateoftheMarkets.com and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report