When it comes to technical analysis, most investors fall into two very distinct camps…
They either love it or they hate it.
For those who swear by it, the lines on those charts are more than points on a graph; they are windows to a world where the price action of the past gives clues about the price action of the future.
This swath of market players wouldn’t even think about wading into the markets without consulting their charts first. (I am one of them… Though I do give equal weight to the big-picture world of the fundamentals.)
Pure technicians — often referred to as “chartists” — focus almost solely on price and volume to predict the future market movements. Using charts, they study the supply and demand in the markets in an attempt to determine whether current trends will likely continue in the future, or fall apart.
Long story short, technical analysis basically rests on two assumptions:
1. Stock prices tend to move in trends.
For a technical analyst, the trend is always his friend. That’s why most technical trading strategies are trend-following. (That includes the broader market trends as well as those of individual stocks.)
Because once a trend has been established, technicians know the future price movement will likely continue in the same direction. Of course, any break in this trend is often where technicians decide to sell.
2. Markets, like people, repeat themselves.
Above all, technicians believe that since markets are made up of people, they follow predictable patterns. Thus, they attribute the repetitive price movements in stocks to market psychology.
The belief is that once a consistent pattern of behavior has been established, it can be used in the future to provide good entry and exit points.
Trading around support and resistance levels is a perfect example of this.
However, there are times — like today — when key levels in the broader markets come into play. It’s at these levels the broader direction of the market really begins to take shape for the technical crowd, because when markets fall through key levels of support, traders begin to look for even more downside.
Given the ongoing selloff, a move below 12,000 on the Dow opens up the prospect for a head and shoulders top, which has the technical crowd on the edge of their seats…
For a technician, it’s a chart pattern that’s simply impossible to ignore.
Head and Shoulders
So what does a head and shoulders top look like?
Using the current chart of the DOW as an example of what has technicians abuzz, the classic head and shoulders top looks something like a human head with shoulders on either side:
The first point (1) — “the left shoulder” — occurred as the DOW marked a new high in February and then promptly fell back. The second point (2) — “the head” — happened when the DOW went even higher before falling roughly back in line with the prior low.
But the third point (3) is the one that bears watching: the-all important “right shoulder” that occurs when prices fail to go beyond the previous high and begin to move lower.
The key to the pattern is what’s known as “the neckline.” In this case, it is the support level provided by the previous lows — roughly DOW 11,900.
The pattern is complete when the support provided by the neckline is broken. This occurs when the index falls from the high point of the right shoulder and moves below the neckline…
(Technical analysts will often say the pattern is not confirmed until the index actually closes below the neckline; simply trading below the 11,900 level is insufficient to complete the pattern.)
However, if the technical pattern is confirmed calculating the downside target for the DOW, then it’s a simple matter of math.
To figure it out, you subtract the high of the head (roughly 12,850) by its distance to the neckline of 11,900. That gives you a figure of 950 points. Then you subtract that 950 from the 11,900 neckline to arrive at a DOW target of 10,950.
If that happened, it would make for roughly a 15% pullback overall — not quite bear market territory, but close.
For investors looking to hedge their bets in anticipation of a wider decline, inverse ETFs are certainly one option. Among them are the UltraShort Dow 30 (NYSE: DXD) and UltraShort S&P 500 (NYSE: SDS). Tied to the broader indexes, they go up as the markets goes down.
A Summer Rerun?
I would be remiss if I didn’t bring up the fact that we’ve been here before.
A year ago today, the same exact chart pattern began to form…
But as we all know, the Fed arrived in the nick of time to prevent a wider loss.
On August 27, in a speech at the Jackson Hole Economic Symposium, Bernanke’s promise of even more quantitative easing arrived to save the day. Not long after, QE2 set sail with a $600-billion price tag.
From that point forward, the market reversed and went 30% higher, burying the shorts in the process.
Of course with all the economic data now pointing toward yet another double dip, all eyes are on Jackson Hole again. That’s where the rubber will really meet the road — even for the most diligent of technicians.
Your bargain-hunting analyst,
Editor, Wealth Daily
P.S. As part of our Whiteboard Weekly series, I’ve produced a short video clip about dividend stocks. You can watch it here.