Head-and-shoulders completed
Bearish chart pattern suggests 600 point drop on S&P 500 By Vince Heaney FT Investor, 09:34 BST Jul 12, 2002
LONDON (FT Investor) - The S&P 500 slumped 3.4 per cent on Wednesday July 10, sweeping aside key technical support to complete a major bearish chart formation, which has an eventual price target some 600 points below current levels.
Even after a volatile session on Thursday, which saw the S&P reverse early losses to close higher, the bearish chart signal remains intact.
The pattern
Wednesday's close at 920.47 on the S&P 500 [SPX, News, Chart, Research] completed a head-and-shoulders formation on the long-term weekly charts
The head-and-shoulders is a pattern that forms at the end of an up trend and signals a change in the direction of the trend. As the name suggests it is formed by three successive peaks. The middle peak (head) marks the high point of the market and is flanked by two lower and roughly equal peaks, which form the shoulders.
The pattern is completed when the market breaks through a line drawn through the troughs between the peaks, known as the neckline.
The pattern can be clearly seen on the five-year weekly chart for the S&P 500 [SPX, News, Chart, Research], and is a "textbook" example of the formation - the shoulders are of a similar height and time duration, and the neckline is flat.
The left-hand shoulder was a pattern that lasted for nine months from start to finish, peaking at 1190.58 and ending at 923.32 in October 1998.
The rally off the September 21 2001 lows at 944.75, from a level similar to the October 1998 lows, formed a peak at 1,176.55 and has also lasted for nine months.
Break down
Some leeway should be allowed when drawing trend lines on long-term charts. The neckline drawn through the October 1998 and September 2001 lows comes in around the 950 level.
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The S&P 500 has probed the support area - dropping to an intra-day low of 935 last week, before rallying clear of the immediate danger zone last Friday.
Wednesday's close at 920.47 was a clear close below the neckline area, and was also clearly below the September 2001 low at 944.75.
The pattern has now been completed. The price objective on a head-and-shoulders reversal is the height of the formation between the head and the neckline, with this distance applied to the breakdown point through the neckline.
In this instance the distance from the high at 1,553 in May 2000 to the neckline directly below that point at approximately 935 yields a projected price drop of 618 points. This projected price decline is applied to the breakdown point on the neckline - taken to be 950 - and gives an eventual target of 332 on the S&P 500, a level not seen in more than a decade.
False breaks can be seen when following chart patterns. It would be prudent to look for more than one trading session below the neckline before accepting that the pattern is a valid one. But the close at 920.47 puts the market on red alert.
Immediate further selling pressure from current levels would obviously strengthen the validity of the pattern. If the market rallies back to the 950 level and is rebuffed - support once broken tends to become resistance - this would also strengthen the pattern.
To negate the pattern the market needs to rally quickly back above the 950 level and remain there. Thursday's roller-coaster session, which closed at 927.37 after early sharp losses is insufficient to negate the bearish signal.
Whether you are a believer in technical analysis or not this chart pattern will have a significant market impact. Investor sentiment has been rocked by accounting scandals and the weakness of corporate earnings despite a macroeconomic recovery. This will make it more difficult to dismiss chart patterns as an irrelevant sideshow. The proponents of technical analysis have called the market correctly and they have just been given a further major bear signal.
Vince Heaney is markets editor for FT Investor in London.
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