By David Franklin is director in charge of retail funds at Christows It has been said that the ...
By David Franklin is director in charge of retail funds at Christows
It has been said that the S&P 500 Index is in the process of forming the mother of all head and shoulders patterns.
The first shoulder was formed in 1998 to 1999 by the index rising from 980 to 1,190 and falling back again to 980.
Over the past year, a similar pattern has emerged, with the index once again rising from 980 to 1,180 before falling back again.
These two periods represent the shoulders. In the middle is the head, the speculative bubble of 1999 to 2000 and subsequent collapse.
Technical analysts are watching this development with increasing trepidation.
Why? Well, several conclusions can be drawn from a classic head and shoulders pattern.
The main worry is the downside target, which is calculated from the tip of the head down to the trend line joining the neckline.
Normally, the downside price target is equal to the distance between the tip and the neckline, or, in this instance, nearly six hundred points, giving an eventual price target for the S&P of 380.
If achieved, this would represent a further fall of 61% from the neckline at 980.
Opinion among analysts is divided as to where the neckline actually lies. Some choose to use the closing day's index level, while others prefer to watch the intra-day highs and lows. The critical range is 944 to 980.
For a classic head and shoulders pattern to be valid, the key break points must be broken with decent trading volumes.
What is worrying is that the plunge through the 980 level has been accompanied by the highest overall trading volumes in a five-day consecutive period so far this year, confirmed by record volumes also traded on the Nasdaq.
So, if the pattern has already completed, and the jury is out on this point, when can we expect the next plunge in equity values?
Followers of Elliot Wave argue, with some validity, that corrective periods are in direct proportion to the length of the previous bull run, or to the length of the formation of the pattern.
Given that this head and shoulders has taken nearly five years to form, it is reasonable to assume the subsequent price target will take up to three years to be met (up to two-thirds of the formation period).
The alternative interpretation is the channel of activity. Unfortunately, this interpretation gives only a little comfort, as the price target from the failure of a channel formation is equal to the width of the earlier channel, or 616 on the S&P 500 Index, still substantially below current levels.
Should we give any credence to these technical patterns? The simple answer is yes. Head and shoulders and channel patterns are among the most well known and highly regarded technical indicators and are known to work on most occasions.
Of course, this time may be an exception, but it is better to be safe than sorry.
The US economy is reasonably strong.
In bear markets, shares rarely fall in straight line.
Accounting scandals confined to some areas.
A long bear market may hit confidence.
The market has lost it transparency.
The fall in asset values may lead to deflation.