As any reader of my blog knows I pay attention to the technical indicators of the market as well as the fundamentals. There are many technical indicators ranging from crazy ones based on the Super Bowl, blimps, and even (go figure) politics. But there are a few indicators that have a solid history of signaling trend reversals. I speak regularly about the 50 and 200 day exponential moving average but once in a while a head and shoulders forms in the market.
No flakes here
Before I explain the head and shoulders formation I want to make it clear that this formation (while a funny name) is serious business in the world of finance. Just as the 200 day moving average is a well known and respected indicator so to is a head and shoulders formation. It is said that a head and shoulders predicts the market direction with 70% accuracy. Head and shoulders formations can form in reverse (as it did from December 2008 to July of 2009) to indicate an uptrend or as we see it now indicating a downtrend. A head and shoulders formation in the market in a verbose description is when a stock:
- Rises to a peak and declines
- Then, rises above the former peak and again declines
- Rises again, not to the second peak, and declines again
Visually, the below chart is the current head and shoulders formation in the market. Click on the image to see a larger version of the same chart.
As you can see from the chart it looks like a head and shoulders with a neckline. This is a picture of the S&P 500 from the morning of 8/25/2010. The head and shoulders have formed at this point the only part left is the breach of the neck line. The breach of the neckline is typically where a fall off occurs (or rise if the head and shoulders is forming in a market bottom). Below are further charts of the fall off in 2008 as well as the resulting rise in 2009. Notice what happens when the neckline is crossed either on the up or down.
Head and shoulders of fall off in 2008 ( click image below for larger image):
Head and shoulders of rise in 2009 ( click image below for larger image):
