Technical price analysis dates back at least to the Japanese rice traders of the 1700s. Since the 1870s, it's been applied to the stock market in Japan. While there are many variations, all technical price analysis can help investors form opinions about the probable direction of an equity, commodity, or index.
Please note that I did not say it "predicts" the direction. I said it helps investors "form opinions about the probable direction" their investments are heading, which is an entirely different thing.
Technical analysis gets a bad name on occasion because an analyst will issue a dubious prediction after a string of successes. That's unfair, because no indicator is perfect or accurately predicts market direction 100% of the time.
I know, because I've been looking for one for 50 years. While I have frequently found indicators that work well for a while, each one eventually fails... only to start working again months or even years later.
So here's rule No. 1: Base your opinions about where a market is heading on several indicators. Rule No. 2: Set a target price, and if the investment falls lower, admit your guess was wrong.
Technical indicators focus our attention by reminding us what was important in the past. This week, several indicators are creating familiar pictures. Although they don't predict where the market is going, they underscore its pivotal nature.
One indicator is the inverse head-and-shoulders (H&S) pattern. In technical analysis, H&S is a chart showing the rise and fall of the price of an investment through a given period. It's characterized by a peak followed by a decline, a second peak that rises above the first followed by a decline, and then a third rise to a level below the second peak followed by a decline. The pattern resembles the silhouette of a person, with the first and third peaks the "shoulders" and the second peak the "head," as shown here:
If you look at the chart, you can trace the market's movement. After rallying to a high, a decline forms the left shoulder. Then the price rises higher than the previous peak, but falls back again to form the head. Finally, there's a third rally. The price climbs, but it does not climb higher than the second peak. It's followed by another decline -- a pattern that forms the right shoulder.
If you draw a line through the lows, (blue dash in the chart), you form the neckline. That's an important metric. Technical analysts generally consider a head-and-shoulders pattern a bearish indicator if the price of the stock or index falls about 3% lower than the neckline. It confirms the pattern, indicates a breakout has occurred, and signals that further losses are likely.
Now let's look at a chart that extends the one we've already reviewed. In this case, the H&S pattern led to an extended market decline after the 2007 financial meltdown. Then, it turned and created an inverse H&S pattern, something that often marks the transition between a falling and a recovering stock market.
To confirm the pattern, the price has to close at least 3% higher than the neckline. After a breakout, a stock or market index may fall back to test the neckline, shown above by the blue arrow. In some cases, the test fails and the market decline resumes. Other times, as the chart shows, the market starts moving higher and confirms the advance by gaining 3% or more.
To bring us to the present, let's look at an enlargement of the circled area shown in the chart above. This represents the Nasdaq from December through this past Friday's close.
The Nasdaq closed higher than the neckline of a new inverse H&S pattern on April 20. Last week, it tested the neckline. We'll be able to confirm the breakout if the market closes around 2,900, or about 3% higher than the neckline. This is why analysts who follow this indicator consider this a pivotal week.
At this point, there's no way of knowing for certain whether the breakout will be confirmed or whether the neckline will be penetrated again But we do know this is an important week because the market is in a position to make an important choice.
The H&S isn't the only indicator in a critical position this week. We'll discuss some of the others in future posts.
— Fred Goodman, a registered investment advisor and Certified Financial Planner, publishes MarketMonograph, a daily, Web-based subscription service specializing in technical stock market analysis and the application of economic indicators to market timing. You can reach him at email@example.com.