by Jim Stanton, Technical & Quantitative Analyst and Editor of The 1-2-3 Trader
Last week, the market did what it often does best: Confounded the experts and did the opposite of what most people expected.
This time, the market teased technical traders, luring them into thinking that the Dow and S&P 500 were mapping out a bearish “head-and-shoulders” pattern in the wake of the indexes topping out in mid June.
As the news gathered momentum on blogs and in newsletters, mainstream media outlets like CNBC and Bloomberg began running with the story. And that was part of the problem!
It soon became clear that this particular pattern might not follow the conventional path - a theory that gained credibility when both the Nasdaq 100 and Nasdaq Composite traded at new recovery highs when the closing bell sounded last Friday.
So what is going on here?
This Pattern Signaled A Reversal… Or Did It?
Below is a daily chart of the Dow Industrials, which I published in the weekly “Inside Mt. Vernon Research” e-mail last Friday.
As you can see, there is a clearly defined “head-and-shoulders” pattern spanning the last two months. However, what many people forgot is that while this pattern usually signals a reversal, it also has a failure rate of around 30% - something I also I warned my 1-2-3 Trader subscribers about.
The Breakdown Of A “Head-And-Shoulders” Pattern
When a “head-and-shoulders” pattern closes below the “neckline,” which the Dow did on July 7, sellers usually take control and send the market lower.
However, although the Dow did close below the neckline for four straight days, crucially, the bears couldn’t gain any traction. The low for the move was on July 8, which raised a caution flag.
When the media got hold of the story, highlighting the potential bearish pattern and the prospect for a reversal, the masses began shorting the market. From July 7 through July 10, the equity put/call ratio closed between 77% and 85% (bullish) - the first occasion in a long while that a four-day reading had been that high.
