Below, we've labeled the elements of the current "head and shoulders" formations on the S&P and Dow (regular moving averages have been removed for better visibility of the pattern):
If the S&P and Dow are unable to move higher in the coming days, the highs of their "right shoulders" will remain below the highs of their "left shoulders," thereby increasing the chance of bearish follow-through. If, however, the indexes manage to close significantly higher than the highs of the "left shoulders" (930 for the S&P 500 and 8,587 for the Dow), odds of breaking down below the "necklines" will be diminished. Obviously, a rally back above the June highs would be rather bullish, and would completely invalidate the "head and shoulders" formations.
When a "head and shoulders" pattern follows through to break below its "neckline," the projected price target is a drop equal to the distance between the top of the "head" and the "neckline." For the S&P 500, that equates to a drop of approximately 8% below the "neckline," around the 810 level, if the index breaks below its "neckline" in the first place. For the Dow, the projected drop would be 7% below its "neckline," or around the the 7,650 area. With both indexes, their downside price targets would be roughly equal to a 50% retracement of their gains from the March 2009 lows to their June 2009 highs.
The Dow's current formation of its "right shoulder," resistance of its 200-day moving average, and its fifth "distribution day" in recent weeks provided numerous technical reasons to initiate a new, bearish position in the blue-chip index yesterday. Rather than actually selling short the Dow Jones DIAMONDS (DIA), we bought an inversely correlated "short ETF," the UltraShort Dow 30 ProShares (DXD). Since the Dow is forming a bearish "head and shoulders" pattern, DXD is conversely forming a bullish "inverse head and shoulders" pattern.
Although the "head and shoulders" patterns of the S&P and Dow may be ominous indications of their intermediate-term trends if last week's lows are broken, we're certainly not suggesting the March 2009 lows will be broken anytime soon. In fact, we'd be surprised if the indexes give back more than half of their gains from the uptrend off the March lows, before heading back up. There's also the possibility that the relative strength of the Nasdaq will prevent the S&P and Dow from even following through to break below their "necklines" in the coming days. Still, the reality is a 50% retracement would actually be quite beneficial for the longer-term health of the overall market. Markets that go up too far, too fast, without correcting along the way, are less likely to retain those gains when the inevitable pullbacks come.
