Monday, December 8, 2008

Today's market surge: A head-fake or the beginning of a real turnaround?

Whether Congress's proposed temporary bailout of Detroit combined with Obama's stimulus plans to create jobs by repairing our aging infrastructure was the engine that fueled today's broad-based rally is immaterial to market technicians who, like me, are getting excited over the forming chart patterns. Not only are today's break-outs and bullish gaps displayed by many individual stocks (most notably the best-of-breed companies in the infrastructure and basic material sectors such as water transport, coal, construction, and steel as well as some tech stocks and electronic stock exchanges) but for me, the most exciting and possibly telling pattern could be forming in the the S&P 500 index itself.

Below is a daily chart of the SPX. To me, it sure looks like it is in the process of forming an inverse head and shoulders pattern. For the chartologically challenged, a head and shoulders formation is a very powerful chart pattern that is coveted by many traders because it is so successful. (For a closer look at these patterns and some examples, see my March 5th and 6th blogs.) Let's look at this chart more closely.

You can see that the left shoulder was formed from the beginning of October to the beginning of November. The neckline, or the new level of overhead resistance, is at 1000. The top of the shoulder is at 850. The head was put in two weeks later and occurred at the 750 level, one hundred points below the shoulder. The last several trading sessions have touched the 850 level again and today's gap up is a strong indication that a right shoulder is beginning to form.

If this pattern is indeed in the formation process, what can we expect from here? As my arrows on the chart indicate, we should expect to see the SPX retest the neckline level at 1000 in the next week or so. The index will then reverse, and head back down to the 850 shoulder level probably some time in the beginning of January. If this level is successfully retested, then the only thing left to complete the pattern is for the S&P to rise back up again to the neckline. If it manages to break through that on heavy volume, we can easily expect it to rise at least another 250 points which is the magnitude of the distance between the neckline and the top of the head.

Of course, these are a lot of ifs. Trading mavericks can play each leg of this formation as it develops; for the gun-shy, I'd recommend waiting until the entire pattern is formed and then taking a bullish position if and only if the index decisively breaks through its neckline level which will most likely happen in the middle to the end of January.

If this pattern does play out as I've indicated, it would do a lot to boost the confidence and morale of the retail investor which, I believe, have been more badly beaten up than the market itself.

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