20 June 2010

Knees and Toes

The U.S. Stock Market is currently tracing out the final part of a head and shoulders pattern. While I've stated before that most technical analysis is bunk, the H&S is a common "topping" pattern that can occur at major tops and bottoms of long market trends. It begins when an asset is bid up to unsustainable levels. A correction follows, encouraging the types of people who "buy on dips" to enter the market. The asset then rises to slightly above the previous peak, but runs out of steam as no further buyers enter the market. It then falls again to around its previous lows. I suppose the same buy on dips argument could be made for what drives the asset to rally a second time. I also feel however that the movement of stock prices often tends to take the path that would most frustrate the largest number of people. So perhaps the second rally simply exists to frustrate the less sophisticated short sellers. Perhaps the professional short sellers close their bets in anticipation of this pattern forming. This is the great thing about the markets, there is never one explanation.

I can tell you that three weeks ago I felt there was a large chance of this pattern forming. (A fact which I conveniently failed to mention on this blog.) Here's why. The stock market tends to never behave the same way twice. People's observations of the market's past behavior cause them to change the way they react when they encounter a similar situation. The last time the Dow Jones Industrial Average broke through 10,000 in 2008 it smashed through it. Its that simple. It was unlikely to do so again. The stupidest money would bet on the same thing re-occurring facsimile.

If this sounds like bullshit, I assure you, it is. You cannot approach something that acts so irrationally, rationally. But I can also assure you, if I've learned one thing in the past four years, the market and its participants are seldom rational. And the more obviously an effect should follow a cause, it almost never does. This, mind you, is not the same as being contrarian. It is more subtle than that. But now there I go... more bullshit.

There were two other reasons it was unlikely to smash through 10,000 three weeks ago. There was very strong resistance around 10,000 due to the fact it marked the previous low from February 2010, and the fact that big round numbers tend to act as psychological landmarks and consequently many people make decisions around them. (Furthermore, many world indexes were battling up against large psychological resistance numbers, the FTSE 100 @ 5000, the Shanghai Composite @ 2500, Gold @ $1250, Euro/USD @ 1.20, Copper @ $3.00) Secondly, large lasting trends do not simply reverse course on a dime. A trend reversal is a large scale battle between two groups with opposing opinion. It takes time for them to fight it out and a victor to emerge.

The Dow will most likely stall before 10,800 (just north of the first peak in the pattern from January) There will be a lot of congestion, as people start to recognize this pattern and the market moves to frustrate the greatest number of people possible. But then it will fall and not stop until at least slightly south of 8000.

Here are a few head and shoulders examples... (Click to view larger.)

The Large Cap (Dow) 2007 Peak:

The Small Cap 2007 Stock Top and 2008 Gold Bottom:

A possible long term H&S?!? (I saw this theory advanced by some quack but who knows...):

Of course, this is the true underlying picture. (Inflation adjusted, Log Scale, 1950-2010):

No comments: