More Signs of the Bear

How a chart pattern called head and shoulders may signal more trouble ahead for stocks

By Mark Arbeter

The stock market tried very hard to hammer out a short-term bottom last week but the attempted rally ran into a brick wall of resistance. In our view, when the market can't generate a decent rally after getting to an extreme oversold condition, it looks like bear market action to us. We continue to recommend a very cautious approach to equities.

The proliferation of intermediate- to long-term topping formations among major indexes and individual stocks is significant, in our view, and does not bode well for stocks in general for the fourth quarter and as we move into next year.

The most widespread chart pattern that we are observing is the bearish, head-and-shoulders (H&S) top. The H&S configuration consists of a left shoulder, a head, and a right shoulder. Sometimes, there is a symmetrical aspect of the H&S formation when the shoulders are equal distance from the peak or head.

The key to analyzing any chart pattern, in our view, is to wait until the formation gives confirmation that it is complete. Once this is done, then we can say that a reversal has occurred and a new downtrend or uptrend has begun. Confirmation from a head-and-shoulders top is given when the neckline, the trendline drawn off the lower parts of the shoulders, breaks. Only when the neckline breaks can we have confirmation that a reversal has been put in.

One of the tenets of technical analysis is that the bigger the price pattern (the length of the pattern as well as the height of the pattern), the greater the expected move is once the formation is complete. Unfortunately, we are seeing many H&S patterns on the weekly charts that have been forming for almost the last two years. Some, but not all of the indexes that have completed head-and-shoulder tops include the Dow Jones Industrials, Morgan Stanley Cyclical, Philadelphia Bank, Philadelphia Housing, Goldman Sachs Software, S&P Consumer Discretionary, S&P Materials, and S&P Telecom Services.

The other common topping pattern that is evident is the rising bearish wedge formation. This formation occurs after a strong advance and consists of two trendlines. The lower trendline or support is steeper than the upper trendline (resistance). To complete this formation, the lower trendline has to be taken out. Indexes that have completed bearish wedge formations include the S&P 500, the Nasdaq, NYSE, the Russell 1000, 2000 and 3000, the Value Line (Geometric) and the Wilshire 5000. The nice thing about reversal formations is that they give the technician specific upside and downside targets once the patterns are completed. For the head-and-shoulders top, the distance between the neckline and the head is subtracted from the point of the neckline breakdown to give us a potential price target. For instance, the distance between the neckline and the head on the Dow Jones Industrials is about 960 points. Subtracting this from the breakdown point of 10,300 gives us a measured move or target of 9340. For the rising bearish wedge pattern, the completion of the formation implies a complete retracement back down to the bottom of the pattern. For the S&P 500, this would give us an eventual target of 1063 or the low from back in August, 2004. Of course, nothing is set in stone in the investment world but these large reversal formations bear watching, in our view.

Getting back to the near-term picture for the stock market, we still believe there is a chance for a rally over the short term, but would be reluctant to participate because of the overriding bearish intermediate- to long-term picture. The S&P 500 has found good support recently in the 1170 to 1175 range. This is right on top end of the layer of support from the April lows between 1137 and 1178. On the upside, the index faces many hurdles, in our opinion. Trendline resistance, drawn off the lows in August, 2004, and April, 2005, and that was formerly support, comes in at 1194. Chart resistance lies between 1190 and 1210. The 200-day exponential moving average lies at 1196 and this is where the S&P 500 peaked out after Wednesday's big advance. The 150-day exponential moving average is at 1203 and the 50-day exponential moving average is up at 1208. Trendline resistance, drawn off the peaks in September and October, is at 1220.

Market sentiment is a tough read presently, in our view, with many contradictions being seen. For instance, the CBOE put/call ratio has soared while the equity-only ratio remains fairly low. The 30-day CBOE put/call ratio hit 1.015 on Oct. 14, the second highest reading we have ever seen. Our chart of this data goes back to 1989. The highest reading for the 30-day was 1.017 on December 12, 1994, right at the major low in that year.

Meanwhile, the 30-day equity-only put/call ratio was at 0.64 on October 20, closer to the bottom of its range than to the top of its range. Investor's Intelligence poll of newsletter writers has seen some shift from the bullish camp to the bearish camp but is still generally positive about the market. The latest readings show 45.3% bulls and 29.5% bears. The Consensus and MarketVane polls are still showing about 60% bulls, not near the typical bearish extremes of 30% to 40% bulls usually seen at market bottoms.

The Treasury bond market may have put in a short-term reversal last week, as the yield on the 10-year note found strong support at the 4.5% area. Bonds retraced back to chart resistance and trendline resistance in the 4.39% zone. Additional resistance can be found in the 4.2% to 4.3% range. What we find interesting about bonds is that the last two moves higher in yields lasted about 30 trading days with each move encompassing about 50 basis points. The first rise in yields, from late June to early August, was followed by an 18-day period of falling yields. If this pattern were to occur again, we believe there could be a bottom in yields around Nov. 9 before the next move higher in yields occurs.

Arbeter, a chartered market technician, is chief technical strategist for Standard & Poor's

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