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Stock Indexes Ignore Technicians’ Head and Shoulders Calls

Since May 2010, many technical analysts identified a head-and-shoulders pattern in US equities, which is typically interpreted as a predictor of further bearish conditions. Daryl Montgomery called it as early as May 28. On June 22 Erik McCurdy wrote about the pattern, predicting “stocks will struggle to advance.” On June 29 Barry Ritholtz told us that the confirmed head-and-shoulders had been followed by a dreaded “dark cross” (or death cross), where the 50-day moving average breaks below the 200-day moving average. The dark cross signal predicted continued downward momentum for stocks. The next day Philip Davies analyzed the market’s technicals and fundamentals and called a “firm bottom,” which, at least in the short term, is looking like a solid prediction. On July 4, Richard Shaw provided his own analysis, concluding that the best course of action was to “wait and see.”

The head and shoulders and ensuing death cross is depicted in the graph below (graph courtesy of StockCharts.com).

Now, it’s fair to point out that technicians also consider a failed head-and-shoulders — one that does not fully “pierce the neckline” — a strong bullish signal. But, as the chart shows, the neckline was clearly pierced, and closely followed by the death cross.

This instance points out what’s missing from the technical side, and prevents me (and many others) from taking the “discipline” of technical analysis too seriously. The best fundamental analysts and portfolio managers conduct extensive performance attribution post-mortems in an attempt to understand why their strategies worked or didn’t work, and proactively communicate this analysis to clients. But, in my experience, when classic technical signals fail, technicians are not nearly as eager to analyze “why it’s different this time.” They just stop talking about their unsuccessful prediction, lay low for awhile, and re-emerge a bit later with their next “chart du jour.”

Most investors have longer memories than that. I know I would enjoy reading a thorough analysis of the market factors that contributed to this widely-publicized head-and-shoulders/dark cross pattern leading to a 5% market rebound. I hope someone among the more technically-minded among us will write about this in the next few days and forward the link to me.

Categories: Market Commentary