A head and shoulders top may be forming

Commentary: Prominent technical analyst alarmed by what he sees

CHAPEL HILL, N.C. (MarketWatch) — As if we didn’t already have enough to worry about, with a completely dysfunctional political system possibly leading the government into a default, a prominent technical analyst just issued a bombshell:

According to an email he sent out on Tuesday, the stock market is very possibly forming a massive head and shoulders top — with quite bearish implications.

The analyst is W. H. C. Bassetti, who is an adjunct professor of finance and economics at Golden Gate University in San Francisco. He is better known in investment circles as the editor of the latest edition of the classic textbook on technical analysis, originally written many decades ago by Robert Edwards and John Magee: Technical Analysis of Stock Trends.

A head and shoulders formation, for those of you not familiar with the strange language of technical analysis, exists when the market rallies on three successive occasions and when the second of those three rallies rises to a higher level than the other two. The “shoulders” in this pattern are formed by the first and third rallies, while the second one forms the “head.”

The “neckline” is defined by the lows set between each of the two shoulders and the head. The formation is complete when that neckline is broken following the third rally.

SPX 1,304.89, -27.05, -2.03%

Consider the S&P 500 index (SNC:SPX) . The head came in the rally into the late April high, while shoulders were formed by the rallies in February and early July. The neckline is in the 1250-1270 area and, if that neckline is broken, Bassetti says the downside target is S&P 1127.52.

It’s tempting for those who aren’t technical analysts to dismiss this talk as little more than crazy mumbo jumbo. And, indeed, in the 1970s and 1980s, finance professors had great fun dismissing technical analysis as a huge joke — a complete waste of time.

But in more recent decades there have been a number of academic studies of technical analysis, including of the head and shoulders formation in particular, that found that chart formations have some predictive abilities after all.

One of the more prominent defections from that erstwhile academic orthodoxy is Andrew Lo, a finance professor at MIT and director of that institution’s Laboratory for Financial Engineering. Lo also is chief investment strategist at AlphaSimplex Group, a hedge fund firm.

To be sure, neither technical analysis in general, nor head and shoulders formations in particular, are foolproof, so the market is not automatically doomed just because of what Bassetti sees in the chart.

In any case, note carefully that the formation to which he draws our attention is not yet complete; the market would need to drop another 5% to 6% for that to happen.

Still, Bassetti points out, the chart formation is “not encouraging,” especially given what’s going on in Washington. “Playing with matches is never something irresponsible children should do, and especially not around head and shoulders formations.”

The MasterMetals Blog

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