Revisiting the "S&P 500's 60-minute Complex Head and Shoulders Top"

01/23/03 10:23:10 AM

by David Penn

How a bearish complex top got even more complex--and more bearish.

Security: $SPX
Position: N/A

Back in mid-November 2002, I suggested that the S&P 500 was becoming dangerously overextended to the top side (see my "The S&P 500's 60-minute Complex Head and Shoulders Top," Traders.com Advantage, November 12, 2002). Up some 20% by November 6th, the S&P 500 appeared to have established a left shoulder from October 18th to the 29th, and a head from the 29th of October to about the 12th of November, when the Traders.com Advantage piece was posted. At the time, I concluded that the S&P 500 might make another rally, but that this rally would not exceed the highest point of the "head" at about 925. This rally, I believed, would complete the right shoulder and, thus, finish the head and shoulders formation. Given the size of the formation (925 to support/neckline at 872), I anticipated a decline to around 820.

As the second half of November began, the S&P 500 did rally as expected. However, far from stopping short of the 925 level, the S&P 500 soared higher, eventually reaching a peak of 954 on December 2nd. The enthusiasm with which this rally was met in the marketplace was palpable, and I was forced not only to reconsider my projection of the head and shoulders top, but also of an Elliott wave-based wave count upon which my intermediate-term bearishness had been based (a review of that wave count will be the topic of a forthcoming Traders.com Advantage piece, stay tuned).

The price action in the S&P 500 over the next month and a half, however, was quite instructive. The S&P 500 declined over the balance of December, retreating from its 954 high market in early December to a low of 871 at the end of the month. So far, the support/neckline level around 871-2 was holding and, in fact, provided the platform for another rally in the S&P 500. As 2003 began, the S&P 500 rallied from support up to a high of 935 by the middle of January when it began to slip, falling to as low as 887 by January 21st.

This intermediate-term head and shoulders top threatens to take the S&P 500 down to a test of the July and October 2002 lows.

Graphic provided by: TradeStation.

As such, I believe that a complex head and shoulders top--most clearly visible on the 60-minute price chart--is in fact building in the S&P 500. My error was, in part, seeing the left shoulder of what I now believe is a head and shoulders top as the left shoulder and head of a smaller formation. It is difficult to shrink down the 60-minute chart for display here, so I will use a daily chart that still provides a fairly good idea of the formation and the relevant levels. If you find the intermediate term head and shoulders pattern worth further investigation, I encourage you to bring up a 120-day 60-minute chart on the charting software of your choice.

The volume cues for head and shoulders tops is not especially apparent here--though volume appears to be slightly higher on the left side of the formation as opposed to the right side. To that end, I have included the on-balance volume indicator. On-balance volume, as explained by Steven Achelis in his must-own text Technical Analysis from A to Z, is an indicator developed by legendary technical analyst Joe Granville that measures the flow of money in or out of a security. Essentially a "running total of volume," a rising OBV suggests buying and a falling OBV suggests selling. Applied here to the S&P 500, it appears that the requisite "higher volume" for the left side of the head and shoulders formation is indeed present.

What does a successful intermediate head and shoulders top here suggest for the S&P 500? Given a formation size of approximately 85 full points, and a support/neckline at about 870, a minimum decline to 785 is the most sound bearish estimate. Such a decline would then represent a test of both the July and October 2002 lows. And should this decline in fact turn out to be a "minimum" of 85 points, then that test of the lows will be a serious exam indeed for the S&P.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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HEAD & SHOULDERS

Revisiting the "S&P 500's 60-minute Complex Head and Shoulders Top"

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