If head and shoulders fail, just shrug it off
Went to a meeting of the Technical Analysts Society the other day and got lost, as usual, in all the talk of RSIs, Stochastics and Elliot Waves.
But a feature of one of the charts displayed by a speaker immediately stood out. It was a failed head-and-shoulders reversal formation on the Hang Seng Index over the last three months.
Technical analysts, in case you didn't know, are the investment industry's version of astrologers (they won't invite me back after that comment). The future of the stock you hold is not written in the stars, they say, but in the history of its price and volume of trading. Know the past and you may know the future.
I've got time for them because they do indeed often get it right, and one of the things they look for is the head-and-shoulders formation. It has time and again proved a reliable indicator.
The idea is that you look for a price which has gone up and retreated (the left shoulder), then rises higher and falls back again (the head), and finally rises once more but not as high as the head before dropping away (the right shoulder).
You then draw a line, the neckline, that starts at the bottom of the dip from the left shoulder, touches the bottom of the dip from the head and continues straight on from there. If the dip from the right shoulder goes through that line, then theory has it that you sell immediately.
The price is sure to go down.
An ancillary rule is that you must have volume confirmation. The volume of trading should peak with the left shoulder, rise again with the head but not as high as on the left shoulder, and fall away on the right shoulder.
If you used the head-and-shoulders formation to time your exits from the Hang Seng Index over its history, you probably will have outperformed the index. It does not always show up, but there have been some classic instances of it signalling the top of a bull market, most notably in the big boom and bust in 1981.
Another one showed up between February and May last year. If you had let it guide your investment decisions, you would have been out of the market at over 10,000 on an index that then plunged to 6,600.
But it doesn't always work, as the accompanying chart of the index over the last three months shows. The shoulders and the head were classic, with perfect volume confirmation, and the dip from the right shoulder crossed the neckline at just over 9,700 in mid-December. This was the Sell signal.
But then the index went up and down again in a second right shoulder and from the bottom of the dip on that second shoulder it suddenly rocketed up.
If you took the view that the bottom of the dip from the head was actually represented by the bottom of the dip from the first right shoulder, then you have a neckline which the index never crossed and you would still be in the market.
But that's cheating. The rules are the rules in technical analysis and they won't offer you much value if you add too much interpretation to them. Sometimes, it just doesn't work, and you have to live with that.
Nonetheless, it's still worthwhile keeping an eye on those head-and-shoulders formations.
It may be a form of palmistry, but stay acquainted with that woman in the kerchief inside the tent.
