Inverted Head-and-Shoulders…Now What?

With all eyes on the Fiscal Cliff, here's what we're watching to help make sense of this market

   

If you are still wondering what is moving the markets right now, wonder no longer. The fact that we are seeing stocks of all stripes moving in lock step with each other tells us that all correlations have gone to 1.0, and there is only one factor that is pushing the markets…the Fiscal Cliff negotiations.

To see just how tightly stocks are moving together, take a look at the inverted head-and-shoulders patterns that have formed across various stock indexes. Let’s start with the S&P 500 because, as you can see in Figure 1, it has perhaps the most “textbook” formation.

IHSP1 Inverted Head and Shoulders...Now What?

Figure 1 – Inverted Head-and-Shoulders Pattern on the S&P 500

The index broke up through the neckline of its formation on Tuesday, Dec. 18 – confirming the veracity of the reversal pattern.

Next, we have the Dow Jones Industrial Average (DJIA). As you can see in Figure 2, the DJIA also broke up through its neckline on Tuesday.

DJIA1 Inverted Head and Shoulders...Now What?

Figure 2 – Inverted Head-and-Shoulders Pattern on the Dow Jones Industrial Average

And lastly, in Figure 3, you can see the inverted head-and-shoulders pattern for small-cap stocks on the Russell 2000 Index, which was also confirmed on Tuesday.

Russell1 Inverted Head and Shoulders...Now What?

Figure 3 – Inverted Head-and-Shoulders Pattern on the Russell 2000

Okay, so the markets are all moving in sync … now what?

We think there are two things to watch for. First, watch for the various indexes to reach the price targets indicated by the inverted head-and-shoulders patterns. Second, watch for a potential “buy the rumor, sell the news” pullback if the White House and Congress announce a finalized deal on the Fiscal Cliff negotiations.

Price Targets

Price patterns are fantastic technical analysis tools because they provide specific price targets you can shoot for. In the case of an inverted head-and-shoulders pattern, the price targets are based on the distance between the neckline and the right shoulder (Target #1) and the distance between the neckline and the head (Target #2). You can see these two price targets illustrated in Figure 4.

SP5001 Inverted Head and Shoulders...Now What?

Figure 4 – Price Targets Based on Inverted Head-and-Shoulders Pattern on the S&P 500

Based on this pattern, Target #1 has the S&P 500 moving up to 1,455 and Target #2 has the index moving up to 1,515.

Naturally, it is much more likely the index will hit Target #1, but if it breaks up through that level, Target #2 becomes a distinct reality.

“Buy the Rumor, Sell the News”

Conversely, we’ve seen a lot of buying on the speculation that President Obama and Speaker Boehner are going to be able to reach a compromise and avoid going over the Fiscal Cliff. If that expectation is already baked into the cake, the chance we could see investors who have been bullishly buying on the rumor start to take profits on the news – sending stock prices back down.

However, if that were to happen, there is a very good chance that the same price level that served as resistance during the formation of the inverted head-and-shoulders pattern could turn around and start serving as support once again (see Figure 5).

Neck1 Inverted Head and Shoulders...Now What?

Figure 5 – Neckline on Inverted Head-and-Shoulders Pattern on the S&P 500

The Bottom Line for Next Week

Keep your ear to the ground as President Obama and Speaker Boehner continue their negotiations. This correlated market is going to react to every snippet of news that comes out and discount virtually everything else until this is resolved.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.


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