Going by historical market data, this bearish reversal might actually be pointing toward bullish market action
The market just completed a bearish trading pattern … so it looks like more gains are coming.
Obviously, that sentence makes no sense. A bearish trading pattern indicates bearish market action, right?
That takeaway would be logical, but if we study what’s actually happened in past markets when this pattern has occurred, the results are surprising.
For more explanation, and what it might mean for market direction over the coming weeks, we’re turning to John Jagerson in today’s Digest.
Regular Digest readers know John as one of the editors of Strategic Trader, a trading service with a staggering track record of 79 for 79 closed, profitable put trades — with an average annualized return of 43.25%. Their strategy provides a consistent, safe way to generate 20%+ returns week in, week out.
Part of the reason for John’s success is that he’s a student of history. As a quantitative investor, John dives into historical market data to analyze what’s happened in the past, in order to give him an idea as to what to expect in the future … and it turns out, this “bearish” pattern in the markets might actually be pointing toward market gains.
***John begins his analysis by explaining what has just taken place in the markets from a technical perspective
One of the most well-known charting patterns is the bearish head and shoulders reversal. It looks a lot like the name implies with a peak in the middle surrounded by two smaller price-tops and it is supposed to signal a bearish shift in momentum.
After another rough open on Thursday, the S&P 500 looks like it may complete one of these reversal patterns, which you can see in the following chart.
John goes on to describe what you’ll see in the chart below. In short, the first peak (or shoulder) of the pattern formed back in late March. It coincided with the Fed taking another potential rate hike off the table for the rest of 2019. John notes that while that sounds like it would be good for the markets, traders frequently “sell the news.”
The head formed on May 1st when the Fed met again and began setting expectations for a potential rate cut in 2019. John explains that, here again, this would sound like good news for the market, but concerns about low inflation triggered another round of “selling the news.”
Finally, the right shoulder formed in mid-May, when U.S. Commerce Secretary, Wilbur Ross, announced restrictions on the Chinese technology company, Huawei. This trade-war escalation has rattled investors.
Let’s now go back to John to make sense of this pattern:
If you connect the lows on both sides of the pattern’s “head” you can create a trendline called the “neckline.” If prices trade below the neckline, the pattern is considered complete, and as the name implies, price targets should shift to the downside.
But is it as reliable as analysts believe?
The head and shoulders pattern is famous because it has preceded many of the biggest declines in the market in the past. For example, the big bear market of 2008 was preceded by a massive head and shoulders pattern.
***But how often does the pattern generate failed signals?
This is the critical information we want. Though popular market belief is that this bearish pattern sets up a decline in market prices, what does history actually tell us?
Back to John:
It turns out that most of these signals are false alarms if you define “failure” as a significant drop in price.
I tested the head and shoulders pattern on a pool of 1,500 mid to large-cap stocks from January 2002 through January 2019. A little more than 75% of those patterns failed to lead to a drop of more than -5% in price.
However, this is not to say that the results were random. What surprised me the most was that the head and shoulders patterns in the test led to above average positive returns rather than random or negative returns.
***To test this “above average positive returns” takeaway, John ran a simple backtest
He wanted to determine what would happen if an investor bought a stock at the open of the day following a head and shoulders breakout with a -5% stop loss and a 15% bullish target.
Here’s what he found:
Over the 2002-2019 testing period there were 1,018 completed patterns and the average annual gain of the strategy was 10.53% while the S&P 500 returned less than 7% per year.
If you were to run this test on other asset classes like commodities and currencies, the data is just the opposite. But for stocks, failures of the head and shoulders pattern are the rule in just about any market condition.
Unlike other markets, stocks are designed to rise in value on purpose. This is not the case with currencies, commodities, or many other asset classes. Therefore, when a head and shoulders pattern appears, it has a tendency to act like a consolidation pattern rather than a reversal signal.
***So, what should traders do with these stats?
John cautions us against translating the results as an explicit recommendation to buy stocks when a head and shoulders pattern completes.
That said, the data clearly indicates that this signal shouldn’t be used as a bearish entry point. Three out of four times this trade (in stocks) would likely lead to failure.
Here’s John for the key takeaway:
Smart investors should watch the pattern emerge. If prices continue to drop beyond -5% then taking further action is probably warranted. However, if the neckline is breached and then prices in the index reverse and start to head higher, the stats suggest that would be the right time to look for buying opportunities in individual stocks.
***Now, if you want even more clues about overall market direction, you can look to the FANG stocks
John and his Strategic Trader partner, Wade Hansen, wrote about this in their Wednesday issue. In short, the performance of the FANG stocks is important for the performance of the overall stock market. For any readers unaware, “FANG” stands for “Facebook, Amazon, Netflix, and Alphabet (formerly Google).”
Here’s John and Wade to explain:
To put into perspective just how important the FANG stocks have been to the U.S. stock market, and the performance of the S&P 500 in particular, take a look at the FANG fundamental performance chart in Fig. 1.
In early 2013, the FANG stocks accounted for a little more than 3% of the S&P 500’s market capitalization (blue line). Since that time, the value of these stocks has grown so much in comparison to the other S&P 500 components that they now account for 10.3% of the index’s market capitalization.
This increase in market capitalization has been driven by an incredible increase in earnings (red line) from these four companies. The FANG stocks went from producing less than 1% of the index’s earnings in early 2013 to producing an amazing 3.4% of the S&P 500’s earnings today.
***Basically, the FANG stocks have dominated for years as the darlings of Wall Street. But caution is warranted …
John and Wade go on to say that whenever the stocks that have been leading the charge higher begin to show weakness, traders get nervous.
So, has that been happening?
The FANG stocks began losing ground in the run up to the bear-market pullback the S&P 500 experienced in late 2018. They’ve each drawn another “line in the sand” with the S&P 500’s pullback from its recent all-time high.
John and Wade tell us these lines in the sand will either confirm the strength of the current uptrend if they hold as support, or will confirm the uptrend is over for now if they fail to hold as support.
The guys point toward the following lines in the sand for the respective FANGs:
Facebook – $178.10
Amazon – $1,815.75
Netflix – $341.39
Alphabet – $1,121.40
Here’s John and Wade for what to look for:
If the FANG stocks can remain above their respective lines in the sand, it’s a sign the S&P 500 is likely to continue fighting its way higher this summer.
However, if they can’t hold onto their gains, it may be a summer of trading that is characterized more by profit taking than continued bullish buying.
So, based on historical backtesting, watch to see if the market falls 5% below its neckline — if so, it’s likely suggesting more selling pressure. If not, we’re likely in for more gains. In addition, watch the key support levels for the FANG stocks to get a sense for what to expect as the summer plays out. At the time of this writing on Friday morning, all the FANGs are trading above their key levels, though not with too much buffer.
We’ll be monitoring, and will continue to keep you up to speed.
Have a good evening,