HEAD AND SHOULDERS TOP?
John J. Murphy
WHAT IS IT?... Quoting from the Glossary in my book Technical
Analysis of the Financial Markets: "A head and shoulders top is the best
known of the reversal patterns. At a market top, three prominent peaks are
formed with the middle peak (or head) slightly higher than the other two
peaks (shoulders). When the trendline (neckline) connecting the two
intervening troughs is broken, the pattern is complete." While most major
averages show a similar pattern, we're using the NYSE Composite Index for
illustration purposes because we believe it probably gives the best
overall measure of the state of the "market". There's no question that the
chart has the look of a "head and shoulders" top. The two "shoulders" were
formed during 1998 and 2002. The "head" formed during 2000. The "neckline"
is drawn under the 1998-2001 reaction lows. As of Friday's close, the
neckline is already been pierced on the downside, but not by much. There
are two other support levels that bear watching. The first is the
intra-day low hit last fall (which is at 494). The second (and more
important) is the late 1998 low at 463. Friday's close was only a shade
below last September's low, but not by enough to call this a clear
breakdown -- at least not yet. Regarding the breaking of the "neckline",
there's also a 3% rule which comes into play at major chart points. That
means that the neckline needs to be broken by at least 3% before we can
call it a "major" breakdown. We may get there (about 485), but we're not
there yet. Unless the market attempts a rally soon, however, a breakdown
could be imminent, which could carry the market lower into the
September/October period.
Chart 1
MEASURING IMPLICATIONS... The head and shoulders top has
measuring implications. In general, this pattern suggests that, after the
neckline break, prices will drop by an amount approximately equal to the
distance from the top of the head to the neckline. On the NYSE chart, the
distance is about 200 points. That would call for a potential drop of
another 200 points -- or to the 300 level. That's a pretty bearish
forecast. Is a drop that far really possible. To answer that question,
take a look at the next two monthly charts of the NYSE -- for some
historical perspective. The first shows the entire bull market from 1982
using a log scale, which is preferred for longer-term work. I've drawn two
trendlines on the chart. The green line from the 1982 bottom has already
been pierced. The purple line drawn under the 1987, 1990, and 1994 lows
(which may be the more valid line) is being threatened, but hasn't been
broken. In my opinion, a decisive break of both trendlines could easily
lead to much lower prices. How far down? The second chart uses the more
traditional arithmetic scale. On that chart, the major trendline sits near
300 -- which would be the downside target from the "head and shoulders"
top. Yes, it is possible.
Chart 2
Chart 3
OTHER INDEXES SHOW SIMILAR PATTERNS... The next three charts
show that several other major stock averages are perched at critical chart
points. The Nasdaq and the S&P 500 have flat "necklines" drawn along
their 1998 low, which is being threatened. The Dow has held up better than
the rest, but is nearing a test of its "neckline" (and last September's
low) near 8000. That will be a very important test.
Chart 4
Chart 5
Chart 6
LONG-TERM DOW VIEW... The next two charts show the entire
20-year bull market in the Dow. The first (log) chart shows the Dow
testing its 20-year up trendline. A decisive break of that would indeed be
very bearish -- and could signal a more subtantial retracement of the
entire uptrend. The final chart shows some standard percentage
retracements that could serve as downside targets if the Dow takes out the
lows of last September near 8000. The first downside target would a 38%
retracement to the 1998 low near 7500. A second potential target would a
50% retracement in the vicinity of 6000. A third possibility would be a
62% retracement to 5000.
Chart 7
Chart 8
THE MARKET ISN'T CHEAP... The purpose of looking at the
long-term charts isn't to scare anyone. Our main goal is to show that this
market isn't cheap. In fact, it's still historically very high. We've
expressed the view several times before that we believe the twenty-year
bull cycle has ended. That means the current bear market could last longer
-- and fall much further -- than most people realize. We don't know how
low it can go. It's the direction that matters most -- not the actual
numbers. The "head and shoulders" tops shown in the preceding charts is
another warning that things could still get a lot worse. As the message is
finally getting across to the public that this bear market is indeed
different from those in the recent past, mutual fund redemptions are
starting. Imagine what could happen when the public finally decides to
start selling.
July 16, 2002
John J. Murphy, CNBC-TV's technical analyst for many years, and Greg Morris offer money managment and market services at MURPHYMORRIS.COM , email address orders@murphymorris.com .
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