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.