Technical versus Fundamental Analysis

There are two basic ways to look at the stock market.  In evaluating a stock most people look at the attributes of the company, the industry or the county’s economy to determine whether the stock represents good value.  They might ask, “is demand for the company’s products accelerating and will that acceleration lead to growth in earnings and dividends?”.  This type of analysis is called “fundamental” analysis.  Often you hear analysts on CNBC or Bloomberg speak of a company’s ”fundamentals”.  The theory is that higher earnings and dividends will lead to higher stock prices over time.

The other type of analysis looks not at the supply and demand for the company’s products but at the supply and demand for the company’s stock.  These analysts look at the historical price and trading volume to discern patterns of accumulation and distribution by the so called “smart” money (also known as “the herd”).  This type of analysis is called “technical” analysis, a misnomer, but one that has been around for 75 or 100 years.  There are traders who make money with a myriad of “indicators”, but sadly, most do not.

However, there is formation of stock/market index prices that has stood the test of time.  It is called a “head and shoulders” formation for a reason that will become obvious.  It comes about in the following manner.

1. The stock/index is in an uptrend.  The price cycles up and down, but each high point in the cycle is higher than the previous high point.  Each low point in the cycle is higher than the previous low point. 
2. However, there comes a time when the pullback from the last high matches the previous low.  What has formed at this point is a potential left shoulder and head in the head and shoulders formation. 
3. If the subsequent rally fails to make a new high and pulls back to the previous two low points then we must respect the potential for a trend reversal.
4. If the price goes below the previous two low points (known as the neckline) then we have to assume that the price trend is down and the lows in the cycle will be lower and the highs in the cycle will be lower.
5. Ideally, volume will be highest under the left shoulder, a lower level under the head and even lower under the right shoulder.
6. The larger the distance between the “neckline” and the peak in the “head” the bigger the subsequent decline.  As a rule of thumb, many say that the predicted decline from the neckline would be the same number of points as the distance between the peak and the neckline.  Translation:  a break below the neckline would indicate that we are only half way through the pain.

Currently, the major indices in the U.S. have traced out potential head and shoulders formations.  See the chart of the S&P 500 shown below.  A close below 1050 would put in play completion of a head and shoulders with a working target of 884.

The comparable numbers on the Dow Jones Industrial Average are 9,816 for the neckline and 8,428 as a working target.

One caveat:  there are times when the market will make a slight break below the neckline and then rally to new highs.  There are no sure things in this business.  Someone has said that the market will do whatever it takes to make the maximum number of investors look foolish.

Prices below are daily through the close price on June 28, 2010.

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