Head and Shoulders

I use technical analysis as one tool among many. For the last week, I’ve heard so much about the developing head and shoulders formation in the S&P 500 that CNBC sounds like a shampoo commercial. For those less technically inclined, here’s what all the babble is about:

What does it mean? Not much yet, but chartists look at this and say that if the market closes below the neckline (the horozontal line I’ve drawn at about 880) then the market will continue to fall. If it doesn’t, well then, this means absolutely nothing. As with most technical indicators, there are also lots of caveats. Where do you draw the neckline? I’ve heard several people over the last few days say the neckline is anywhere from 878 to 888, so obviously this isn’t an exact science. How far will it drop if it breaks the neckline? Supposedly, the drop will equal the distance from the head to the neckline, but obviously it matters where you draw the neckline so good luck figuring that out. Does the neckline violation have to be on the close or does intraday count? Most chartists work off the close, but not all of them so that’s a tossup. How much below the neckline does it have to fall to count as a violation? Today the S&P closed almost exactly on the neckline I’ve drawn above and I have no idea whether that counts or not. The bottom line is that a head shoulders pattern doesn’t mean a damn thing. People see what they want to see.

Here’s something I have learned over many years in the market. The market will usually act in a way that frustrates the maximum number of traders. If everyone is expecting something, it probably won’t happen and for that reason, I’m a bit skeptical about this particular chart pattern. Will the market fall from here? It may and it may not, but if it does it has nothing to do with the pretty picture I’ve drawn above.

Technical analysis is a useful tool, but you can’t use it with the exactness that most try to apply. I mostly look at support and resistance points. In the chart above, I take 880 as support and 940 as resistance. What those levels represent to me are groups of buyers and groups of sellers. Since the market has hit on 880 a number of times and moved higher afterward, it appears that there are people willing and able to buy at that level. And since the market can’t get above 940, that means there are enough willing sellers at that level to overcome buyers. Don’t take the numbers for gospel; support could be 875 and resistance could be 945. The levels are just guidelines.

The current market is interesting because I think the fundamentals are actually pretty bullish and the technicals seem to be on the bearish side. We are entering earnings season and if things turn out like last quarter, earnings will come out generally better than expected. I think most investors are just too pessimistic. While layoffs are disconcerting, they can be good for the corporate bottom line if productivity is rising as it has through this entire recession. Even if you produce and sell less, if costs fall faster than sales, you can still produce good profits. That’s what happened coming out of the last recession and I suspect it will again.

On the technical side, if 880 support doesn’t hold, the market will probably pull back more as those 880 buyers reassess or turn into sellers as their positions start losing money. If 880 doesn’t hold, next support looks to be around 820 but it could be as low as 780. Again, upside resistance is around 940.

So what should we do with our investments? Well, today, I did some selling of the S&P 500 but it wasn’t based on the head and shoulders formation. First, it was precuationary in case 880 support gives way. Second, I want to reduce my US exposure and increase my international exposure. This correction gives me an opportunity to do that while also acting conservatively and locking in some of the gains from the March lows.

Foreign markets look better technically and more importantly, I think the economic situation in a lot of foreign markets is better than the US. Emerging markets such as Brazil and China (and most of the other Asian markets such as Taiwan, Korea, Malaysia, etc.) seem better positioned for recovery than the US. Their fiscal house is in better order; they have the cash to invest right now. Their economies are more cyclical which hurt them in the downturn but should give them more upside in the recovery. Other markets a little off the beaten path also look attractive with Chile in a particularly enviable position. More developed markets also look attractive with natural resource rich Australia and Canada leading the pack. Even Germany appears to be turning around with business confidence rising. Lastly, Japan, which no one seems to like, has performed admirably considering the depth of their recession. Japan is cutting corporate taxes by shifting to a territorial tax system which will leave the US with highest corporate tax rate in the world. That is a positive for Japanese after tax corporate profits.

Meanwhile in the US, as I pointed out in last week’s update, all we have is uncertainty. What will the Fed do? Will they monetize the massive deficits? What will happen with healthcare reform? Cap and trade? Will healthcare reform involve higher taxes (on health benefits)? Will cap and trade raise energy prices? How much? Are anymore big banks in trouble? Will PPIP relieve the banks of their bad assets? At what price? I don’t know the answers to any of these questions and I don’t expect to any time soon.

Here are charts for some of the markets mentioned above:

Chile