Another Head and Shoulders Pattern?

Regardless of Washington misleading the public (see: Too High to Buy, Too Strong to Sell) we need to trade the markets we are dealt and it has been a tricky tape to trade. Nonetheless my message to readers and clients for has been that we need to remain nimble as the antics in Washington get resolved. There have been several notable opening gaps in the markets so deciding not to hold positions overnight has been the right call, especially short equities, interest rates, and long gold.

As a short term debt ceiling deal including a resolution to open the government surfaced during the overnight futures trading session on Thursday (10/10) the S&P ripped higher. Here we are one short day later and the S&P 500 has rallied +56 handles. It begs the question… is all the good news already priced in? Only time will give us the answer but the charts can provide us with clues.

One technical pattern that could be developing is another bearish head and shoulders pattern. This would mark the third such pattern to develop since July/August. I highlighted the other two patterns in the following posts: September 24 and August 15. Both of these bearish head and shoulders patterns worked as prices met their bearish objectives.

If this current pattern plays out and the neckline is broken (estimated to be in the 1653 area) the price objective for the S&P 500 would be a move down to the 1480 level. In my opinion that would create a great buying opportunity for one more attempt at new highs in the market during sometime during Q1 next year (2014). It is important to remember that this pattern could take several weeks to develop (in the neighborhood of 4 to 8 weeks) before the neckline is breached. On the contrary, if the S&P December contract (ESZ3) closes above 1707 this pattern would fail and I would expect new highs in the market, perhaps before year-end.

The bottom line is the most important trend line on the board is connecting the lows from 8/28 to 10/9. This represents the neckline of another possible bearish head and shoulders pattern and if broken would signal much lower prices. Shorting the S&P December contract in the 1700 to 1707 level is a good set-up against a severely overbought market on a short-term basis. If prices close over 1707 the pattern fails so using stop losses is highly advised.

Hourly and daily ESZ3 charts illustrating opening gaps (grey boxes) and the developing head and shoulders pattern (right hand side):