Reverse Head and Shoulders?

Click on Chart to Enlarge

I wanted to have a short discussion about the reverse head and shoulders bottoming pattern today because I have started to see various blogs, etc., suggesting that this pattern may be occurring in the stock indexes.

You can refer back to the post from a couple days ago about SNDK to get an example of a pretty healthy volume pattern for a reverse head and shoulders. The chart above today is $INDU which is the Dow 30 index. When analyzing a reverse head and shoulders the volume of the pattern is of paramount importance. First, the heaviest volume should be in the left shoulder, which is the case here, so that is OK. Next, a real good pattern should show substantially lighter volume at the head or lowest point. The volume is slightly lower at the head in the Dow, but not enough that you could be really confident in the pattern even at that point.

Probably the most important part of the pattern are the upward moves off the bottom and especially the breakout move. In this chart the volume is low coming off the bottom relative to the left shoulder and head, and that is not a good sign. Next, if you could construe this week as a breakout, then it is a pathetic breakout, because volume should be very heavy here, but in the case of the Dow shown above, the volume is very light.

Another thing bad about this pattern is that (assuming the formation is already complete) the neck line is rather steep for a good head and shoulders pattern. A steep downward neckline indicates weakness coming off the bottom/head.

Another more subtle point about the pattern that I have never heard mentioned before, but stands to reason, is that the move up off the head to the neckline should not take substantially more time than the move down from the neckline to the head/bottom. If it does, then that indicates that the rate at which the market is advancing now is weak relative to the rate at which it was falling. If the time of the moves was closer to equal, then that would be better.

Now I know that the holidays will decrease volume across the board, but it is not a good idea to make excuses for a pattern like this, and the holidays shouldn't really have hampered the volume of the first move off the bottom much anyway.

So my advice is to be very suspect of this "breakout" and the potential reverse head and shoulders pattern.

With that said, I have seen some individual stocks with decent looking patterns (take SNDK for example, which happened to break out strong the last 2 sessions), but most of them have not broken out yet. I personally would wait to see if the stock breaks out, then plan to buy on a pullback to the neckline in the days/first few weeks after the breakout if things look OK at that point. I don't think the market is strong enough right now to worry about missing a breakout and never getting a chance to get in on a pullback/retest of the neckline.

Pete