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Point & Go Figure: Is the Dow Forming a Head & Shoulders Bottom?


Is beauty truly in the eye of the beholder?


Yesterday I read an interesting piece from a technician whom I greatly respect suggesting the Dow Jones Industrial Average was tracing out a head and shoulders bottoming formation, or an "inverse head and shoulders" pattern. Naturally, because my indicators remain bearish longer-term, I was concerned that, should this be true, it suggests something important is changing in the market that I have yet to pick up on.

The chart in question was a long-term chart of the Dow Jones Industrial Average, which began its trading range in February 2004. This is how the potential inverse head and shoulders pattern appears on a weekly bar chart, courtesy Thomson Financial Charting.

I have drawn in the potential left shoulders, the head, and then the potential right shoulders.

Dow Jones Industrial Average (DJIA) Weekly Bar Chart

If this is, in fact, a head and shoulders bottoming formation, then the length is significant, since according to John Edwards and Robert McGee in "Technical Analysis of Stocks Trends," the length and duration of the formation is significant, since the longer the pattern formation, the more significant it is to the primary trend. Based on the view above, that this is a head and shoulders bottoming formation, the measuring implications suggest potential to around 12,000 in the Dow.

I respectfully disagree with this interpretation.

According to Edwards and McGee, in a head and shoulders bottoming pattern, the specifications include "a decline, climaxing a more or less extensive downtrend," which makes up the left shoulder. Moreover, one of the key, critical tenets of the Edwards and McGee identification criteria for major reversal patterns is that a reversal pattern must have something to reverse.

What is this potential head and shoulders pattern reversing? It is certainly not a major decline as it is taking place after a run-up in the Dow of 3,400 points since the low in March 2003. And, it is taking place within 900 points of the Dow's all time peak.

One of the reasons I rely mostly on point & figure charts and indicators is that I like the fact they only record significant price action, and thus in my opinion eliminate much of the noise a bar chart captures.

The chart below, a 100x3 scale of the Dow Jones Industrial Average shows what I believe may actually be a much more defined head and shoulders topping formation, especially as it is occurring within the context of very high risk in the long-term bullish percent indicators I use to evaluate market conditions and field position.

Dow Jones Industrial Average (100x3 point and figure chart)

On this chart I have added what I believe may be the left and right shoulders and head of a long-term Dow head and shoulders topping pattern.

As well consider the following:

1) The pattern is occurring after a rise from March 2003 to March 2005 of 3,400 points, not after a major decline.

2) In March 2003 the bullish percent for the Dow Jones Industrial Average was at 10% - only 10% of the stocks that comprise the Dow were at that time on Point and Figure buy signals - and rising from very low risk conditions.

3) Presently, the bullish percent for the Dow Jones Industrial Average is at 58% and declining, after having peaked in January 2004 at 92%.

There is one area where I do agree with the interpretation of the pattern, and that is with the significance of a move to 11,000 in the Dow, which would void the potential head and shoulders topping pattern. Even before that, however, a move to 10,800 would break a triple top.

In my analysis, much more important than the absolute price of the Dow are the overall risk conditions and context of such a move. Unless the indicators I follow shift to a positive context, the probabilities favor a topping formation of significant degree, potential new breakout and possible move to 11,000 notwithstanding. I first look at risk before seeking reward as part of my style. That may be far too conservative for some, but I have found that in the long-run it keeps me in the game and away from potholes that can erase hard earned capital very quickly.

If you would like a chart reviewed, let me know here.

I have added text and illustrations to the charts where necessary.

Point and figure chart courtesy Dorsey, Wright & Associates.

No positions in stocks mentioned.

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