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Why the Chart Isn't Always Right


Technical analysis has its limits.

Now that it appears that the textbook head-and-shoulders formation in the S&P 500 chart isn't playing out with a breakdown, it's safe for to come clean: For the life of me, I just couldn't see that pattern that was so apparent to everyone else. No matter how long I looked at the chart, that formation wouldn't rear its head to my aging eyes.

I even used some of the tricks from my childhood -- or at least, my younger days. As budding market mavens, one of my high-school friends and I would pore over charts together, teaming up to cover more ground and using the second pair of eyes to confirm our finds. Of course, if the other guy didn't see what you saw, you'd want to make a case.

One of the first -- and often, only -- tactics was the "squint-and-wiggle." That is, you tell the other guy to squint and then wiggle the chart in front of his face. The hope was that in the ensuing blur, the pattern would appear. Remember, this was when everything was on paper and charts were often updated each night by hand.

But even as I shook my laptop last week, I saw nothing. So I asked people to show me. Still couldn't see it. To me, head was too small and flat, and right shoulder was a mess. What I saw was a market that had been in a range between 875 and 950 sine the beginning of May. In fact, on a longer-term chart, I was seeing a large inverted head-and-shoulders, albeit the fact that the March low makes kind of a pointy head. Trust me -- if you squint and wiggle enough, you'll see it too.

Now, in no way am I disparaging technical analysis (TA). Just about all my trades start with chart-gazing. And then I use them for defining stop and exit points. That's part of the reason TA works to some extent: It shows the price levels of accumulation and distribution. But it's good to understand the limits of TA and acknowledge some of the inherent biases. The chart is always right, but often that's after the fact. What seems so obvious after the fact --like a double top or filling the gap -- might not have been so clear at the moment.

Part of the problem with this recent head-and-shoulders formation might have been that it was too obvious to too many people. Almost no trade set-up works when everyone sees the same thing.

We're visual creatures, and we like to find order in chaos. This makes pattern-recognition a very attractive method for navigating not only the markets but our daily lives. Often there's enough stability to the data or reference points to produce somewhat reliable and repeating patterns. Let's face it: Navigating by the stars worked pretty well, but that doesn't mean Orion is really wearing a belt.

Of course the market might just turn back lower and the head-and-shoulders pattern will be borne out. But I just don't see it. Maybe if I just squint and wiggle some more...
No positions in stocks mentioned.

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