90 day anticlimax

THE ARGENTINE APEC meeting gave markets a Christmas present - a 90 day reprieve from the imposition of additional US tariffs on Chinese goods. Investors need to breathe deeply and quickly because like so many of US President Donald Trump's tweets, these promises are not worth the paper that they are written on. Infamous for his capriciousness, he can reverse the verbal agreement at the twitch of a twitter button - and this has significant implications for investors.

One of the most powerful and reliable chart patterns is the head and shoulder pattern. This signals a trend reversal. The pattern usually takes several weeks or, with an index market, several months to develop - and is best seen on a weekly chart. Once confirmed, the pattern is used to set downside targets which have a high level of reliability. These targets are reached in around 80 per cent of occurrences and are often exceeded - and that is bad news for investors in US markets and ultimately in our home markets.

Let us start with the classic and perfect head-and-shoulder pattern. It starts with a long-term uptrend that peaks and develops a retracement. The retracement is significant enough to be traded as a new downtrend. The retreat often breaks below an existing long-term trend line.

New rally

This is at the end of a strong long-term uptrend, so buyers come back into the market, buying on temporary trend weakness. Their buying creates a new rally, and also confirms the development of the left shoulder of the pattern.

This was the activity in January 2018, shown as point 1 on the Dow chart.

The rally rebound is often quite strong, and moves higher than the peak of the previous uptrend. Things look like they are back to normal. The long-term uptrend appears to have resumed, and everybody is a happy bull again.

The key difference in this uptrend continuation is when the second rally hits a new peak high and then collapses. This index retreat is significant enough to call an end to the recent rally. The index moves below the recent rally trend line and continues falling.

Investors who missed out on buying the first dip come back into the market expecting a new rebound rally. Their expectations are self-fulfilling, and their buying arrests the fall and sets the conditions for a second rally rebound. This activity establishes the head in the head-and-shoulder pattern shown as point 3 on the chart.

The two low points form the base of the neckline of the pattern. This is an important calculation point. However the pattern is missing the right shoulder. This is created with the new rally rebound. The problem is that buyers are leaving the market. Investors are worried about other factors which they see as contributing to weakness in the market. The result is that the second rally peters out and collapses.

Confirmation required

Two features are required to confirm this as a head-and-shoulder pattern. The first feature is that the peak of the second rally is lower than the peak that forms the head. This is shown as area 3. and will be established by the rally triggered by the 90-day reprieve in the trade war.

The second feature is that the head-and-shoulder pattern is only confirmed when the index falls below the projected value of the neck line. The value of the neckline has been projected on the Dow chart. A fall below this neck line on a market retreat confirms the head-and-shoulder pattern.

The two low points in the pattern - the beginning of the first and second rallies - are joined with a single trend line. This line might be horizontal, slope upwards, or slope downwards. It makes no difference to the accuracy or reliability of the pattern.

A line is drawn down from the top of the head to intersect the neckline. This value, in index points, is then projected below the neckline. This sets the first downside target for the market downtrend. Sometimes these values seem extreme, but 80 per cent of the time these values are met and exceeded.

On the Dow chart, this sets a downside target near 21250. Many investors will use the rally generated by the 90-day extension as an opportunity to exit positions at a slightly higher value. They will do this, not because most of them understand a head-and-shoulder pattern, but because by the first quarter of 2019 the adverse impacts of tariffs will show up in the bottom line of US companies that depend on China for their profits. It has already shown up with Apple and this contagion will spread.

Patterns are rarely perfect so investors look for as much compatibility as possible and adjust the probability of reaching the target level accordingly. The pattern has a left and right shoulder formation and a head. In 2008, this pattern developed two right shoulders so investors are alert for a repeat of this pattern in 2018/2019. The occurrence of two right hand shoulders did not reduce the reliability of the pattern. The head-and-shoulder pattern is invalidated if the second rally moves higher than the peak of the previous rally - higher than point 2 on the chart.

President Trump has given investors a gift of 90 days of time to get their affairs in order - but a twitchy twitter finger may cut that time short.