Sunday, March 28, 2010

Massive Head and Shoulders on the Dow?

A couple days ago a reader sent me this very long-term chart of the Dow Industrial Average:

At the moment I am not sure who made up the chart. Anyhow, the implication here is that a break of this neckline generates a price target of practically nothing, or sub-1000 on the Dow, at least.

This raises some questions about how to form price targets from chart patterns. With H&S patterns, everyone seems to like this formula where the downside target is the distance below the neckline that the head was above the neckline. Sounds rather simplistic to me, but I suppose under normal circumstances a simple target like that can serve as a decent guideline.

But on a major formation like this, the implication for a one to one target can become rather absurd. And no mistake, any analysis that has the Dow dropping to lows of the 1970s is absurd. There is no other word for it.

It's perfectly reasonable to look for the Dow to decline, perhaps significantly. But it is not going to drop to 700 or whatever. It just won't.

But it happens that today I was playing around with the reciprocals of some price indexes. On stockcharts you can make a ratio of '$ONE' to anything, so to get the reciprocal of the Dow you just enter $ONE:$INDU. So essentially you are charting the performance of a dollar relative to the stock market, rather than the other way around. Here is the $ONE:$INDU over the past couple years:

Now the cool thing is that this ratio gives you a dramatically different target on the big H&S pattern than the right side up chart of the Dow. Look:

I used the 21 day moving average just to smooth out the pattern some. The actual target -- if you are using the head to neckline measurement -- varies depending on whether you place the neckline at the 2002 low or the 2009, but in either case, the potential is for the Dow to move back to some level it traded in the mid-90s. 5000 maybe?

Of course, that's only if this actually ends up being a potential head-n-shoulders pattern, and we are a long ways from being able to say that now.