A tough call on the Dow by Ben Turney

Earlier in the week I posted a chart, which indicated a possible Head and Shoulders pattern forming on the Dow.  This fitted in line with my view that a major top is in place for US indices and the next significant move will be down.  With the outlook for American QE having changed considerably since last Wednesday’s press conference with Ben Bernanke, this seems a logical enough bet.  It is also a bet I am sticking to for now, although the pace of developments this week has left me slightly wrong footed.

Things started off well enough.  The formation of the Head and Shoulders seemed clear.  The left shoulder and head appeared well formed (“LS” and “H” on the chart below) and the neckline should have been at about 14,450 (the horizontal line).  As the market fell steeply on Monday and there was further selling before the open on Tuesday it looked like the pattern was going to complete in a fairly conventional manner.

However strong buying since Tuesday afternoon has left me in a bit of a quandary. 

The market didn’t touch my 14,450 neckline target and instead has rallied strongly to 15,000.  In my original analysis I identified 15,000 as the reasonable target to go short on the proviso that the formation of the right shoulder occurred.  The question now is – has that right shoulder formed (“RS?” on the chart above) and, more importantly, do I open new short positions?

In all honesty it is a tough call to make.  The speed at which the market has regained ground is indicative that this bull market still has life left in it.  Normally I would have expected a right shoulder to take longer to form than a few trading days.  The fact that this right shoulder (if it is even one) has also risen higher than the left shoulder is another factor to be wary of (ideally I want to see more weakness in the market at this stage).

The following view of the Dow also has given me a little pause for thought: 

Marked “1”, “2”, “3” and “4” you can clearly see that the Dow has now made a succession of significant higher lows since the turn of the year, which should be synonymous with a healthy bull market.  Admittedly higher low 4 is only marginally higher than higher low 3 but it is higher nevertheless.  I certainly wouldn’t buy on the strength of this signal, but there are clearly those out there who still believe this market can move higher.

Overall I’ve decided I am going to stick with my original analysis that the outlook for US stocks has fundamentally changed in the near term as the Federal Reserve starts to withdraw its bond purchasing programme. However, I am mindful that the charts haven’t quite given me the confirmation I would like. They are close, but close can often not be enough.  As such, I am going to tread a little carefully, not taking on too much risk and managing my stops fairly tightly.  At this point the risk/reward seems nicely balanced in my favour.  If I’m wrong I should be able to get away without suffering too great losses, but if I’m right then there is a large potential profit to be made.