The Past, the Present, with a Watchful Eye to the Future…

In the last article I espoused the benefits of the First Principles of technical analysis. Today I am going to look at the application of two of these, specifically area patterns and broad market theory. I will be examining the Dow Jones Transportation average – an average often cited as a leading indicator and a key component of Dow Theory – as to where it stands at present. I will be looking at a potential area pattern as it may be developing in the transports and how, as a CMT, one is taught to analyze. Now on to business.

 

The chart below is a 4-year chart of the Transports. You can clearly see the March 2009 low and the distinct Inverted Head and Shoulder pattern it formed. I have marked the minimum price target as well, which it exceeded, as well as double the price target. Head and Shoulders patterns will have a price target that is the width of the pattern – that is, the neckline to the head, added to the neckline. This goes for normal H&S patterns as well as inverted patterns. These price targets can only ever be established once the pattern is confirmed. This means that had you been watching the pattern developments in the transports as they unfolded in early 2009, you would have seen the first shoulder, the head, and then maybe the second shoulder all before any actual implications could be derived.

 

4-Year Weekly Chart of Dow Transports

 

This pattern took roughly nine months to develop. Because it took many months, its implications, when and if it confirmed, would be significant. As you can see, the pattern was confirmed and its effects were indeed significant. The minimum price target was reached and the double target was nearly reached. You can expect the price to reach between 1 and 2 times the target. The volume characteristics for the pattern were mostly inline with expectations as well, though they were somewhat muted. For an Inverted Head and Shoulders, you should expect the heaviest volume on the first shoulder and then you can expect it to level off thereafter.

 

Now let’s examine what is happening in the Transportation Average currently. You can see from the daily chart below a potential Inverted Head and Shoulders pattern developing. Because it is on a daily basis, any potential implications will be less significant in both the likelihood of a move and length of distance and time of a move. I want to stress that this pattern is a developing pattern, and that currently there are no implications and there will not be any until this pattern is confirmed. That means a decisive close above the neckline for three consecutive days. This pattern looks somewhat promising because of the volume pattern, which is heaviest into the first shoulder, as well as the fact that the transports last major pattern was an Inverted H&S. Oftentimes a stock will repeat its pattern (if only in degree) because the character of either itself or its investors or both remain the same over time.

 

Six month daily chart of the Dow Transports

 

Does that mean that our analysis, as it stands, is useless? Far from it. As a Market Technician you can extract data from the market on a day-by-day basis, a week-by-week basis, a month-by-month basis, and even a minute-by-minute basis for shorter working time frames. Knowing now that there is a potential Inverted Head and Shoulders developing, you can look specifically to see whether or not this pattern is confirmed or rejected. Since this is a daily chart, we will gain additional insight every day or every couple of days as it continues to develop.

 

Scenario 1

 

You can see from the chart the 4,300 level appears to be very important. A decisive break to new lows – below 4,200 – would indicate the break down of the pattern. This would signal to the Technician a continuation of the downtrend, and can be used as a signal to initiate short positions, or remain in short positions previously initiated.

 

Scenario 2

 

Should the transports reverse course and decisively break above the neckline at 4,700 – the pattern would then be confirmed and its minimum upside target given at 5,200. Of course this may still be a reactionary move in an otherwise down market, however the knowledge and implications of the confirmed pattern should aid any investor. A confirmed pattern would indicate a renewed rally, and would signal to shorts to exit their positions, longs to remain in their positions, and possibly new longs initiated on a short-term horizon.

 

Scenario 3

 

The pattern may neither break down nor be confirmed right away, but merely consolidate sideways as it waits for further direction. After a certain point the Inverted H&S pattern would be ruled out because long periods of consolidation are not synonymous with these patterns. At that point the Technician would need to evaluate any further (new) pattern developments as well as critically examine support and resistance levels.

 

Conclusion

 

Dow Theory is an essential element and First Principle of Technical Analysis. It states you must look at both the Dow Jones Industrial Average as well as the Dow Jones Transportation Average to gauge the overall market direction. Together these will tell you if the market is moving together (either up or down), is unsure of itself, or if it may be in the process of reversing its course. Today I have only briefly examined Dow Theory while looking at less than half of the picture to demonstrate how you can make use of developing patterns. My purpose is exploratory rather than exhaustive, in order that one might improve their technical skills.

 

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