In many blogs and investment sites there is a talk about the stunning resemblance of the price action in S&P 500 index back in May-June of 2008 and just before the market collapse that followed, to the current price action pattern. I argue here that those who make such claims simply do not understand technical analysis.
The 2008 pattern and the recent pattern are shown on the SPY weekly chart enclosed in ellipses with a grey background. Both patterns occurred after a head and shoulders formation. Both patterns involve a break below the 40-week simple moving average – SMA(40 Week) – followed by a double bottom and then a test of SMA(40 Week) support. Up to this point the similarities are stunning. Can we draw any conclusion from them? No, we cannot.
To start with, we have two historical observations, or events, and whoever assigns a property to the second event that is found in the first event just on the basis that they look similar may be commiting the informal fallacy of a false analogy. The assumed common property in this case is the drop in prices that followed after event A and it may not be a property of the second event. But that is too theoretical.
From a practical perspective, after the 2008 pattern there was another attempt for a test of the SMA(40 Week), enclosed in the red circle. Thus, there were two attempts to test resistance at the SMA(40 Week). The second test was at the same level where the double bottom was formed. This makes sense because that was a support level that turned into resistance, indicating a change in trend. However, in the second pattern this second test has not taken place yet. There are (at least) four possibilities:
(A) The second test never occurs. In this case we have two possibilities (A1) Prices reverse and rally and (A2) Prices fall towards the March 2009 lows.
(B) The second test occurs. In this case too we have two possibilities (B1) Prices rally and (B2) Prices reverse and fall towards the March 2009 lows.
These are some of the possibilities. Price action may signal which of the above four possibilities will take place, but only if properly analyzed. The job of a technical analyst is to identify the possibilities and assign probabilities to them. A technical analyst should not try to predict the future but only to evaluate the probability of various scenarios occurring and thus understand the risk and reward involved. Trying to predict the future based on a just a few past observations often leads to false analogies.
Disclosure: no relevant positions.
Disclaimer:The author is not a financial advisor and does not recommend the purchase of any security or advise on the suitability of any trade or investment in any timeframe. ETF, stock, futures, forex and options trading and investing involves substantial financial risks and can result in total loss of capital. If investment or other professional advice is required, a licensed professional should be consulted.
