Is the Market Due for a Modest 'Right Shoulder' Rally?

With all the grim economic news out of Europe and China and the disappointing U.S. jobs report released Wednesday, it might seem counterintuitive to expect the stock market to rally. But there are three technical reasons to suspect the market will muster a modest rally in the next few weeks.

  • The VIX "fear index" is flashing an extreme of negative sentiment, which usually signals that the market is at a bottom.

  • The "head and shoulders" chart pattern many see hasn't really completed the classic form.

  • Time symmetry suggests another rally into mid-July.

These all may sound like obscure and overcomplicated reasons to expect stocks to rise under current conditions, but read on for the analysis.

As the two charts below show, the VIX fear index rises and falls in negative correlation with the stock market (using the S&P 500 as a proxy for the U.S. stock market). When the VIX shoots up, reflecting investors' fear and negative sentiment, that coincides with market bottoms. When the VIX slides to extreme lows, reflecting complacency and confidence, that often signals a market top.

Though the VIX could continue racing higher, its sudden ascent from 23 to over 35 in a few days suggests the sort of surge of negative sentiment which usually signals a market bottom.

Technically speaking, there is some long-term support around the 1,035-1,040 level for the S&P 500. If the market holds this line for the next few days, that will strengthen the case for a rally, at least in the short term.

One "Shoulder" Is Lower Than the Other

There's a frequently seen pattern in the charts of stock markets over time: "head and shoulders." Prices rise and hold fairly steady around a peak (left shoulder), rise again later to a higher peak (the head), fall again, and then rise a bit to a right shoulder peak in the same value range as the left shoulder.

Numerous market watchers have called attention to the "head and shoulders" pattern which is visible today in any chart: The January 2010 high is the left shoulder, the April top is the head, and the right shoulder is either last week's S&P high of 1,130 -- or it has yet to arrive.

In a classic "head and shoulders" pattern, that right shoulder would be expected to reach the previous line of resistance created by left shoulder -- in this case, around 1,150. If last week's 1,130 mark for the S&P, was indeed the right shoulder, the market should plummet from here. But a purist would predict that the right shoulder should reach the resistance line marked by the left shoulder.

Should the market exceed this line of resistance, then it could make a run for a new high above 1,200. If it stalls out in the 1,150 to 1,175 band and then turns down, that would confirm a "head and shoulders" topping pattern, which is bearish.

Time for a Peak? Look for the Symmetry

The other technical theory in support of an upcoming rally concerns time-symmetry in the head-and-shoulders pattern. Essentially, you should expect your pattern not to be lopsided: In general, the periods on one side of the "head" are of similar duration to those on the other.

So, let's look back at those charts again. It took about three months for the market to reach its April top from the right shoulder. Symmetry suggests that the right shoulder will form around three months out from the top in late April. That would target mid-July as the high point of a right shoulder.

Of course, such pattern symmetry is rarely perfect: The market tends to do what frustrates the maximum number of investors and speculators. This is the basic idea behind the view that VIX peaks reflect extremes of negative sentiment which then set up reversals and market rallies.

Even if the market rallies into mid-July, it will be what happens next that is of greater importance to investors. If the market rallies to new highs above 1,200, that would initiate a new bullish trend. But if the market fails to exceed the 1,150 level and falls back to the 1,035 level, that would complete the "head and shoulders" -- technically, a topping pattern and thus a bearish signal for any market.