If you’re an average investor the odds are everything you think you know about trading stocks is wrong.
Most investors believe stock prices are the result of some mixture of financial ratios, executive team acumen, and investor sentiment.
But that’s not right.
In reality, price is everything — and the rest is simply investor rationalization.
In this special report, I’m going to show you how to identify one major price reversal pattern, what it means, and why it is so reliable.
Let’s begin by addressing the elephant in the room. There is an entire ecosystem built around the myth that stock prices can be predicted, assuming you are following the correct economists, investment strategists, and professional money managers.
This is Wall Street malarkey.
Peter Lynch, the legendary Magellan fund manager who averaged 29.2% annual returns during his 13 year tenure at Fidelity, often said he never met an economist who was a successful investor. In fairness, predicting stock prices based on macroeconomic factors such as interest rates, and aggregate corporate earnings is tough. There are simply too many moving parts.
And collectively, investment strategist and professional money managers have no history of beating even the unmanaged benchmark indexes. A study by S&P Dow Jones Indexes in 2022 found that not a single mutual fund managed to regularly beat S&P 500 over a 5-year period.
The problem for pros is that stocks can advance during even the direst circumstances, and decline when all of the macroeconomic and corporate stars seem perfectly aligned.
The S&P 500 surged in 2020 to a record high, even as 20.5 million Americans sought unemployment insurance and corporate profits plunged to the lowest level in a decade. The carnage was so bad economists began calling the era the Great Recession.
By 2021 strategists were wildly bullish. Shares of Nvidia (NVDA), a cutting-edge semiconductor firm catapulted from $125 per share to $350, garnering 96% “buy” ratings. One year later, with shares at $113 the same analysts were talking about a glut of semiconductors, and why the stock might be a good source of funds.
There is a consistent theme; Professionals rationalize their investment expectations based on the prevailing price trends. They assume that the prevailing trend will persist indefinitely.
A better strategy is to identify time tested reversal patterns. Let me share the best of these: The “Head and Shoulders” formation.
This is the part where the detractors will argue that technical analysis, the study of price patterns, does not work. Bear with me.
Price is everything, and patterns do repeat, for obvious reasons that I will get into in a moment.
First, you should that Head and Shoulders price patterns consist of three price peaks, with the middle, the “head”, being the most extreme. H&S patterns also come in two flavors, tops and bottoms.
5 Things To Know
1 This is a reversal pattern, a trend killer. Formations occur at the end of big trends.
2 Patterns can occur in multiple time frames (ie, hourly bars, daily, weekly or monthly).
3 The price action reflects the transition from hope to hopelessness, and vice versa.
4 Price stalls, then accelerates in the opposite direction despite the prevailing news cycle.
5 The price pattern is self-fulfilling. H&S patterns are widely known by professional traders. The price implications are programmed into automated software.
Now that you understand the basics of H&S patterns, let’s look at some recent examples.Head and Shoulder Top
Tesla (TSLA)Shares of Tesla became the quintessential growth vehicle in 2020, rolling from only $27 in January to $235 at year’s end. During the next two years the electric vehicle maker grew rapidly. Brisk EV sales pushed revenues sharply.
However, the stock price stopped advancing in November of 2022 when prices reached $414.50. Fun fact, at that point the market capitalization of Tesla was greater than the combined value of Ford (F), General Motors (GM), Stellantis N.V. (STLA), and Toyota (TM).
The price pattern on the weekly chart, with a distinctive “head” and two “shoulders” became obvious.
Tesla shareholders went from hopeful, that the share price would reflect the improving fundamentals, to hopelessness in October 2022 when the stock price fell below its neckline (dotted line) at $217. The plunge occurred after the Austin, Tex.-based company announced it delivered a record 343,800 EVs during the third quarter, up from 254,700 the previous year.
According to bears, Tesla was growing quickly, yet not fast enough to support its rich valuation.
The share price plummeted further when the company announced the waiting time for new vehicles had shrunk to only a few weeks. Shares reached a low of $103 in January as Tesla cut the price of its EVs to spur demand.
There is one other aspect of technical patterns you should know, measured targets. In the case of head and shoulder tops, the target is the height of the head, less the break point level. For Tesla, the head occurred the first week of November 2021 at $414.50. On that date the neckline was $191.40. The height of the head is $223.10. The breakdown occurred. Subtracting the height October 2022 at $219.70. This the target is $219.70-$223.10, or minus $3.40.
The share price of Tesla is not going to decline to a negative number. In this case I would use the first critical support level at $64.10.
Head and Shoulder BottomRemember, these patterns can occur in all time frames, and they can be quite small.
A small head and shoulder bottom pattern started in December 2022 when Tesla shares fell to a low of $108.7 before rallying back to $124.48. Shares declined on January 8 to a relative new low at $101.81 before once again rallying back to the $123.52 on January 8. The stock dipped to $115 between January 10 and January 13. The head and shoulder bottom breakout occurred January 17 when shares opened above $125. Within a month, Tesla stock pushed to a high of $216.75. The gyrations created a well-defined head and shoulder bottom pattern, often also called an “inverse” H&S pattern.
It is noteworthy that bullish move occurred even as the company announced dramatic new price cuts on January 12. The price began to move in the opposite direction of the prevailing news cycle.
That’s the thing about stock prices; Often, they do not reflect the prevailing perception about value. Almost everything average investors think they know about stock prices is wrong. The best strategy for understanding price is to follow prices, not investment pundits.
Learning how to read price charts and patterns is a good first step.
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