Ford Motor Company (F) recently completed a compressed Head and Shoulders pattern that exceeded the price projection inherent in the pattern.

The Head and Shoulders pattern in Technical Analysis consists of an initial swing (left shoulder) that results in a second higher swing (head) and terminates with a failure swing (right shoulder) that takes price beneath the support zone known as the “neckline” which can be absolutely horizontal or slightly slanted.

Although this head and shoulders pattern in the Ford example is not a classic or textbook pattern because we normally expect these patterns to form AFTER a sustained uptrend, as these patterns are often of the major reversal type.

Let’s look:

The initial condition – left shoulder – completed mid-October and then price swung up to complete the ‘head’ section before creating a failure swing-up in early November.

Keep in mind that there is no way possible in technical analysis to forecast which price swings will complete themselves into head and shoulders patterns, and the pattern is absolutely undiscernable until the final failure swing around November 12^th is completed.

It is at THIS POINT that you can enter a trade to take advantage of the pattern, its implications, and measuring rule (price target). The target is traditionally the same distance from the top of the head (top of the highest swing) back to the neckline, and from this projecting price by that same amount lower. I have highlighted these with green lines. Notice that the objective was not only achieved but exceeded.

Even though price continued lower, it was still better to play for a small target with this and most patterns in technical analysis, as the ‘window of opportunity’ or ‘forecast zone’ lasts for a very limited time.

For educational purposes, I have also highlighted a positive momentum divergence in August that preceded a large volatility move up which created the eventual head and shoulders pattern.

While no pattern is perfect, it helps to study as many patterns as possible to see how you interpret them and whether you feel comfortable incorporating them into your growing trading arsenal.

There is temporary reason to be optimistic on the US Dollar Index with its recent momentum divergence, which has already achieved its index price target.

Momentum divergences are – by their very nature – countertrend trades and often are applicable only for a small target, such as a return (snap-back or reversion) to the 20 period moving average.

Momentum divergences can create high probability short-term trades as they highlight the lack of conviction, or strength, of the prevailing force on the most recent price swing.

Notice the recent swing divergence on the US Dollar Index, which would have set up a quick trade (in the futures market) for a retracement to the declining 20 period moving average.

Divergences do NOT overrule the current market/price structure, which is in the most bearish trend orientation (notice the ‘total bear’ orientation of the key moving averages):

Nevertheless, the divergence (with price making a lower low and the momentum oscillator making a higher low) forecast and achieved its profit target effortlessly and rapidly (thanks, in part, to short-covering to those who over-positioned themselves).

Lessons to take away from this chart:

• This is a “Textbook example” of a clear downtrend
  
• Momentum divergences are high-probability trades with a small target (window)
  
• Even the strongest downtrends need a ‘pause’ or reprieve
  

Freddie Mac (FRE), chartered by Congress to increase the supply of money that mortgage lenders can make available to homebuyers, recently suffered an astounding price decline and horrific downtrend that culminated in a potential exhaustion gap which has now been virtually eradicated.

The stock represents a unique company that is at the center of the “Mortgage Meltdown” or “Sub-Prime Crisis” or whatever term you wish to describe the recent tightening on financial lending which has resulted in catastrophic losses to many financial institutions across the board.

The technical picture of Freddie Mac (FRE) seems to be at its darkest, but as we know from technical analysis, prices can often turn around at their darkest point on the chart.

Recently, price carved out a large volatility gap in which Freddie Mac plummeted overnight from $37.50 to $25, losing 33% of its value instantly.

However dark the picture seems, we know that most gaps on price charts do eventually get filled, often right away. It seems that Freddie Mac is filling its gap from its fateful day last November:

Volume is flooding into and out of the stock as price may have ‘overshot’ all fundamental logistics and created an immense buying opportunity for those who wish to hold the stock long-term, and are not afraid to be “buying when others are crying.”

We cannot know for sure whether this will be the bottom in the stock, but we must observe that a primary downtrend is in effect on the daily chart, the moving averages are in their most bearish orientation (20 below the 50 which is below the 200, and price beneath them all), and price recently made a significant new momentum low (momentum precedes price). Also, price seems to be finding resistance at the declining 20 period moving average.

Tread with caution, ye who wish to own this stock, and know that things are not always what they seem.

What would be the ideal picture of a technical downtrend? A few names come to mind but let’s examine Pulte Homes (PHM):

I have annotated the Daily Chart of Pulte Homes (PHM). Let’s define a downtrend using the simplest two definitions possible:

• A series of lower lows and lower highs
  
• The 20 period moving average being beneath the 50 period moving average which itself is beneath the 200 period moving average
  

We see these two events occurring on the chart. Notice the orientation of the three key moving averages (20, 50, and 200).

Notice how ’sloped’ the 200 period MA appears and how steady the space remains between the declining 50 period and the 20 period MAs.

This would be the epitome of a classic downtrend – one need look no further for a ‘picture perfect’ example.

Notice the “Short Squeeze” which occurred around August 2007. Rapid (and violent) up-thrusts in price also characterize a downtrend because even the slightest bit of good news will cause shorts to cover quickly and ‘bottom fishers’ to buy up shares. Unfortunately, such quick ’squeezes’ in price often fade just as rapidly as they occur.

What we see at the end of the chart is a potential “capitulation bottom” where volume has skyrocketed as price has made a large volatility move to the downside. While “volume confirms price” or “volume precedes price,” there are instances where everyone who wants to sell (and is still holding shares) HAS sold and there’s no one left to sell. Unfortunately for most, these instances occur when all news both from a fundamental and technical standpoint is at its worse (else, why would people sell en masse?).

Let’s take a quick look at the weekly chart:

I have highlighted the recent sustained increase in volume to the downside.

The orientation of the moving averages is in the most bearish position possible yet again.

Nevertheless, if you wanted to observe a ‘picture perfect downtrend’ in the simplest terms, view Pulte Homes or almost any other homebuilder stock in the current environment.

It’s time to expand our horizons beyond the stock market to other inter-related markets and also glean insights from the sector rotation model.

All charts are courtesy StockCharts.com, and we will be examining the “Intermarket Relationships” profile of the last 200 days first:

I have highlighted the clear negative correlation (inverse relationship) between commodities (blue line) which have been making new highs and have outperformed all other asset classes on the chart this year and the US Dollar Index (green line) which has – not surprisingly – underperformed all other above asset classes.

The next observation is the recent divergence between commodities and the US Stock market. Notice how the two have generally followed a positively correlated relationship until two months ago when commodities ($CRB Index – blue) have risen relative to the S&P 500 index (red).

Bonds have historically led stock prices in the short-term (sometimes by three to six months), and if that is to be the case again, we see bonds have been increasing in value since October (as a result of the Rate Cuts by the Federal Reserve and the ‘flight to quality’ in which investors have been buying bonds and exiting stock positions).

John Murphy at StockCharts.com summarizes the four major asset class relationships as the following:

What’s throwing the model off currently is the positive relationship between commodities and bonds which has been occurring since mid-August 2007.

Notice how the Dollar Index has continued to make new relative lows all year long.

Now, let’s look quickly at the Sector Rotation Model:

I have divided the chart into two segments:

“Expansion” refers to sectors that tend to do well (outperform) when the economy is expanding, business is growing, and the stock market is expected to rise.

“Defensive” refers to sectors that do well (outperform) when the economy is contracting, business is retracting/downsizing, and the stock market is expected to decline.

We see now one of the clearest pictures from the Sector Rotation Model possible: Over the last 65 days (from late August until late November), money (the large funds) have clearly favored defensive, safer positions than the more risky positions established when the economy and stock market is expected to rise.

What this means according to the model is that the “Big Funds” who must be ‘long’ the market (such as major mutual funds, etc) are preferring the safety of quality over risk-taking positions in the current environment.

Despite the large recent moves by high-flyers such as Research in Motion (RIMM), Apple (AAPL), Baidu.com (BIDU), and Google (GOOG), the technology sector remains barely profitable over the period on the chart.

Odds are favoring placing longer-term positions in safer areas that do well when the market is expected to decline… or in the safety of bonds.

Keep in mind that the month of December has been known to return positive returns on aggregate in the stock market, and be especially cognizant of the upcoming “Santa Claus Rally” which takes place before/after the Christmas holidays.

Be safe in this current murky market environment.