Charting Asia

As S&P drops, keep your eye on the head and shoulders

One month into the New Year U.S. stocks look the worse for wear. With the S&P 500 down 5.7 percent year to date, investors are beginning to wonder – should we expect a rebound or is a reversal in trend at hand?

The S&P 500 fell below the much-watched 100-day moving average at 1770 on Monday as weak manufacturing data sparked concerns about slowing momentum in the U.S. economy. The data heightened concerns about Friday's payrolls report, which could play a key role in determining when the Federal Reserve next tapers its asset-purchase program.

(Read more: Markets now fear U.S. economy chilled by more than weather)

Traders work on the floor of the New York Stock Exchange.
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The question remains, is the S&P 500's fall below 1770 the beginning of a temporary retreat and rebound or the beginning of a trend reversal? To answer that question we will look at the daily chart.

The S&P 500 has developed a potential reversal chart pattern in the form of a head and shoulder pattern, which allows clear downside targets to be established. The pattern starts with the rally and retreat in 2013 November that forms the left shoulder.

The head of the pattern is created by a new rally and retreat that moves higher than the left shoulder. This part of the pattern was completed in December 2013 and January 2014 with a double top near 1840.

(Read more: US markets to focus on January manufacturing report)

The final part of the head and shoulder pattern is the right shoulder, which is created by another rally rebound and retreat.

This head and shoulder pattern was confirmed when the market closed below 1770, however full confirmation comes from the weekly chart with a weekly close below 1770. The pattern would be invalidated if the market is able to rally above 1800.

The head and shoulder pattern has a neckline that is plotted between the two lowest points of the heads and shoulder pattern. With the S&P 500, the neckline is a horizontal line near 1770. The combination of the neckline and the head is used to calculate downside targets; the height of the pattern is projected down to give a pattern target near 1692.

The validly of this target is confirmed when it coincides with an established historical support feature. The 1692 pattern target is close to the support and resistance level that developed in July, August and October of 2013, which suggests this is a reasonable support level for any fall below 1770.

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A fall to 1692 would represent an 8 percent retreat from the peak high near 1840. In the broader long-term analysis this suggests the market can retreat to 1692 and still remain in a long-term uptrend. A retreat of less than 10 percent is a technical correction in the trend rather than the end of a trend.

As the market falls towards the head and shoulder downside target it is important to remember that this pattern target points the way to the first support consolidation in any market fall. Investors should watch the pattern of development near 1692 to determine if this is technical correction, or if it has the potential to develop into a longer-term downtrend.

Disclosure: The writer holds an open position in the S&P Asia 50 Exchange Traded Fund.Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders – He is a regular guest on CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

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