Market Insider

Scary pattern forming in stock chart may be sign of another move lower

Key Points
  • A so-called head and shoulders pattern looks to have formed in the S&P 500, a sign to some technical analysts the market has reached a near-term top and could be heading into a rocky period.
  • The S&P 500 broke what would be a "neckline" on Wednesday, after it traded below 2,800.
  • Bank of America Merrill Lynch analysts said there is downside risk to 2,650, the 50% retracement of the December to May rally.
Trader on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters

Stock market selling accelerated Wednesday as major indexes broke through some key technical levels, and a worrisome pattern formed in the chart.

The so-called head and shoulders pattern formed when the S&P 500 broke support at 2,800, and from there, analysts said it could lose another 5.4%. The S&P also fell below its 200-day moving average at 2,776, an important level of support and momentum indicator. The index recovered some ground and closed above that level at 2,783, a decline of 0.7% on the session.

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"If the 2800 area breaks, it would confirm a head and shoulders top that suggests deeper downside risk to 2650, which is also the 50% retracement of the December to May rally," Bank of America Merrill Lynch technical analysts wrote in a note. The top of the pattern would be the top of the head at 2,950, and 2,800 was considered the neckline.

Head and shoulders chart in the S&P 500

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Source: T3Live.com

Scott Redler, partner at T3Live.com, follows short-term technical trends and said the 200-day level is important for the S&P to hold, and he too sees 2,650 as a level indicated by the head and shoulders pattern.

The Nasdaq also fell below its 200-day Wednesday, when it dropped through 7,527. It later regained the 200-day, closing at 7,547.

The Dow, Russell 2000 and Dow transports have previously broken the 200-day, which is basically an average created from the past 200 days' closing levels.

The head and shoulders pattern, however, may be a warning of more weakness and marked a near-term top for the S&P at 2,950.

"Actually, the market was weak enough to break the neckline. In the past several years, the neckline has been strong enough and became a place to buy," said Redler. "We've been in a bull market for 10 years, and when the market set up a head and shoulders pattern, it was mostly a better place to buy. This is one of the few times the market set up a head and shoulders pattern, and then traded down another 30 handles."

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Even if the market ends the day higher, it has still formed the head and shoulders pattern, and possibly signals more weakness ahead. "It shows distribution of the market and obviously, the market's been in distribution as we figured out the trade war wasn't going to end in May like it was supposed to," he said.

Stocks have been nervously following bond yields lower. Yields move opposite price, and bonds have been attracting investors who are fearful the economy is weakening and the trade war could make it worse.

The 10-year Treasury yield was at 2.22% on Wednesday, after the starting the month at about 2.55%. J.P. Morgan technical strategists said the 10-year's break below 2.29-2.30% signaled a potentially lower move to 2.15%, then possibly 2.08%.