Several weeks ago on CNBC Squawk Box we discussed the breaking news that Goldman Sachs had sold more of its stake in the Industrial and Commercial bank of China (ICBC).
This news broke prior to the open of the Hong Kong market . My task is to look at the chart and analyze it in a few seconds. It showed a strong inverted head and shoulder pattern which is a very reliable signal of a trend reversal. I commented on the pattern, its strength and its implications. I noted that I would be a buyer when the rebound developed following the sell-off.
Look at the chart with its strong inverted head and shoulder pattern. As an investor would you be a seller? The answer is clearly no. Wait a little longer and you can exit at HK$6.00 ($0.77) or higher. In this case you need to question the motives of the sellers.
Earlier in August Bank of America sold a $8.3 billion stake in China Construction Bank and it did nothing to halt or reverse the long term downtrend in the stock. The selling of shares of China Construction Bank by Bank of America was indicative of problems with Bank of America rather than problems with China Construction Bank. Perhaps the same may apply with the Goldman Sachs sell down of ICBC .
The Goldman Sachs long-term trend is also down. This is a grab for cash and we think it suggests a much higher level of weakness in the U.S. banking and financial system than is being publicly acknowledged. This has the hallmarks of a forced sale to raise cash – the sort of thing you do when you need to meet a margin call. Weakness in the U.S. banking sector is greater than acknowledged and this suggests further shocks and an increase in volatility – but that’s another trade.
As expected there was an initial reaction to the Goldman Sachs sell down of ICBC when the market opened. Later that day I received an email that in part told me that I was wrong because the stock had fallen that day. Obviously the sender had not listened to the discussion of the chart pattern or the strategy that develops from it.
The inverted head and shoulder pattern is a very reliable pattern of trend change. It led the trend change coming out of 2008 when markets reversed. Head and shoulder patterns have appeared in the Dow both in 2007 and again in 2011. In both instances the change in trend has occurred, and the pattern targets have been achieved or exceeded.
There has been a small change in pattern behavior in 2010 and 2011. This is an increased frequency of a throwback following the completion of the right shoulder of the pattern. This is a rally in the head and shoulder pattern or a retreat in the inverted head and shoulder pattern. A throwback developed with the Dow head and shoulder pattern in July.
It’s the retreat throwback that developed with ICBC. The low of the retreat was not enough to invalidate the head and shoulder pattern. It’s the rebound from this level, and the break of the short- term downtrend line, that provided the entry signal at around HK$4.35.
The head and shoulder pattern was established with a comparatively weak right shoulder pattern. Weak because the pullback was small, and lasted about 6 days. Significant because the retreat was substantial and it was followed by a substantial rally. The neckline of the pattern is placed along the two rally peaks. The distance between the low of the pattern and the neckline is measured. This is around HK$1.20. This value is then projected above the value of the neckline to give an upside target near HK$5.85.
With an entry near HK$4.35 and an exit near HK$5.85 this delivers a comfortable 34 percent profit. This is the first application of the trading strategy to the chart pattern.
The second application recognizes that the inverted head and shoulder pattern is part of a longer-term trend reversal. The pattern targets are initial targets and traders watch for consolidation activity near the target levels. The historical chart shows that there is a support resistance band between HK$5.70 and HK$6.00. Once the target is achieved, a move below HK$5.70 is an exit signal. This is protect profit, stop loss.
A move above HK$6.00 is a signal to add to the existing position in preparation of a longer-term uptrend with targets at HK$6.30 and HK$6.70.
Chart patterns provide advance notice of opportunities. It’s the combination of analysis and trading intelligence that makes the patterns profitable. It’s the use of stop loss to protect profits that locks in capital gains.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –www.guppytraders.com. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.
If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.
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