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Some Stocks Foretold Their Big Declines

Some of this year's biggest stock market losers gave warnings that could have saved investors at least some of their losses.

We're talking about the arcane science of technical analysis, the study of chart patterns to predict a stock or index's next move. In some of the cases, patterns served as a warning that the stock market was topping. In other cases, in which the stock in question later dropped on news, technical analysis served as a warning that something was amiss. A few insiders and followers knew, and they were selling. That is technical analysis's greatest benefit: as an equalizer for those who aren't in the know.

We'll break down the most common technical patterns into two categories: reversal patterns, which mean a stock or index's trend is reversing; and consolidation or continuation patterns, which are a breather before a stock or index continues in the initial direction before the consolidation occurred.

Reversal Patterns

The Head and Shoulders is probably the most common reversal pattern. It is essentially two higher highs (the left shoulder and head), followed by a lower high (the right shoulder) that shows that the rally is running out of steam. The pattern is not considered complete until the neckline is broken by 3% on a closing basis (a good rule of thumb for all pattern breakouts). America Online and JDS Uniphase were two stocks that formed a head and shoulders top (note that AOL also later formed a symmetrical triangle, which we will get to under consolidation patterns).

An inverse head-and-shoulders pattern, the reverse of the topping pattern, can signal a bottom (see this United Technologies chart).

The head-and-shoulders pattern predicts a move equal in size to the pattern (measured from neckline to head) from the neckline break; in the case of AOL, this meant a 30-point move from 70, or to $40 a share.

The Wedge is another reversal pattern. It is essentially a three-week to three-month rally (or sell-off) with converging boundary lines, signaling that the rally or sell-off will run out of room eventually. It is common for bear market rallies to be rising wedges. The Nasdaq 100 had two rising wedge rallies within a larger rising wedge, signaling to investors that the rally wasn't going to last.

The predicted move out of a wedge is to the point where the wedge began. Also, rising wedges usually precede rapid moves, while falling wedges predict slow ones. The Nasdaq's recent bottom was a falling wedge, predicting the index's subsequent slow recovery.

And the most maddening falling wedge of all belonged to Amazon.com, which broke out of a falling wedge at 35 and retraced all the way to the apex of the pattern at 19 before recovering (also note the complex head-and-shoulders top in the stock).

Two other reversal patterns are worth mentioning. They are normally rare, but appeared often enough this year to signal to technical analysts that something was amiss. The Broadening pattern, a series of three higher highs and two lower lows, appeared in Nokia and Juniper Networks.

Such patterns can sometimes have a flat top or bottom, and in the case of Nokia, can sometimes go on to make a fourth high. The pattern has a particularly fascinating history; it occurred so frequently in leading stocks leading up to the 1929 crash that the appearance of broadening patterns struck fear into technical analysts for decades afterw