A Major Bottom?

A chart pattern that marked tops in many tech stocks a
year ago
is beginning to show up in reverse in many of the same
stocks, signaling a potential bottom.

The pattern is called the head and shoulders, and it marked major tops
last year in stocks like AOL, Amazon.com and JDS Uniphase.

The pattern’s opposite, called an inverse head and shoulders, is
beginning to show up in leading stocks like Juniper Networks , Ciena and Microsoft , among others.

We’ll begin with Network Appliance , this week’s
Company of the Week (http://www.wsrn.com/COW/) and one of the few
inverse head and shoulders patterns to be completed with a break to the
upside. The others are still theoretical until they break out.

Here’s a chart of the Network Appliance pattern:

The pattern is essentially an upside down head and shoulders, with a
neckline that marks the breakout, or the pattern’s completion. The NTAP
example is a particularly nice one, because the pattern was broken by
the required 3% on a closing basis, and the neckline was successfully
retested on Friday, confirming the breakout. The projected advance out
of a head and shoulders pattern is arrived at by measuring the distance
from the tip of the head to the neckline, and projecting that advance
from the neckline, or breakout point.

The head on NTAP was at 11.44, and the neckline at 23.50, giving the
stock minimum upside potential to 35.56. The pattern is considered a
major trend reversal (a bottom), so NTAP should exceed the potential
upside target if the trend reversal is for real, just as many stocks
exceeded their minimum downside targets on the way down. These are not
short-term price projections, however; just as it took two months to
form that pattern, it should take at least that long to reach the $35
mark. And the pattern could still fail on a 3% closing breach of 23.50
support.

A look at the psychology behind the pattern offers reasons for its
effectiveness; it was certainly a deadly accurate pattern on the way
down. The head represents capitulation, or investors throwing in the
towel in one final selling frenzy. The subsequent rally catches those
who sold (or who didn’t buy at the bottom) by surprise, and they buy at
a higher level, fearing they will miss out on something, thus creating
the right shoulder. By the time the stock breaks out, its trend has
changed through a series of higher highs, with buyers willing to pay
higher and higher prices for the stock.

A few other examples that are appearing in stocks at the moment:

Juniper’s pattern is particularly nice. With a bottom of 28.60 and a
neckline of 66, Juniper could be headed to 103 on a 3% closing break of
66:

Microsoft’s pattern is a massive one. The stock could be headed to 102
on a 3% closing break of 71:

Ciena and Check Point have somewhat sloppier
necklines, because investors bid them higher in the frenzy following the
latest surprise Fed rate cut. But Ciena could be headed to 101 on a
close 3% above 62, and Check Point could be headed to 106 on a close 3%
above 73.

Even some fallen leaders are breaking out of similar bottoming patterns.
CMGI has already exceeded its upside potential and
will likely need to consolidate before further moves.

The appearance of many of these important patterns at once is worthy of
note, but it remains to be seen whether the upside targets will pan out,
or whether it will turn out to be one more bear market rally fooling
investors. Fundamentals in all but a few tech stocks have fallen apart –
three notable exceptions include Juniper, Ciena and Check Point – but
perhaps the market is telling us something about the ability of the
fundamentals to rebound in the face of the most aggressive Fed rate
cutting in history.

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