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Journal of Financial Econometrics Advance Access originally published online on December 27, 2006
Journal of Financial Econometrics 2007 5(2):243-265; doi:10.1093/jjfinec/nbl012
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Copyright © The Author 2006. Published by Oxford University Press.

The Predictive Power of "Head-and-Shoulders" Price Patterns in the U.S. Stock Market

Gene Savin
     The University of Iowa

Paul Weller
     The University of Iowa

Janis Zvingelis
     Mesirow Financial

Address correspondence to Paul Weller, Department of Finance, Henry B. Tippie College of Business, The University of Iowa, Iowa City, IA 52242, or e-mail: paul-weller{at}uiowa.edu


  Abstract

We use the pattern recognition algorithm of Lo, Mamaysky, and Wang (2000) with some modifications to determine whether "head-and-shoulders" (HS) price patterns have predictive power for future stock returns. The modifications include the use of filters based on typical price patterns identified by a technical analyst. With data from the S&P 500 and the Russell 2000 over the period 1990–1999 we find little or no support for the profitability of a stand-alone trading strategy. But we do find strong evidence that the pattern had power to predict excess returns. Risk-adjusted excess returns to a trading strategy conditioned on "head-and-shoulders" price patterns are 5–7% per year. Combining the strategy with the market portfolio produces a significant increase in excess return for a fixed level of risk exposure.

KEYWORDS: kernel regression, stock prices, technical analysis

We are grateful to Bruce Lehmann, to three referees, and to seminar participants at the University of Iowa for very helpful comments, and to Ken French for making available the data on factor risk portfolios.

Received May 3, 2004; revised December 6, 2005; accepted November 27, 2006


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