February 20th, 2008

Symmetrical Triangles or Moving Averages

This is what makes a market …. identical views of the same data leading to completely opposite conclusions. Specifically, I’ve seen several blogsters writing that the S&P 500 Index is close to completing a symmetrical triangle with the hope that it will be resolved with an upside breakout:

  1. Trader Mike wrote on February 19: “The indices closed right in the center of triangles they’ve been building. The good news is that those triangles are closing on themselves quickly, so they’ll have to be broken soon. Unfortunately, that doesn’t mean that the indices won’t remain range-bound. I imagine we’ll need some real news — good or bad — to break the market out of its sideways march. Maybe tomorrow’s reports, the CPI and/or the FOMC Minutes, will do the trick…

  2. Woodshedder at iBankCoin.com wrote also on September 19: “I feel more confident trading triangles because I understand the psychology that shapes their development. The triangle starts with a period of extreme volatility and ends as volatility stabilizes. The price bounces up and down, coils tightly, and then stabilizes. Its as if all the market participants finally reach an agreement on price, if only for a day. As the triangle breaks, it is usually very clear as to which side has taken control.

    As these triangles form, volume decreases. Both sides are waiting to see where to place their funds. As most will place their money with the herd, following whatever direction the index breaks out to, the addition of this sidelined capital will accelerate any move.

    As triangle consolidations are typically continuation patterns, should these index triangles break to the downside, a re-testing of January lows seems inevitable. Should these triangles break to the upside, I expect the SPY and DJI to regain their 50 day averages fairly easily. Once the indexes re-gain and test their 50 day averages, I will again be a bull. As it stands, I’m market-neutral in terms of positions, but am ready to add shorts as soon as these triangles confirm.

[As an aside, I traded comments with the author as to whether a symmetrical triangle was either a “consolidation” or a “continuation” pattern … my argument was essentially that a “rose by any other name ….” ]

But my expectations of the current situation were outlined in my previous posting, ”10-20 days to a stock market crash”. Although as a chartist I strongly concur with everything said about symmetrical triangles except that I don’t believe it necessarily holds when applied to an index of a group of stocks. By definition, an index is comprised of many stocks, the chart of each evolving from its own unique set of dynamics. The only thing linking the stocks comprising the index are the background macro-economic forces and these take a longer time to unfold than is allowed in the above chart’s 4-5 weeks chart.

What drives all charts, particularly charts of market indexes, is momentum. Market momentum, or investors’ psychology, matures over extended periods and once set in a direction don’t, on their own without an external driving force, change that direction. After extensive research, I’ve found that moving average(s) are the most reliable measure of market momentum.

Even more important (and more reliable, I should add) than the symmetrical triangle written about by others is the fact that the 180-day moving average is on the verge of crossing down below the 300-day moving average. The 90-day and 60-day moving averages have already done so. For the momentum to unflinchingly and convincingly turn and move the market higher, the index would have to move back up above the 90-day moving average and that has happened in only 7.6% of cases based on over 40 years of daily trading data that the relationships existing in today’s chart of the S&P 500.

It’s more likely, occurring in nearly 60% of cases, that the 180-day moving average drops below the 300-day before the Index crosses back above the 60-day. And when that happens, significant further downward momentum pressure ensues.

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