September 4th, 2009
I would be dishonest if I didn’t show you a new pattern in the S&P 500 I have been noticing over the past several week but haven’t yet mentioned. It’s important to talk about because of all the debate as to whether the market is going to decline as the economy goes into a W-shaped recovery or bust out to new high territory as the US economy follows what appears to be recovery in Germany, France and emerging markets.
I’ve been thinking a lot about the question Jesse, a frequent commenter here, asked the other day when he wrote “At what point would you become a bear? What are you looking for in the market to convince you of this?” Innocent enough question but one that I may have brushed off to quickly by answering:
“A 20% move to 800? I don’t think I would ever predict that from this vantage point. Why should I? That would mean I’d have to dump all my stocks and go into cash and there’s no evidence to do that now. Move to 50% cash? Still not enough evidence.
In the same way that I wouldn’t invest 100% until the Index crossed above the 200-DMA, I wouldn’t go into 0% stock/100% cash unless the Index dropped to 870. That’s where the neckline of the failed H+S was (May-July). I guess if the Index broke below 870, that’s when I’d become a bear.”
As you know, I was one of the earliest proponents of the inverted head-and-shoulders bottom reversal pattern and have written extensively about a new upleg starting soon after after Labor Day. Here’s that now familiar chart:
Stepping back for another long-term view, you see another possible outcome in the charts. Here’s the same chart with another pattern:
Take the same chart, draw different trendlines and you see a dramatically different story. A rather large sloping, diagonal triangle better known as a “wedge”. As described in chart school at StockCharts.com, a rising wedge:
The rising wedge is a bearish pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. In contrast to symmetrical triangles, which have no definitive slope and no bullish or bearish bias, rising wedges definitely slope up and have a bearish bias…..
The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely. There are no measuring techniques to estimate the decline – other aspects of technical analysis should be employed to forecast price targets.
So here we have two huge patterns competing against each other for supremacy and control for the stock market’s future course over the next several years. Sort of like two summo wrestlers going at it right before our eyes. One heavy-weight is the inverted head-and-shoulder reversal going back a year indicating that a bottom has been put in while the other is a year long wedge consolidation indicating that bears have more pain to inflict as this rest comes nears its end. It’s conflicting situations like this that give “stock charts” a bad name and reinforce fundamental analysis. It’s ambivalence like this that underscores charting’s inability to predict, and reinforces its status as an art and not a science.
Some of you are going to write “Chart Guru, which do you think will it turn out to be: head-and-shoulder or wedge?” If you’ve been paying attention you would have known my bet is on the inverted head-and-should. But, I’ll let you in on a little known stock charting secret: we won’t know for sure until it’s over and then it won’t truly matter.
A chartist knows that patterns tell you when supply and demand are in equilibrium, when bulls and bears are fighting it out to control the trend. Trends tell you which has won and is in control. The best that charts do is act as timing mechanisms that alerts you that a new trend might has begun. While there’s equilibrium in the market, charts can’t predict what the outcome might be.
After you’ve read charts for awhile, you learn you need to remain flexible in your interpretations or run the risk of costing youself a ton of money. In this particular case, we’ll learn the answer very soon. If the herd of buyers succeeds, their demand will push prices convincingly above 1040, the inverted head-and-shoulder will have succeeded and the uptrend will continue to the next way-station. If, however, sellers begin crashing through support levels (crossing over moving averages, breaking below resistance trendlines) we’ll quickly learn there’s going to be more market trouble ahead and we’re gong to have to become cautious again and move back into cash. Again, I’m routing and betting for the bulls.