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Comparing Flag Formations: Then & Now at Trader’s Narrative

technical analysis of stock trends edwards magee

In mid May, I pointed out the similarities between the technical formation we were seeing now and what we saw at the end of the bear market of 2002-2003: Comparing Wedge Formations: Then and Now. The S&P 500 has fallen out of the wedge formation - by trading below the lower trend line (see previous link for charts).

Something else noteworthy: the S&P 500 closed above its own 200 day (simple) moving average. For those keeping count, the index has spent 358 trading days below that threshold. And this is the second longest streak in its history! The one that was longer? You guessed right if you said sometime in the 1930’s (August 5th 1932 with 414 days).

The Nasdaq closed above its long term moving average in early May and then spent the whole month bobbing and weaving above and below to finally close 8.5% above it today. Even the NYSE Index managed to climb above this line in the sand. The Dow is the only major index still not above its long term moving average.

The next formation that we may end up seeing is what occurred in 2003: a flag consolidation pattern. According to Technical Analysis of Stock Trends by Edwards & Magee:

An Army that has pushed forward too rapidly, penetrated far into enemy territory, suffered casualties and outrun its supplies, must halt eventually, perhaps retreat a bit to a more easily defended position and dig in, bring up replacements and establish a strong base from which later to launch a new attack.

A Flag looks like a flag on the chart. That is, it does if it appears in an uptrend’ the picture is naturally turned upside down in a downtrend. It might be described as a small, compact parallelogram of price fluctuations, or tilted Rectangle, which slopes back moderately against the prevailing trend.

These pretty little patterns of Consolidation are justly regarded as among the most dependable of chart formations, both as to directional and measuring indications. They do fail occasionally, but almost never without giving warning before the pattern itself is completed.

You can see the flag technical pattern in this chart from 2003. The script sounds familiar. After making a sharp low in early March and bottoming, there was a sharp rally that propelled prices almost non-stop until June. From then until the end of August, prices traded in a tight range. After this pause, prices continued to rise.

(As you’re comparing the two charts, note that the vertical scales are slightly different.)

pennant formation 2003 SP500

So far, we’ve seen a relatively small flag consolidation pattern which took the whole of May 2009 to develop. Here’s what we may see soon:

pennant formation 2009 SP500 potential

The benefit of such a scenario would be that as prices grind higher - two steps forward, one step back - the long term moving average would flatten much faster. Then it would rise to support prices from under. As you’ll recall, when we looked at the two wedge formations separated by 6 years, the position of the 200 day moving average was one of the glaring differences between then and now (Comparing Wedge Formations: Then and Now).

Obviously what I’m showing is hypothetical - no one knows what is in store for us at the hard right edge of the chart. But I can’t help but project this potential formation onto the chart because of all the other similarities which we’ve seen so far between the two market periods. Although I didn’t foresee this rally coming and actually expect lower prices in the short term, I’m trying to keep an open mind because this rally has angered and confounded everyone. Just take a look at the recent comments here from readers!

I’ve yet to read a comment from someone who is outlandishly bullish and riding prices higher. Instead all I see are various degrees of vitriol heaped on the market and anyone or anything that attempts to justify higher prices. That’s just an anecdotal layer of sentiment we can let fall atop all the other more formal ones. Just something to tuck under your hat.

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4 Responses to “Comparing Flag Formations: Then & Now”  

  1. 1 David Forster

    You are spot on regarding the view on sentiment. Most people using the web to trade / invest are hating this rally with a passion. Though the technicals do suggest we are overbought or will soon be overbought on an hourly (easily corrected) daily and weekly basis.

    The trade to frustrate the most people might be the one you have traced out - up sharply and then a retrace - maybe it occurs even faster and sooner than people expect.

  2. 2 Babak

    Yep, the market is a cruel vixen that heaps on the maximum pain on the maximum number of participants.

  3. 3 Paul

    Charts are bullish, more money piling in, straight up to 1050 by August absent a retrace catalyst. Although Rosenberg said 20% and for risk, any chance for any catalyst in sight to begin even a small 10% retrace?

  4. 4 Paul

    The rising 2-10 year spread topping affordable rates with higher unemployment could be the catalyst. But 1050 could happen before the catalyst.

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