Trader’s Narrative

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.)

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:

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.

In April we played an easy guessing game to point out the strange similarities that the stock market is exhibiting almost to the day, six years apart.

Since then the similarity is even more striking as the S&P 500 index is in a clearly defined wedge formation. That’s why I decided to pull out my trusty “Technical Analysis of Stock Trends” by Edwards & Magee - the classical and definitive work on technical analysis - to see what they say about this formation. Here’s an excerpt from the pages they dedicate to the topic:

The Wedge is a chart formation in which the price fluctuations are confined within converging straight (or practically straight) lines, but differing from a Triangle in that both boundary lines either slope up or slope down. In a Rising Wedge, both boundary lines converge, the lower must, of course, project at a steeper angle than the upper.

It can develop either as a sort of Topping-Out Pattern on a previously existing uptrend, or start to form right at the Bottom of a preceding downtrend. It normally takes more than three weeks to complete… Prices almost always fluctuate within the Wedge’s confines for at least two thirds of hte distance from the base (beginning of convergence) to the apex; in many cases, they rise clear to the apex, and in some, they actually go a short distance beyond, pushing on out at the Top in a last-gasp before collapsing.

As a final note, we might add that the Rising Wedge is a quite characteristic pattern for Bear Market Rallies. It is so typical, in fact, that frequent appearance of Wedges at a time when, after an extensive decline, there is some question as to whether a new Bull Trend in in the making, may be taken as evidence that the Primary Trend is still down.

We can clearly see the definition of a rising wedge formation being realized on the chart. I don’t think there is any equivocation (if you disagree, let me know what you think the formation is):

And it looks very similar to what we saw exactly 6 years ago. With a few exceptions. Not shown on the chart is what happened immediately after May 2003. The S&P 500 continued to go higher, then lurched lower to retest the 920 level. This action broke the lower trend line and made many believe that a text-book wedge formation was playing out. I was one of them, by the way. Of course, it didn’t. Just as abruptly, the market again turned up and never looked back.

To explore why, I want to concentrate not on the similarities between the two scenarios but the differences. For starters, the 2003 wedge formed above a previous low (October 2002). Related to that, the long term moving average (200 day simple) was not only flat and turning up slightly, it was below the pinnacle of the wedge. Finally, 960 was an area of resistance for the index and when it was clear, there was nothing but “blue sky” after a lengthy base.

Right now I’m more focused on those differences and as I pointed out before when we looked at the market through Weinstein’s stage analysis, we need to do more back and filling before this bear is really over. I would be very surprised if the market didn’t look back from here. Shocked more like it since it would be the second time in 6 years it had fooled me in the same way!

To prevent that, I’m relying on an indicator which I didn’t know about back then: the Coppock Curve. Of course, even if the Coppock guide gives us a rare and valid bullish signal by month’s end it wouldn’t negate this scenario from playing out:

…the market falls once more but not beyond the swing lows it has already marked. This allows for the sideways action or basing which ameliorates the steep slope of the 200 day moving average and eventually sets up for a final push which takes price, along with the 50 day moving average, above the long term average.