Friday, September 09, 2011

Classic Bear Flag Is Snapping in the Breeze

Two bearish patterns dominate the chart of the U.S. stock market.

Technical analysis is a process of pattern-matching and assessing probabilities of future price action. From time to time we get beautiful, classic chart patterns, and this is one of them: the chart of the Dow Jones Industrial Average (DJIA) has traced out not one but two classic formations: a bearish flag, and a triangle/wedge. (The S&P500 looks very similar.)

In the usual scheme of things, bearish flags resolve to the downside, and triangle/wedges resolve in the direction of the trend, which is currently down. As TA folks say: surprises tend to happen in the direction of the primary trend.

In a wedge/triangle (a formation with many variations such as pennants), price traces out a pattern of higher lows and lower highs, compressing price action into the apex of a triangle as buyers and sellers reach an uncertain equilibrium.

As price gets squeezed into a narrowing band, the likelihood increases that price will break out of the triangle, either up or down, in a major move. While Bulls might discern hope for a breakout to the upside here, the presence of the bear flag lends weight to the bearish expectation of a continuation move in the downtrend.

One feature of chart patterns is their fractal nature: they appear in charts of all durations. Though we usually look for a head-and-shoulders "topping pattern" in longer term charts, this 15-minute (10-day) chart certainly exhibits head-and-shoulders-like characteristics:

Nobody knows what will happen tomorrow or next week, much less next month, but if these patterns are setting up a distinct possibility that the current snapback rally is simply resolving oversold conditions, and that a continuation of the trend (down) will soon reassert itself.

Probabilities are not guarantees, and the past is not a template for the future, it is only a palette of possibilities.

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