Stocks: Price Patterns Are on Market's Side

A look at chart action in previous years suggests that the lows reached by major indexes in January and March will hold

We got some much needed relief from the sweltering heat wave in the Northeast last week. Unfortunately we did not get any reprieve from the energy market, as crude oil prices stayed above the $130 per barrel level and natural gas prices hit their highest level since 2005. Our call for a correction in the energy complex appears to have been early, and with it, our call for some stability and higher prices in stocks has been delayed.

On the plus side, the financials appear washed out again, and we think they are due for a counter trend rally in the near term. In addition, we are seeing some, but not enough, good signs from our cadre of sentiment indicators we so fondly embrace as a road map for the stock market.

Before we take a look at the good, the bad, and the ugly of the current market situation, we wanted to take a step back and look at historical, bullish reversal patterns and see if we can come up with some similarities to today’s formation. The question that has come up recently, during many in-house meetings is, what is the probability that the lows from January or March will be retested, or, heaven forbid, taken out.

Our immediate answer, based on the many intermediate- and long-term bottoms we have looked at, is a resounding "no". Once a double bottom or inverse head-and-shoulders bottom is complete, it is a textbook example of a bullish reversal pattern and technically suggests that the prior bearish trend has been reversed back to a bullish trend.

However, is there an example where a reversal formation was completed only for the market to rollover and retest the lows or make new lows. Evaluating price patterns can be somewhat subjective because they often don’t match the symmetrical ones seen in technical analysis textbooks, but we will do our best.

When looking for reversal patters, we will limit them to what we consider “major,” and, therefore, will only observe the ones that have occurred after a bear market or major correction. The last bear market that ended in March, 2003, was reversed by a triple bottom or inverse head-and-shoulders (H&S), depending on definitions and what index you are looking at. Once the bottom was complete, not even the top of the base of that reversal pattern was tested. The market put in a quick double bottom in 1998, and took off, never even retesting the base. The bottom in 1990/1991 was an inverse H&S, with additional shoulders outside the primary pattern. That low looks somewhat like today’s low in that the market broke out, then retested the base of the formation, however it never tested the low of the pattern. The final low during 1991 equated to a retracement between 50% and 61.8% of the rally off the closing low in 1990, close to the retracement we have seen today.

The completed double bottom in 1987 saw prices come back into the base of the pattern, but the low was never tested. The market bottom in 1984 was a double bottom with the eventual pullback after the pattern completion never dropping back to the base. The market bottom in 1982 looks somewhat like a triple bottom, as it was a series of lower lows and lower highs all in the same area. Once prices broke out, they never looked back. The double bottom in 1980 was never tested, while the top of the inverse H&S in 1978 was tested but not after a strong rally.

This takes us to the grueling bear market of 1973-74, which was reversed by a double bottom, as prices shot out of that punishing period for equities. However, during the middle off that bear market, after the DJIA had dropped 24% into the December, 1973, low, the index completed a double bottom, but quickly failed in monumental proportions.

So, we finally have an example. Or do we? The breakout out of that double bottom by the DJIA lasted all of four days, and the index was only able to rise 1.3% above the interim high of the pattern. The S&P 500 never completed a reversal formation during that period, while the Nasdaq squeaked out a double bottom before rolling over. So, we will discard that period as a failed reversal because there was not enough uniformity in the breakouts, nor enough time or distance once the breakouts occurred.

So, we are back to zero.

Moving to the bear market bottom in 1970, the DJIA put in an inverse H&S, while the S&P 500 put in some kind of bottom, we just don’t know what to call it. Nevertheless, once the indices cleared their respective bases, only the DJIA pulled back to a near test of the breakout point. Once prices broke out of the inverse H&S in 1966, they rose for about eight months before pulling back and testing the breakout point or top of the H&S pattern. The double bottom in 1962 was another success with prices rising into the 1966 high. The complex low in 1957-58 was another major low that worked out and, while the base was tested following the breakout, the lows of the pattern were not.

Well, we have to go all the way back to the latter part of the 1940s to find a completed reversal pattern that failed. So, it can happen, but not very often. In late 1946, the S&P traced out a complex bottom, broke out strongly, then came all the way back to undercut the lows from 1946. In 1948, the “500” broke out again only to have the gains wiped over the next year, with prices once again taking out the prior low. So, we have to go back 60 years to find a period in market history where a breakout following a bear market or major correction failed.

If we can come back to the present, we got a continued washout in the financial stocks, and the recent price deterioration is bordering on historic weakness. In the 25 days that ended on June 11, the KBW Bank Index (BKX) has plummeted over 23%. Going back to 1994, this pummeling has only been exceeded twice; in July 2002 and August 1998. Both of these were excellent times to commit funds to the banking stocks as well as the overall market. In both cases, the financials rallied, retested the lows and traced out double bottoms, and then took off.

Taking a look at the S&P Financial SPDR (XLF), we have seen a similar cascade in prices. In the 27 days ending on June 11, prices have fallen over 19%. This was exceeded in January 2008, and then way back at the bear market lows in July and October 2002. So, in the not too distant future, we expect a strong counter trend rally in the financial sector, but all within the confines of an ongoing bear market. We suspect it will take many more months, if not years for the sector to stabilize, base, and then move higher.

We are starting to see some encouraging signs on the sentiment front, but may need more price weakness in the overall market to throw all our indicators into a bullish mode. On the positive side, the Consensus poll has dropped to only 29% bulls, not far from the recent low in March of 22%. The AAII poll is showing 54% bears and 31% bulls, not quite at the pessimistic levels we saw in January and March of 59% bears and 20% bulls, but certainly getting there.

The ISEE Sentiment Index had two straight readings last week in the mid-70s, the lowest and most pessimistic this index has seen since March and early April. During the market bottom in January and March, the index fell below 60, so we are moving in the right direction.

However, at many bottoms, there is a series of daily readings that are very low, not just two instances. The one concern on the sentiment side is the levels of overall put/call ratios on the CBOE. Using the last couple of years as a guide, the 10-day and 30-day total CBOE put/call ratios have spiked well above current levels at market bottoms, so we think we may need some more buildup of pessimism in the options market, and therefore, weaker stocks prices, before we can trace out another strong and durable low.

With the study we just did, and considering where all the sentiment indicators lie, we still think that some more price weakness is needed to increase the bearishness among the sentiment tools we rely on, but we think the weakness will be contained above the March closing lows of 1273 on the S&P 500.

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