SP500 - Is rally over - for now?

US stocks have been on a tear for 6 months now. However with the extreme uncertainty in the Middle East and energy prices soaring, the headwinds have been building for a while.

Yesterday's sharp correction lower, followed a reaction to the prior week's sell-off which saw a decent 76.4% rebound. - The big question now is whether the larger rally is over, and if so do we head much lower. - Looking at the clues, the signs are increasing that the rally may be close to terminating. The chart below shows how the market has continually made higher reactions lows over the past 6 months, this continues to be the case, however if the price of the SP500 breaks the last reaction low from last week at 1294.4, then this sequence will be over. - In addition, price action since late December appears to have formed a 'Rising Broadening Top / Megaphone' pattern. These type of formation are often seen at trend ends (although they can be notoriously tricky to navigate as trading signals). Saying that however, the fact that this pattern is rising, as opposed to the more usual sideways, suggests to me that the underlying upward trend is probably very strong. Hence, I would suggest that a deep reversal lower is probably the less likely scenario, with any breakdown of the pattern seeing some further correction possibly to somewhere in the region of 1260/80 before a sideways ranging or sideways/upward ranging market starts to take hold. - If on the other hand 1294.4 holds, then it is quite possible that the trend is still up, or at worst market enters a prolonged sideways range in the low 1300s. - One can of course not rule out a much deeper retrace, but I think this would be more likely to occur after more prolonged topping action.

For the record, I last discussed 'Broadening Patterns' in light of the market last summer (See link here). This shows how difficult trying to identify and neccessarily make conclusions from these type of patterns is. Hence, I would be careful not to use the signals from Broadening pattern without looking at all other underlying factors and considering other alternatives.

Broadening Patterns : SP500 + World Equities Bigger Picture.

Yesterday proved to be a day of consolidation across many markets. Even then, US equities managed to surrender any gains, and finish close to the lows of the previous day. - Equities remain very much on the defensive, in light of this I thought I would take a step back from the looking at the near-term picture, and see how markets look from the distance.

The chart below is the Weekly SP500 Index with volume. I have highlighted the pattern that I consider the dominant feature of this market, it is a 'Broadening' pattern [also known by many other names - 'Expanding Triangle', 'Megaphone pattern', 'Reverse Triangle', etc.], which has formed over the past year. - This is one of the most complex and hardest type of patterns to trade. Identification of the pattern is often not immediately obvious, in many cases various other patterns and set-ups appear to be occurring, which add to the confusion by creating many cross-currents. - I think anyone who has tried to make sense of the Equity markets in recent months may identify with that. - Even when the pattern has been successfully identified, trading it is not easy, unlike many other patterns it does not present Low Risk/Reward set-ups. 

Note on the chart above, how the 'Broadening formation' also occurred at the 2007 top.

John J.Murphy in his book 'Technical Analysis of the Financial Markets' (in my opinion - the Bible of Technical Analysis) shows a diagram of an idealised Broadening Formation. (See image below).

 
Murphy goes on to say - "This situation represents a market that is out of control and unusually emotional. Because the pattern also represents an unusual amount of public participation, it most often occurs at major market tops. The expanding pattern, therefore, is usually a bearish formation" . With regard to volume during the formation of the pattern Murphy says -“The volume pattern also differs in this formation.  In other triangular patterns, volume tends to diminish as the price swings tend to grow narrower.  Just the opposite happens in the broadening formation.  The volume tends to expand with the wider price swings.”

The current pattern on the SP500 pretty much accords with Murphy's idealised description, with one exception; the lower line on the pattern is not downward sloping, but is slightly upward sloping. This is not an issue in my opinion, as it is the character of the formation that is important, it may also be that this is a feature of broadening formations on equity markets, as was the case in 2007.


Broadening Patterns (or variations of them) also appear on a a number of other US and Global equity markets over the past year.  This can be seen on the following group of charts: -

 (Click on charts to enlarge)

DOW INDUSTRIALS

DOW TRANSPORTS

NASDAQ

EUROSTOXX 50

NIKKEI

BRAZIL BOVESPA

AUSTRALIA ASX 200

As with most of my analysis, there is usually a caveat, and in this case there are two: Firstly, I see price patterns not as predictors of future price action, but rather as probability set-ups. Thus there is always a chance that a potential reversal pattern does not follow through and lead to a reversal. Secondly, as has already been mentioned, this particular price pattern is more complex than most, and patience and a close watch on the shorter-term set-ups are essential if one is going to profit from this. - Nonetheless, this is a strong Bearish set-up, and it is prevalent across a wide range of markets. - Shorter-term, as I mentioned yesterday, there may be some consolidation if Wednesday's low can hold, however this bearish pattern should continue to hang over the market like a Very Large Dark Cloud.

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Finally as per the previous couple of Fridays, I will leave you with something for the weekend..... This time it is a more unusual, slightly quirky offering.  -- You will either love it or hate it.......... Me -  I love it.

This is the 'Ukulele Orchestra of Great Britain' does 'Nirvana'.

Have a good weekend :-)