Last week I noticed that The Practical Investor's MTCI sell signals had come unusually quickly after the buy signal of the previous week.  In addition, two weeks ago we saw the Nasdaq put in the best weekly rally in two years followed by an even larger decline last week! Yet we still haven’t taken out the March lows to confirm the bear market. Something else may be going on.

What we may be viewing is called a broadening formation or megaphone structure in the indices. We are used to seeing triangles with converging trendlines. This pattern has diverging trendlines. It is a highly unusual pattern for stocks or indexes, yet it currently appears in the Russell 2000, the Nasdaq, the S&P 500, the FTSE and other major indices. 

This is a failure pattern. However, the next leg up may go all the way to the upper trendline in the next week or so, but that is not necessarily a requirement for this configuration. The SPX may even put in a new high before this rally is over, if the formation follows true to form. Keep in mind that the end of this week marks the Fibonacci 61.8% time retracement of the decline from January 2000 to October 2002. Following a sharp rally, the likelihood is strong that a decline will follow, testing the 1087 intraday low of March 22nd. Following that, a retracement of 50% - 61.8% in wave 2. The decline from there could be devastating.

The NDX also shows the broadening formation. It, too, may test the 1500 resistance level before giving up and testing the March lows.  Following that, a 50% to 61.8% rebound will be followed by a very dramatic decline.

What we may be looking at is the commoditization of the major indexes. Historically, this formation is found quite often in the commodity and futures indexes, while occurring rarely in the stock indexes. For example, the only mention I can find of a broadening formation comes from A Technical Analysis of the Futures Markets, by John J. Murphy (pages 150 – 152). This supports my thesis that the stock markets have started to behave like the commodities markets.

If this pattern is the correct interpretation of the current market, both the bulls and the bears will be frustrated. A rally to new highs on the SPX will only heighten the emotional pitch of the Wall Street bulls and possibly cause the bears to stop out their positions. Then the real rollercoaster ride will begin. If you are short, this would be a good time to consider taking off some of your bear market funds and shorts against the rally in order to reposition at a better point. If you intend to “ride it out,” then check your resolve against a potentially very difficult and emotional scenario right ahead.

Part 2  

© 2004 Anthony Cherniawski
Editorial Archive

The Practical Investor, LLC is a State Registered Investment Advisor

CONTACT INFORMATION
Anthony M. Cherniawski
President and CIO
The Practical Investor, LLC,
State Registered Investment Advisor
East Lansing, MI USA
Email

The opinions of FSU contributors do not necessarily reflect those of Financial Sense.