Hang on, you rollercoaster lovers, you’re in for a ride. Keep your belt buckled and your hands inside the car. The expanding triangle formation is playing out in a number of indices. In my original article, “Ready to Ride the Rollercoaster?,” I introduced the broadening formation, or expanding triangle. The reason for my research is that the expanding volume that accompanied the expanding price swings were giving false signals to our Monthly Trend Change Indicator.  I finally found what I was looking for in John J. Murphy’s Technical Analysis of the Futures Markets, New York Institute of Finance, 1986.

This is a formation that usually occurs in the futures and commodities markets. To the best of my knowledge, I have not found the expanding triangle or expanding formation in any of the stock indices prior to this date.  I have found occurrences of an expanding formation at major tops of individual companies, however. One such case was Air Reduction Corporation, which experienced this formation followed by a 75% decline in 1929.

On page 150 of Murphy’s book, I quote, “The volume tends to expand with wider price swings.  This situation represents a market that is out of control and unusually emotional. Because this pattern also represents an unusual amount of public participation, it most often occurs at major market tops.  The expanding formation, therefore, is usually a bearish formation.”

The most common shape of this pattern can be seen in Figure 1.  The pattern most commonly can be visualized with three successively higher peaks (points 1,3 & 5) and two successively lower troughs (points 2 & 4). According to Murphy (page 151), “It is obviously an extremely difficult pattern to trade because a number of false signals take place during its formation.  This pattern also contradicts much of what has already been said about the trend-following approach in the sense that the penetration of a previous peak usually indicates resumption of an uptrend, while the violation of a previous low normally signals either the beginning or the continuation of a downtrend.  The trader who is using upside and downside breakouts as action signals will be subject to a series of bad signals.”

The pattern follows through with a violation of the lower trendline running from point 2 through 4.  It finally completes with a 50% reversal of the decline from point 5 to point 6.  While point 5 usually moves higher than points 1 and 3, it may stop at the same level as point 3 or fail to reach the same level as point 3.  In this “failed pattern,” the formation begins to resemble a head and shoulders formation with a down-sloping right shoulder.

Following figure 1, you will find a study and commentary on some of the expanding formations currently existent.

Figure 1.  (Source:  Technical Analysis of the Futures Market, by John J. Murphy)

Based on the model in figure 1, the SPX sports two “failed 5s” at different degrees. The same pattern may also be found in the OEX. The smaller red triangle is complete to point 7. Red point 8 also corresponds with blue point 6, which has a likely terminus below the blue trendline, in the vicinity of 1050. Based on our target for blue 6, the SPX has a likelihood of rallying back up to 1100 to hit blue point 7.  Point 8 has a strong target zone (support area) between 965 and 1000. Be aware that the rally from point 6 to point 7 could fail, as the rally from point four to point 5 has already done.

In the Nasdaq 100, points 1 through 4 follow the pattern. In order to complete the pattern, the Nasdaq 100 must violate the trendline running from point 2 through point 4 (possibly to 1350?), then terminate its subsequent rally near 1400 for point 7. Point 8 has a strong affinity to 1250 or below.

The NYSE Composite index has either completed to point 6 like the SPX, or it may still be working its way in that direction, like the NDX.  A likely target for point 6 may be 6000, while the next target for point 8 may be in the 5450 to 5650 range. Note that while point 7 normally retraces 50% of the prior move, it could just as easily retrace only 38.2%, which would place it closer to red 7.

The Russell 2000 appears to be further along, having completed to wave 6 and possibly working its way to point 7 as this article is being written. An alternate interpretation may be a smaller degree triangle now forming with a shorter-term target near 520, while the ultimate resistance area for point 8 being in the 440-480 resistance area. In other words, the much-favored small caps could see a 25% initial decline before the completion of the pattern to point 8.

The foreign markets aren’t exempt, either. The London Financial Times Index is sporting a very well developed expanding formation that may not have progressed quite as far as its U.S. brethren. Point 6 could be below 4250, while point 8 may find support at 3600.

No place to run. No place to hide. The Dow Jones World Stock Average is also well along in its development of the expanding formation.  Folks, this is a world-wide phenomenon. Not all of the countries have this pattern, but cumulatively, this pattern seems to dominate the world picture. 

$30/barrel oil, anyone? The CBOE Oil Index is sporting a near-perfect expanding formation, which has a target of 264 for point 8. That would translate into oil prices dropping to the $30 per barrel range. It is no exaggeration to say that everyone is emotional about the price of gasoline at the pump. Therefore, it should be no surprise to market technicians that we could see a very surprising outcome.

Warning to Elliotticians

The current wave formation is leading many Elliott Wave followers to interpret point 6 as the bottom of a cycle wave four. They may be making a classic mistake by ignoring the “bonus wave” in this pattern. It is a 5-wave pattern, not an A-B-C pattern. The first three indices in this study may be sporting “truncated 5^th waves,” while the last three indices show the normal formation. The reason for this confusion is that all five waves consist of A-B-C waves of a smaller degree.

 The only wave pattern noted by R.N. Elliott that was 5 waves constituted of smaller 3 wave patterns was the Ending Diagonal. (Elliott Wave Principle, by Frost and Prechter, (page 26). Since Mr. Elliott limited his studies to the stock market and probably did not study commodities or futures, he may never have observed expanding triangle formations, or chalked them off as aberrations, since they were so rare. Robert Prechter wrote in his Elliott Wave Theorist –October 28, 2003 edition of a discovery of a new formation, which he named an expanding diagonal triangle.  This fits the pattern that I have been following in this article. These waves consist of 3-3-3-3-3’s. Every one of the illustrated indexes fit the pattern.

Conclusion:

The expanding triangle formation is a bearish formation. As I stated in my previous article, “both the bulls and the bears will be frustrated.”  Sharp rallies after sharp declines will only heighten the emotional pitch of the market and possibly cause the bears to stop out their short positions. The anticipated decline to point 6 in the U.S. indexes will get everyone’s attention. The rally into point 7 will do its darnedest to shake out the bears. The rollercoaster car is clicking to the peak. Check your seatbelts, folks. You’re in for a wild ride!

© 2004 Anthony Cherniawski
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