Bearish wedge an early warning sign for markets

January 21, 201311 Comments

I read that a recent Merrill Lynch survey of mutual fund managers noted the following:

The new year sees asset allocators assigning more funds to equities than at any time since February 2011, while their confidence in the world’s economic outlook has reached its most positive level since April 2010. Investors’ appetite for risk in their portfolios is now at its highest in nine years…”

Interestingly, from April 2010 to last week (January 18, 2013), when the appetite by fund managers for risk was low, equity markets generated strong returns. The S&P 500 Index made about 27% in that period. Thus, even so-called “sophisticated” investors can sometimes be a contrary market indicator. Contrarians might buy when they (fund managers) are bearish, and sell when these folks are bullish.

Coinciding with this increased appetite for risk by both institutional money and individual investors are a few factors that make me a bit nervous. 

  • First, we are steadily getting closer to the S&P’s 12-year highs – a very significant point of technical resistance that has failed to be broken even in better economic times. 
  • Second, we are well into a 5-year market cycle and due to peak within a very short time period. Here is my original July 2012 post on this cycle, which was also present in the last secular sideways market (1965 – 1982): https://www.valuetrend.ca/?p=1325
  • Third, we are about half way through the bullish seasonal period (November – April) according to the “Best Six Months” seasonal strategy. This gives us only a few more months of relative outperformance expectations from the markets. 
  • Lastly, there appears to be a “rising wedge” forming on both the S&P500 and the broader NYSE composite index. Thanks to reader Dave for noting this in a comment a couple of weeks ago. Note also on this weeks charts that the NYSE composite is now attempting to break its 2011 highs, something that I have mentioned before as not having happened yet (https://www.valuetrend.ca/?p=1533). A failure to remain above the 2011 highs by this index will signal weak market breadth.

I should mention here that ascending wedges are usually thought to be long-term bearish patterns. This formation is not one to trade off of immediately. In other words, don’t sell everything and run for the hills just yet. Patterns like a rising wedges are warning signs. They generally should not be traded until the formation breaks – however, there may be reason to sell before a break occurs in the current situation. Let me explain:

It is my opinion that markets will hit their old highs (S&P target of 1550-ish) before a topping process begins. The fact that markets are quickly approaching their long-time ceiling, a 5-year cycle peak,  coinciding with contrarian bullish institutional and retail sentiment, may indicate that we will indeed have plenty of reason to be selling as this wedge formation completes itself. 

I remain long the markets, but look to raise significant levels of cash as my market targets are reached. This means that I may not wait around to see the current wedge pattern break. My reasoning behind an early exit – or at least trailing stop loss orders on certain stocks – at or around the aforementioned target levels revolves more around the longer termed technical resistance and cyclic patterns noted above.

11 Comments

    • Thanks again Dave. I like to say we are in the last inning of the ballgame. Or the last hour of the party before we have to go home. Either way, enjoy it while its here- but have an exit plan.

      Reply
  • Keith: Would you add to your reasons to be cautious the falling volume evident since August 2011.

    Reply
    • Yes–it (low volume) is a sign of lower market participation–or participation by more concentrated players I would guess. Either way, it doesnt help. thanks for the comment.

      Reply
  • Hey Keith, I also believe in the five year cycle. I have noticed, that since 1950, the S & P 500 will have a 14% plus decline either in years 02 or 03, and in years 07 or 08. This has happened in 10 out of the last 12 five year cycles. The two times it did not happen, was during the second half of the 60’s, where you had a 14% plus decline in 66 and 69, but not in 67 or 68, and there was none in 92 or 93, as the markets went sideways. You had a 14% plus decline in 53, 56-57, 62, 73-74, 76-78, 80-82, 87, 98, 00-02 and 07-09. Four of them started a bit early, but most of the damage came in 57, 77, 82 and 02. Since we did not get a 14% plus decline in 12, this tells me the chances are very high that we will get it this year. Once we hit the peak selling period for most stocks, in April/May, I look for another 14% plus decline to start. Time will always tell if I am right.

    Reply
  • Kieth: What about an upwards channel for the S&P? On the same weekly chart I can see an upward sloping resistance line being drawn from the low set in June 2011 and connecting with high in Sept 2012. The support line can be drawn similar to the one in the bearish wedge, but consider starting at open of the first week of Oct 2011 instead of some where in the tail. This gives an upward sloping channel and allows the index to reach the 1550 high.

    I agree the 1550-60 area will be key, and the S&P is likely to reach that area and then begin a new significant decline. Inflation could be the catalyst and then the Gold trade will be on.

    And how about the TSX setting a new 52-week high last week? It also looks to be breaking through significant resistance at 12,750. The Point & Figure chart looks really interesting using a percentage scaling method. Should the index reach 12,900 (just 1% away) it would be a major break out and the index should easily reach 14,000+ territory.

    Reply
    • Good points Grant
      And like you observe, chart formations can be drawn from differenct vantage points to create different results–thats why sometimes charting is known as an “art”.

      And yes, the TSX is outperforming –resistance lies around 13,000 as you say–not sure if it would be able to break that if the S&P starts to round over. We’ll see. I am overweight TSX vs. U.S. equities in the meantime.
      The great thing about TA is that you are allowed to change your mind as things change!

      Reply
  • Keith,

    How sharp a selloff could there be once S&P hits 1550, and would that likely mean another 5 year downtrend? Because of the hyper activity of Central Banks, whose massive intervention has truly distorted the markets, could things be totally different now? For example, there were multiple attempts in the 1970s to break out, and it didn`t happen until 1981, when the P/E valuations were less than 10. Is that what has to happen again for a true breakout through resistance to occur?

    Should there be another bounce off 1550 downward, what would be a good shorting ETF to consider to play the downward move and trend?

    Can I have your opinion on YCS? Also, what do you think of NFLX`s chart? Thank you and always enjoy your appearances on bnn.

    Reply
    • Martin–I tend not to get into individual stock charts on this blog, but happy to comment on the S&P index outlook.
      Typically in the 5-year cycle that I have been talking about on BNN and via this blog, the bear-phase of that cycle is much sharper and shorter than the bull phase. Thus, after a topping pattern completes its self (if it in fact does occur–I could be wrong!), I would expect the selloff to happen over just a few months. My intial downside target is 1100 for the S&P500, but like all things in life–we must be flexible with our targets.
      Could it be more severe? -yes. Will the market need to get to a PE of 10 before the final trough is in place and a true bull market emerges? Thats a good question–historically, that has in fact been the case before most true bull markets (especially if you follow the Shiller PE). It’s not a hard-and-fast fact as a criteria for a bull market, but its quite possible that we will need that to occur before a multi-year bull arrives in the future, based on many cases in the past.

      Reply
  • I would not be inclined to see the wedge pattern drawn out on the chart of the S&P. The starting point would probably be okay but there are no hits along the way, and the ending point might not yet be established. In any wedge or channel formation, several hits along the formation should occur. It looks more like a channel since there are several hits to both lines along the way, the last upper hit still to be confirmed. Coming out of a rising wedge would be sudden and deep, but from a channel not so much. Either way, it’s fun to watch and draw and sometimes to trade these formation.

    Reply

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