S&P 500 Teeters on Wedge

Once in a generation or so, you can spot a chart that has extremely important long-term consequences. The first chart below is such an animal.

It shows U.S. stock prices deflated by commodity prices back to 1800. The stock part of the equation consists of the S&P Composite since 1926 spliced with several other indices back through the ages. The commodity series is the CRB Spot Raw Industrial since 1955, which has been spliced into other historical commodity series.

The momentum indicator in the lower panel is a 120-month rate of change. It is a little-known fact that there is a close relationship between momentum and sentiment. Thus, high readings in this indicator correspond to previous stock market bubbles. The theory is that when the oscillator peaks from a high level, it tells us that the stock market bubble has burst and that the psychological pendulum has begun to shift in the opposite direction. This then needs to be confirmed by a trend reversal in the equity series.

For this purpose, it is possible to construct five trendlines between 1800 and 1980. When each line was violated, it confirmed a secular bear market in commodity-adjusted equity prices. Last month, the secular, or very long-term, up trendline from 1980 was violated, the sixth occurrence since 1800.

In the past, each break has been followed by an average decline in "real" terms of 60% and lasted about eight years. If that were to happen in the current situation, it would take real prices back to their 1994 levels. (Click here for a more in-depth explanation of the long-term bear market scenario.)

So much for the long-term signal. Where does that leave us in the current cycle? The next chart below shows the S&P 500 since 1994. From this perspective, it seems that the S&P has been tracing out a three-year giant wedge pattern.

Historically, technicians have regarded wedges as short-term counter-cyclical patterns, lasting perhaps three or four weeks on the daily charts. Bearish wedges are preceded by a decline, and the wedge itself is a rally that is contained within two rising but converging trendlines. When the lower line is violated, the pattern is completed, and prices work their way lower again.

In my book on price patterns (page 191), I describe a variation that I term a Giant Wedge as "typically much larger (than a standard wedge), and tending to develop at the end of a trend. Occasionally it encompasses the whole trend. ... When they can be correctly identified, giant wedges are often followed by sharp reversals."

Closer examination of the potential wedge in the S&P's chart indicates that it could well turn out to be a countercyclical rally against the dominant (bearish) secular downtrend described earlier.

The next chart shows this potential formation in greater detail. Note that the S&P experienced a false breakout above the line marking the upper part of the wedge in early May. Typically, whipsaw moves such as this are followed by above-average moves in the opposite direction of the breakout; this suggests that the wedge will be completed sometime during the summer.

If so, the arrows in this chart suggest that the S&P could fall to the 1100 area. This is not a prediction but merely a statement of the outcome of the technique of measuring the maximum depth of the pattern and projecting it in the direction of the breakout.

The last chart shows that volatility is picking up. In this instance, I am using the six-month volatility (VIX) smoothed with a five-day moving average. Please note that the actual series has been plotted inversely to correspond to price movements in the S&P. When the average violates an up trendline (indicating a trend of greater volatility), prices typically decline. The exception would be with a parabolic run-up, but the S&P did not experience such a characteristic in the last eight years. A couple of weeks ago we saw the violation of a three-year up trendline, the longest on record, dating back to 1998.

The key point to note here is that the wedge represents a trend of declining volatility as the S&P has traded in a narrower and narrower band. On the other hand, the trendline break by the VIX indicates that a new trend of rising volatility is under way. That can only mean one thing: The wedge will be completed, and prices will begin to cascade down.

If this scenario does play out, the signal to look for would be a decisive Friday close below both the lower trendline in the third chart presented above and the 65-week exponential moving average. Because the average is the lower of the two at 1242, let's play it safe and use 1235 as our benchmark.

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Martin J. Pring is president of pring.com, and is actively involved in Pring Turner Capital Group, a money management firm. He also publishes the monthly market letter "Intermarket Review." Pring is the author of several books, including Technical Analysis Explained, and numerous educational, interactive CDs. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Pring appreciates your feedback; click here to send him an email.

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