Four Theories on Three Indices

Deciphering the chaotic price action since Oct. 10 requires great powers of visualization and a big bottle of Advil. The extreme twists and turns are challenging all market technicians to make sense of the massive swings, and to predict future direction with some degree of accuracy.

I've been a pattern guy throughout my career, looking for directional clues in triangles, double bottoms and all those cute formations that add structure to otherwise meaningless market movement. Over the years, I've discovered that, inevitably, seemingly random price bars will eventually transform into perfect order, which is then followed by a new trend, higher or lower.

Without question, the last month of trading has generated the biggest and baddest sideways pattern I've ever seen on the major indices. I guess that isn't too surprising, considering that Market Volatility Index (VIX) shot up to historic highs nearly six weeks ago and then stayed there, instead of backing off when stocks turned higher last month.

SPDR Trust (SPY)

Click here for larger image.

Source: eSignal

The challenge right now is to decode this huge pattern and tell interested folks whether the next trend will be a big rally or an ugly decline. To complicate matters, there are actually two dissimilar patterns in play at the moment. This fly in the ointment raises the possibility of divergent action between the major indices in coming months.

Looking back, the S&P 500 and Dow Industrials printed their lows on Oct. 10, while the Nasdaq averages undercut those lows, before turning higher about two weeks later. Logically, a higher low yields a more bullish pattern because it points to greater demand. Conversely, a lower low supports a downtrend and sets the stage for new selling waves.

The S&P 500 and Dow stalled at lower highs last week, and then dropped into the current selloff wave. This raises the odds for a triangle or other diagonal pattern. These formations generally show five major swings before breaking out or breaking down. Currently, it looks like price is grinding through its fourth wave.

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At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Farley is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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