S&P Flying Into a Triangle

For all the excitement it has generated, the rally from the mid-March lows has merely brought major averages back toward the top end of trading ranges, bracketed by the mid-October lows and early December highs.

A rally early Friday -- even after the unemployment rate showed official U.S. joblessness at 6% vs. the expected 5.9% -- had major averages again pushing toward the top of those ranges, but still ensconced within them.

Intraday action aside, various technical indicators say a true breakout to the upside may be imminent, but one developing chart pattern suggests a more unhappy outcome.

For a change, let's start with the bad news (for those long stocks). To the untrained eye, the outline of what's known as a contracting triangle -- characterized by a series of lower highs and higher lows -- is forming on the chart of the S&P 500.

By overlaying trendlines on the chart, a triangular pattern emerges that's wider at the beginning and narrowing over time. To wit, the S&P's trading range extends most broadly from its October low of 768 to its December highs of 954. More recently, the range has been compressed between the March 12 low of 804.19 and the April 29 intraday high of 924.24. (Other major indices have similar patterns but we're using the S&P as "the market" in this case.)

Also known as a "flag," the contracting triangle contains "at least two lower highs and two higher lows," according to StockCharts.com.


Brewing Triangle or Technical Breakout?
Even as the S&P's long-term downtrend line is threatened, more recent compression in the trading range could augur a return to the prior trend
Source: Natexis Bleichroeder

Since the market peaked in early 2000, there has been a string of lower highs, so the S&P's chart certainly qualifies in that regard. However, the mid-March lows represented the first higher low for the index. Thus, by its purest definition, there is not yet a contracting triangle for the index.

"I'm not sure I see any triangular pattern," said Rick Bensignor, chief technical analyst at Morgan Stanley. "You still have lower highs but higher lows only since the March bottom. There are mismatched timeframes," which the chart above illustrates.

One of the beauties of technical analysis -- its critical flaw to some -- is that various technicians can look at the same chart and reach vastly different conclusions. This speaks to the "art" of technical analysis vs. the science. (I know that's frustrating to many readers, but please accept it for this exercise, along with the omission of any discussion of fundamentals, which do matter.)

The market's October low being slightly below its July low creates a "running triangle" vs. a contracting one, according to Steve Hochberg, chief market analyst at Elliott Wave International in Atlanta. "It carries the same meaning and message as a contracting triangle."

In isolation, a triangle pattern (of any form) is neither bullish, nor bearish. "Triangles represent a pause in the trend, allowing the market to catch its proverbial breath," Hochberg explained. "Usually when they're done, the market resumes the trend in force coming into a triangle. If there's a triangle here, the trend before was a decline from the March 2002 highs."

A bearish forecast from Elliott Wave International should not surprise anyone familiar with the firm's work. On April 7, Hochberg thought the rally from the mid-March lows was nearing its conclusion and the S&P 500 unlikely to surpass 905.

While slightly off in assessing the recent move, Hochberg remains undaunted, and decidedly negative. "Both our top Elliott Wave count and this triangle carry the same message," he proclaimed. "A decline is imminent and to below the October lows."

The analyst's self-proclaimed "love for triangles" is that "you know exactly when you're wrong." In this case, any burgeoning triangle pattern will be invalidated if the S&P makes a higher high, meaning it surpasses the Dec. 2 intraday high of 954 (9043 being a comparable level for the Dow Jones Industrial Average). If those highs are exceeded "something else is going on," Hochberg said.

The good news (for those long stocks) is many other technicians believe something else is definitely happening.

Confluence of Bullishness

Morgan's Bensignor observed a "major downtrend line" connecting the August 2000 high to the March 2000 high intersects this week at just below 919. Not coincidentally, by his estimation, the S&P has been unable to close above that level, despite surpassing it several times intraday and was midday Friday.

"It's the first time we're testing this major downtrend line so it's no surprise if the market has some troubles here," he said.

However, each time the market tests the downtrend, that resistance is weakened. Furthermore, as time progresses the absolute value of the downtrend line gets lower, "so you need less to hurdle it each time," Bensignor said.

Describing the start of a "cyclical bull within a secular bear," the technician has an intermediate-term target of 973 for the S&P, which could occur in short order if that aforementioned downtrend line is breached. Finally, he observed the S&P's 200-day moving average will very soon exclude the final days of the big swoon last July. "Eliminating those numbers as closing prices could get the S&P's 200-day turning up and that's bullish for a technician," he said.

For various reasons (see above), several other technicians reached similar conclusions.

Martin Pring, editor of The Intermarket Report, said the market appears to be forming a bullish reverse head and shoulders pattern.

If the S&P closes above its Nov. 29 closing high of 935.58, "you're going to get a lot of people coming in and there will be quite a lot of shorts to cover," Pring said. "Sometimes when you come off major lows, you do get explosive rallies."

The veteran technician also noted "financial stocks are leading the pack, which is typical of the beginning of a new bull market." The Dow might even make a "marginal new high" before this "bull market within the confines of a secular correction" ends, he suggested, unwittingly echoing Bensignor.

Tempered optimism was also the message from Scott Bleier, founder of HybridInvestors.com.

The market is currently "eating through the graveyard of supply" in the areas of Dow 8500 and Nasdaq 1500, where a lot of "buried money" resides, Bleier said.

Thus far, the process is occurring with the market "hanging out close" to those "significant resistance points," which augurs positively, he said. A near-term pullback that "might look scary" is possible, but isn't preordained and "will remove a tremendous amount of supply," if it occurs, Bleier suggested. "Next time, we'll get through the graveyard."

John Roque, technical analyst at Natexis Bleichroeder, has been very skeptical about all rallies since the 2000 peak. But he too has become more upbeat. The occasional RealMoney.com contributor recently noted a series of positive technical indications such as improving breadth, expanding new 52-week highs, major averages surpassing 200- and 50-day moving averages, strength in financials, and the market's general ability to ignore bad news, mainly on the macroeconomic front.

In conjunction, they suggest this rally might be different from all others since the peak.

Roque, who graciously provided the chart above ( many thanks J.R.), observed "a combination of factors will give you a better explanation of what you may be trying to prove," vs. using any one indicator in a vacuum.

Similarly, a combination of chart readers is better than just one, even if they somehow recall the allegory about the blind men and the elephant.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task

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