Which way will the market break?
That's the cliffhanger...
In November I set out the reasons why I'm expecting a binary outcome for stock markets in 2012.
Studies of market behaviour going back a century led me to the conclusion that we had arrived at a crunch point, and that market participants would soon be coming to a definitive conclusion about the prospects for better or worse times ahead.
In this kind of study I leave all the fundamental and economic arguments aside as, however important they may be, they're rarely as timely or objective a predictor of markets as pure price action. And in looking at the situation from a purely technical standpoint, I found something very odd: that the case for a substantial rally in stocks seemed finely balanced with the case for a substantial decline.
Precedents strongly suggested we would end up not with a 'muddle-through' kind of year (like 2010 or 2011) but with a decisive move one way or the other.
This may initially seem like a fairly useless forecast. Isn't that just like saying "stocks may go up but, then again, they might go down"?
No, No, Nanette. It's much better than that. First, with monthly volatility contracting to a cyclical low, I argued that a major long-term trend would emerge as volatility expands.
|S&P500 Jan. 2012: dead centre|
But we also have many stock indicies perched right in the middle of their yearly range. The combination of these two factors puts us in an excellent place to take a long term position with very low risk versus our potential reward. Why?
Because the strength of the trend will move stocks away from the centre of the range and out towards an extreme, whichever direction that trend takes.
So if the market breaks higher and we buy here (or if the reverse occurs and we go short), and the market then moves against our position, we have a degree of protection built in; because as long as we restrict our entry-points and stop-loss levels to a very tight band at the dead centre of that range (in this example, the 200-day moving average), and as long as we jump aboard every subsequent breakout, the eventual magnitude of the trend should provide us with a winning trade many times greater than any initial losers, giving a huge risk/reward edge.
Therefore, while some clarity here would be helpful, we don't actually need to know at this moment whether the long-term trend will break up or down because, for those of us ready to trade or invest in whichever direction the market leads us whether long or short, being at the technical hub of a coming move allows us to skew the risk-reward ratio about as firmly in our favour as it's ever possible to get.
Essentially, today's market is like a bucking bronco snorting at the gate. All we need do is to find a way to clamber on board while it's still hemmed in. Then comes the tough part - trying to hang on when the gate goes up, no matter which way the crazy thing breaks and however much it bucks.
Yet if we can get clear in our minds how much greater are the rewards for hanging on compared to the risks of getting trampled, we can gather the courage to plant ourselves right on top of that thang - and stay on it.
Since my last post I've been on constant lookout for clues to which way the beast is likely to break. Although nothing definitive has emerged, one of the most interesting angles I've looked at does seem to be showing us something instructive. It's telling us that:
- unlike the previous two years of whipsaw markets, 2012 is likely to see a sustained and very powerful move develop
- once the dominant trend is established it should move at least 20%-30% over the next one to two years, possibly much more
- there's a strong likelihood we'll push higher initially, even if the dominant trend subsequently turns down
I feel able to make this forecast after analyzing a rare pattern which has just appeared on the monthly charts. It involves a candlestick formation known to bug-eyed chart-watchers as the 'Hanging Man'.
To define terms: a 'Hanging Man' in this study is a candlestick
- which occurs during an uptrend (I used a rising 6-month exponential moving avg)
- where the body of the candle (the price action between the open and close of the month) occurs in the upper half of the whole month's trading range
- where the price range between the low of the body and the low of the month - ie. the 'legs' of the hanging man - is at least 1.5x the range of the body itself
What a Hanging Man reveals is a month in which, following a rally, there has been considerable selling pressure which has been met by a roughly similar commitment from buyers. But either that buying has not been enough to stop the index from falling, or has been enough to push it only marginally higher. So here's the story of the Hanging Man:
- selling pressure has been notable and, despite buyers being willing to step in, they've not bought strongly enough to clearly reassert the prevailing uptrend. We're therefore left suspended in some kind of holding pattern. Either there are no more buyers at these prices, the uptrend has exhausted itself and the market will fall, or this is merely a 'pause to refresh' before new buyers step in and drive prices higher.
Why is this more than just a statement of the bleedin' obvious? To answer that, allow me to crowbar in a tiny bit of context.
WHEN THE MICRO STRANGELY
FORETELLS THE MACRO
HOW THE MICRO CAN* FORETELL THE MACRO
For two consecutive months in 1929, the Dow opened & closed below its
2-month moving average
In case you're not familiar with candlestick charting (and for the life of me I can't imagine why you wouldn't be) here's an example of how it helped saved your host's bacon in the thick of the financial crisis.
I first discovered how valuable analyzing these weekly & monthly candlestick patterns could be in August 2008.
Dow Industrials, 2008
But just to be sure, I looked back through my 90-year database to check what had happened each previous time we'd seen two such beaten-down months. It turned out that the beating was far from over.
My study notes, emailed to an investor friend just before the Lehman flush.
He failed to sell.
On only one of the seven previous occasions where this pattern occured were investors treated to a major turnaround in market fortunes. In every other case prior to 1982, history suggested there was much more bloodshed to come. What these little candlesticks were telling us was that this was a rare, persistent degree of selling pressure that was not about to let up.
Then, this fall I noticed a different kind of pattern in the weekly chart:
Here, the entire weekly bar fell more than 2 standard deviations
below the 20-week mean. That turned out to be... meaningful.
It enabled me to warn readers accurately that a significant low would soon be set in western stock markets which traders and investors could confidently buy.
Both these seemingly innocuous clues were rare developments, seen in moments of highly unusual market action, instances which had led, over many decades, to a set of consistent outcomes.
And because the outcomes were consistently predictable, they proved invaluable in defining potential risk and reward for anyone wanting to invest on the back of them. I believe the cases I've identified in January 2012 fit those same criteria.
Since 1928, there are just six instances where two consecutive Hanging Man monthly candlesticks appeared in the Dow Industrials.
- In each case, either a powerful new LONG-TERM TREND was about to begin, or the existing trend was about to embark upon another major leg.
- Four of the six instances led to a MAJOR RALLY in stocks over the next one-to-two years, each gaining between 20% and 106%.
- The two exceptions preceded MAJOR DECLINES, totalling 89% and 50%, during the 1930s and 1970s.
Since a chart is worth a thousand words, I'll stop yacking and let you study them carefully. I present them chronologically. Each hanging man candle is indentified by a red dot.
A brief sideways move broke upward, resulting in a +33% gain before the market collapsed, losing -89% of its value
A big breakout higher led to +11% gains over 3 months, followed by a -33% decline.
From the close in September '85, the Dow surged higher,
gaining +106% over two years
AUGUST/SEPTEMBER 1991 &
An -8% decline into December 1991 led to a rally of +21% over the next nine months, whereas -
In 1993, stocks moved smoothly to a +20% gain over the succeeding twelve months
If you'd hopped on board at the beginning of August, you would have returned +25% over the following year
It's worth noting that, directly following the signals which led to both massive bear markets, prices initially surged to a new high, sucking in the last bullish investors before finally rolling over. So while we may continue to rally now, there's no guarantee this market will keep on chugging higher. If you're looking to buy however, the risk/reward ratio deteriorates as we move further from the 200-day moving average so protection lies in careful risk management, not delay.*
*In November, I detailed an uncomplicated trading strategy for anyone looking for ways to get invested here. See the link at the end of this post.
In looking at the distribution of these unique candlestick patterns, it also became clear that clusters of them tended to form around market peaks and at the beginning of major moves higher. So even if a pair of hanging men didn't sit right next to each other, two in very close proximity were still helpful in anticipating a substantial move.
Examining the following nine instances in addition to the above examples allows us to consider a slightly broader range of possibilities, even if the basic picture is essentially the same.
Since 1928, I looked for any two Hanging Man candlestick formations separated by no more than two months.
Here they are, with the magnitude of each subsequent move measured from the close of the signal month to the exhaustion point of the trend, and the length of time it took to get there:
March 1935 +95% 2 years
|Dow 1935 - 1937|
Oct 1940 -31% 1yr 6mths
June 1943 +49% 3 yrs
Feb 1954 +78% 2 yrs 2mths
|Dow 1954 - 1957|
Aug 1959 -15% 1 yr
|Dow 1959 - 1962|
Aug 1964 +18% 1 yr 6mths
July 1988 +43% 2 yrs
|Dow 1988 - 1990|
Jan 2001 -34% 2 yrs 9mths
|Dow 2001 - 2003|
Oct 2007 -53% 1 yr 5mths
|Dow 2007 - 2009|
Further research reveals a similar predictive pattern on the weekly and daily timeframes, confirming the general thesis. Clusters of these candles (most reliably, two in succession) consistently appear at significant turning points, and also just as the current trend is about to accelerate.
The overwhelming conclusion to be reached from this simple technical study, and indeed from those I wrote up in November, is that a remarkable investment opportunity is currently presenting itself.
With strong evidence that a sustained move is about to begin, the main challenge for a trader or investor is to minimize risk, jump determinedly on top of that horse as it leaves the gate and stay on board, however much it bucks and whichever way it breaks.
Looking at these 14 examples, in every case the percentage move in the major trend over a minimum of one year exceeded 15%. All but two saw an 18-month move exceeding 20%. Percentage moves in the majority of instances were far greater. Many were one-way directional surges with little counter-trend action, though some required an investor to be nimble and identify, or evade, a trend reversal (eg. 1959, 2001).
At the end of my last post I suggested one simple and practical method a trader might use to profit substantially from the coming move while keeping risk to a minimum. There are plenty more nuanced and sophisticated possibilities, but the essential lesson of this modest little candlestick pattern is clear: once you clamber on top of that crazy hoss, whatever else happens...
Dow Industrials, 2001 - 2011
Everything set for a major breakout