Crouching Bear, Hidden Bull

It’s quite possible we’ve been in a major uptrend for the last month. But
don’t mortgage the house just yet to buy more stocks. The markets have a lot
more work to do before the go-go momo days can return. And here’s an important
warning: Don’t look for technology to lead the next bull charge.

That fateful March day printed washout lows in the S&P 500 Index and
Dow-30 Industrials, after a vertical nosedive that lasted 10 bloody sessions.
The Dow dropped more than 1700 points over this short period, before bouncing
strongly in the last hour of that day. As we all know, the indices moved sharply
higher after the plunge. Technical evidence is also mounting that price levels
printed by the blue chips during that important session marked the end of their
long-term consolidation. If this is true, we could see a major bull leg break
out later this year.

Let’s stop right here and make one thing clear: This “hidden bull”
is not lurking anywhere on the Nasdaq charts. This may break some hearts, but
consider that the Dow and S&P 500 have danced to a beat of a different
drummer for several years now. While the mighty technology engine went vertical
in late 1999, the blue chips just sat there and moved sideways. So it should
come as no surprise that the new bull move might not join all market sectors at
the hip. Nasdaq remains a very broken bubble to this day. But you knew that,
right?

Those tortured by dead money in the blue chips may think those indices have
no master plan. But just hit the “weekly” button on your favorite
charting program, and the picture suddenly changes. There is little argument
that these broad markets have been in a testing phase after an astounding bull
move. In fact, the S&P 500 and Dow-30 patterns look no different than the
last dip you bought on your favorite 60-minute chart, as long as you measure the
progress in months, rather than minutes.

Let’s look at the Dow chart first. From a distance, we can see the two-year
parallel price channel running against the long uptrend. This is not a
complicated pattern. Most traders know it as the common bull flag. If this is
true, then all we need to do is apply standard rules that we use every day to
trade these simple congestion patterns.

What do we know about bull flags? First, we expect them to break out in the
direction of the prior trend. So an eventual breakout is more likely than an
eventual breakdown. Second, the pattern usually completes after price strikes
each channel barrier three times, in alternation. Third, price should pull back
on the third strike to a classic Fibonacci retracement level, such as 50% or
62%. Finally, when price breaks out of the pattern, we should see vertical
movement. Now let’s peek again at the Dow chart.

The Asia low in late 1998 marked the beginning of the Dow’s dramatic rally
through 10,000. The move ended just above 11,500 shortly after Y2K, and the
index has been pulling back ever since. Notice the “hits” at the
parallel lines. The first two at each end are easy to see. The third hit at the
channel’s bottom took place at 2:50 p.m. on March 22 of this year. It also
printed right at a classic 62% retracement of the rally off the 1998 low.
Perfect so far, huh? But the third strike of the upper parallel line is a lot
less clear. Did it already happen earlier this year or, will it occur on the
next pass?

I like the alternation rule when it comes to bull flags. Simply stated, since
the first and second hits printed at the parallel lows, the third must start at
the lows as well. The quick decline that shook the Dow last October never
reached the lower channel, so the next rally to the top channel shouldn’t be
counted. In any case, what’s a good buy signal without a few caveats thrown in?

The weekly S&P 500 chart offers fascinating clues to the start of a
possible new bull leg. It tracks a highly predictive variation of Elliott’s
5-Wave Decline, and you don’t have to be a rocket scientist to figure it all
out. The Master Swing Trader dubs this complex pattern the “TOP-1-2-DROP-UP.”
T12DU is drawn from a high that fails through two steep declines. A major
washout takes place at the end of the last selloff. This generates a double
bottom that eventually breaks through the downtrend into a significant new
rally. If I didn’t have to say it by now, the S&P 500 has faithfully drawn
each aspect of this complex pattern except for the final breakout.

Draw a declining trendline across last year’s double top (1) and the failed
January rally (2). The recent decline ripped right through Fibonacci and channel
support, but then printed a small double bottom and bounced strongly. Now is the
time to watch the trendline closely to see if the index can break through. Some
technicians argue that violation of the 62% Fibonacci level signals that an
uptrend has failed. But not this technician. When a major price level breaks
down but then remounts support, I see a climax, and impending long-side
opportunity.

Of course the eventual fate of the blue chips is still in doubt. Price is now
caught between the boundaries of these classic patterns, and may have its own
twisted logic in mind. But the earlier that traders can anticipate an important
shift in market direction, the better they can capitalize on the opportunities
it will bring.