A Dow Diamond

Dow Jones Industrial Index. Weekly close. Last = 10405 (28-06-2000)

First a brief insight into perhaps that most rare of traditional chart formations. Diamond patterns develop at the end of major bull and bear markets and is interpreted as being reversal formations. In other words, when they develop at the end of the bear market, the break from of the diamond leads into a new bull market, and vice versa.

In terms of market psychology, the diamond should be seen as a combination of two chart patterns – a near horizontal megaphone and a triangle. The megaphone is a widening formation that is indicative of a growing polarisation of the market into two opposed groups – one that believes a (new) bull market is at hand and the other that equally firmly believes prices are due to fall steeply.

The result of these two strongly opposed camps is that whenever the price begins to move in a new direction, the 'supporters' of that trend pile in and try to either buy aggressively or sell aggressively, depending on the direction taken. When the market later goes in the opposite direction, they at first wait it out and then either sell eagerly or buy back into the market to recover their earlier positions.

This explains firstly why the moves tend to get ever more violent and secondly also why turnover is high and often rising while the megaphone develops, and more so near the reversal points.

A triangle, which is a narrowing formation, is also formed when there are two opposing camps. The difference from a megaphone is that the two camps are being exhausted with every swing within the triangle. In the megaphone on the other hand the swings become ever wilder because reinforcements are continuously being drawn into the market. When the two camps are nearing complete exhaustion towards the apex of the triangle, volume is reduced, until the point is reached where the break from the triangle is due.

At that time, turnover increases again as the supporters of the one trend believe they now have sufficient evidence to act. When they enter the market in quantity, either as sellers or as buyers, turnover picks up as the opposing camp reacts to the increase in supply or demand and take advantage of the price movement. Then, if the initial decision to sell or buy spreads into a wider market, the price reacts and breaks from the triangle.

Triangles are normally continuation patterns – the price breaks to extend the trend from what it had been before the triangle started to form. In about a quarter of cases, the price breaks from the triangle in the opposite direction, and then the subsequent move tends to be steep and sustained.

For the diamond to become a reversal formation, the price of course has to break from the triangle that ends the diamond against the initial trend. The reason why it might do so might lie in the sentiments that cause the development of the initial megaphone. At the end of a long bull trend, the megaphone develops because the perennial bulls are keen to see the trend continue, while opposition from the bears build up the longer the market moves mainly sideways. Then, when nearly everyone has committed their resources to their respective views and are sitting on the sidelines, the process of attrition of the remaining market players results in the formation of the narrowing formation – a triangle.

On the premise that if the bull trend really was intact, the price should have broken higher before the triangle was fully formed, the conclusion has to be that the price will break against the old bull trend into a new bear market. Of course, once this fact is clear to (almost) everyone in the market, optimists who have geared themselves up for the resumption of the bull market has to scurry real fast to close their positions.

Their only hope then is that so many people went short of the market that profit taking by the real bears would offer at least some demand to sell into.

For a diamond formation at the end of a bear trend, the opposite would apply.

Chart analysis

Master line M is the rising support line of the latter part of the bull market, including the bottom of the diamond pattern. Line F is a steeper derivative, with F-M a triangle. Line F1 is the shallower derivative with I1 the inverse of F1, so that F1-I1 is a symmetrical megaphone and the first part of the diamond.

Scenario 1: The Dow bounces off support at line M to form another leg (leg 7) within the triangle.

Scenario 2: The Dow breaks lower from the triangle to begin a long term bear trend.

Preference: There is still room for the triangle to develop further. The count of the legs is not a simple matter, as not all reversals lie exactly on the boundary lines. However, it surely looks to have exceeded the typical count of 5 legs before a break takes place.

Of course, chart patterns are not laws that cannot be broken, so a small probability should be assigned to a continuation of the bull trend. It might nevertheless not be wise to bet on it. Scenario 2 is preferred, but the break lower need not necessarily occur this Friday (30th June). Keep in mind that it is the end of a half year and the mutual funds are likely to be there in force to support "their" investments in order to obtain a good ranking.

Next week might be a different story.

Dow Jones Industrial Index with volume. Weekly. Last = 10405 (28-06-2000)

As usual, the volume analysis shows a short price history coupled to the dPdV chart. On the latter the price MACD appears as green bars, while the turnover MACD is presented by the blue bars. When the bars are below the base line, the price (green) or the turnover (blue) is decreasing. Similarly, when the bars appear above the base line, the price or turnover is increasing.

The higher the bars rise away from the base line, the steeper the rate of increase and, the deeper below the base line, the steeper the rate of decline. In principle, and disregarding the slight lag introduced by the use of averages, the price and/or volume tops out (or bottoms out) when the bars return to be level with the base line.

Just for fun a new master line is used here. M is the resistance line of the triangle, with F a shallower derivative (F is similar to the master line on the first analysis.) F2 is now the second shallower derivative of master line M, with I2 still its inverse. Comparison with the new current values for the lines (applicable to Friday, 30th June) with those in that chart above shows that the difference between the two analyses is minimal.

The points indicated on the dPdV chart tell the following story:

A: The Dow topped out with no increase in turnover that would indicate heavy selling into the market. In fact, this decline in August/September 1998 was the reaction to the Russian crisis – the lack of selling beforehand showing that Americans were caught unawares by what happened.

B: In response to the crisis, Greenspan is known to have engineered a massive injection of liquidity into the market. This translated into heavy and sustained buying on Wall Street - the steeply rising blue bars – that ended the sell-off and started a major new bull trend. When the bull trend was under way, turnover decreased sharply as sellers ran for cover to the sidelines.

C: The slightly sideways trend in the market drew in some profit taking, but demand held firm and the Dow took off again, ring steeply until the market topped out on more substantial profit taking at D, to begin the megaphone.

E: As the Dow fell to its first deep low within the megaphone, the bulls saw a beautiful opportunity to stock up for the next leg of the bull market. Volume rose steeply to show the new demand coming into the market and the Dow reversed higher again, with turnover declining briefly (about 5 weeks) as sellers again ran for cover.

F: Between points E and F the Dow first increased on lower turnover, then the Dow peaked as volume picked up markedly, capping the trend as sellers entered the market in number with a strong increase in supply. The whole period of the decline from the January all time high down to the low in February/March took place on a substantial rise in turnover. Sellers were there in force to take profit before prices fell too far, while buyers were eagerly picking up bargains all the way down to the cross-over of F and I2.

The bounce off line F was effectively the last upwards reversal that is clearly part of the megaphone. Volume was very high and rising as buyers stormed into the market - in proportion even more so than at point B – to get both feet in the door before the bull took off and stormed away. This high turnover lasted all the way during the new rising trend, peaking just as the Dow made the small double top that ended the rally.

Now the triangle is coming into place and suddenly turnover falls away drastically. A sign that attrition is taking place, rapidly depleting the two opposing camps. Ever fewer people are left to play the market, turnover keeps falling and the triangle develops further.

Scenario 1: Buyers see an opportunity to obtain bargains again. Turnover picks up steeply and the Dow begins a new rising leg – perhaps even to break out of the triangle into a new leg of the megaphone.

Scenario 2: Buyers rush in to get hold of the new bargains of offer and push the Dow Jones higher, Turnover increases markedly as late sellers grab the chance to get out above the low. Supply swamps remaining demand and the Dow begins to fall – breaking below the support level of the diamond and starting a major bear trend.

Preference: Evidence already exists that turnover has picked up substantially during the current week, with three days where turnover was in excess of 1 billion shares. The main question is how this renewed bout of buying will end. Is this the start of the sell-off?

On grounds of the above reasoning, Scenario 2 is selected, but this need not happen immediately. (Next week perhaps?)

Happy trading and remember the First Law of Trading: "Conserve your capital."

********