Dow Surprises but Nothing has Changed

Our recent forecast of an imminent stock market sell-off was nullified last Thursday when the Dow Jones decided it had other plans and proceeded to leap nearly 400 points to the 8300 level—a level unseen since August.

As anyone who has spent any length of time as an investor, trader or market timer knows, the market delights in making fools of any and all who would attempt to predict its future course. This is not the first time the Dow has made a fool of us and it most certainly will not be the last. Yet our overall near-term forecast remains unchanged.

We pointed out in last week's issue of Leading Indicators that the Dow was trading in a rather wide contracting triangle formation all the while forming a bearish ascending wedge pattern within this larger triangle. Both patterns have clear bearish portent and neither of these patterns have yet been nullified. If anything, last Thursday's action only strengthens our technical outlook concerning the Dow's near-certain demise (a demise we still believe will begin sometime within the month).

A glance at the Dow Jones hourly chart as we have provided shows many interesting technical patterns forming. We of course took liberties with our technical line drawing (as any true market technician would) and some of the incipient technical patterns may later be invalidated. But for now let's examine them in closer detail.

The larger pattern, of course, remains the contracting triangle that can be seen from the extreme upper and lower lines on the chart. Within this large triangle is what could be interpreted another triangle, this one an inverted triangle with a near-perfectly horizontal support line and an upward sloping hypotenuse. It is this potential inverted triangle pattern that is the focus of our attention at the moment. While this pattern can either augur a continuation of the previous market trend prior to consolidation within the triangle (in this case, downward), it can also be a reversal pattern that eventually sends prices to higher levels upon culmination. It is our belief, however, that the pattern in question is a continuation pattern that should see prices break sharply to the downside once completed.

In defense of our position, we reference again one of the most sacred sources of classical technical analysis—Richard Schabacker's Technical Analysis and Stock Market Profits. Under a section of the book dealing with inverted triangles with a rising hypotenuse, Schabacker makes the following postulate:

"The student will presumably have already observed that this is an example of the Inverted Triangle in which the break-out proceeds in a direction opposite to the direction of the hypotenuse (as it forms as time progresses) and, consequently, in the direction opposite to what we should have expected in the case of a normal Triangle with a rising hypotenuse."

It will be helpful, before proceeding further, to understand that the very phenomenon of the inverted triangle—a rare formation—evolves from a market milieu of widespread uncertainty with wide differences of opinion among market participants and without firm leadership in either direction. Such has been the case on Wall Street for the past several weeks. Thus, it is not at all surprising that the inverted triangle has arisen on the Dow's chart.

The measuring implications of the inverted triangle involve equating the distance between the upper and lower boundary lines (support and resistance) that form the triangle. The distance between the "mouth," or widest end of the triangle, generally provide a good indication of the minimum distance in which the market must either fall or rise upon breaking out from the triangle. Thus, if our triangle in question holds up, a downside breakout from its current level at approximately 8400-8500 would yield a drop of nearly 1000 points below the horizontal support line (at DJ 7500). One-thousand subtracted from 7500 yields a minimum downside target of DJ 6500. At the very least, we believe this is the level we can expect to see on the Dow before the month of October is finished.

Note also the much smaller potentially bearish ascending wedge pattern at the outermost tip of the Dow's chart. This could be a portent for a sharp decline sooner than we might otherwise expect (i.e., this week, perhaps).

We note further the more clearly delineated inverted triangle forming in the Dow Jones future chart (basis December). Two side-by-side white candlestick patterns on the candlestick chart of the December Dow futures on Thursday and Friday have perfectly matching lows and highs which probably portends a continuation of the latest upward bias. Based on this pattern alone, we can probably expect at least one more burst to higher levels in the next few days before a turnaround.

From a socio-cultural perspective, we note with interest the recent National Basketball Association player's union strike following failed negotiations with NBA executives over (what else?) player salary caps. For the first time in NBA history, opening season games—two weeks worth—were cancelled, providing an ominous parallel to the 1994 major league baseball players strike. Baseball lost many fans over the strike and only recently never fully recovered from the effects of that strike, and we expect things to be no different this time with pro basketball.

We mention this seemingly irrelevant piece of information only because of the potential stock market indicator it provides us with. Robert Prechter and Pete Kendall of Elliott Wave International have pointed out that basketball is in many ways the quintessential bull market sport as it represents in many ways the distinguishing characteristics of a bull market and as it enjoys the height of its popularity during stock market bulls. Conversely, they tell us, basketball loses fan interest and tends to degenerate into chaos and even violence during bear markets. As such, it provides the perfect socio-cultural barometer for measuring the climate of the market.

With the NBA player union's recent action and immense squabbling among players and executives before the season has even started, it would seem basketball is already degenerating in the face of a nascent bear market. Only time will tell but it is beginning to look like the world of sports has provided us with yet another stock market indicator.