The Dow Diamond

Just over two months ago, a study was published here at GOLD-EAGLE of the diamond formation that had been developing on the Dow Jones Industrial Index. At that time, the diamond appeared more like a kite, with the right hand side of the formation truncated by comparison to the symmetrical first half of the patter – and a somewhat skew kite at that.

Not very long after that, the Dow Jones broke higher through the resistance shown for the diamond and many readers of the earlier report must have been disappointed by this, or perhaps simply thought that the diamond had lost its glitter!!

Yet that break higher only served to extend the truncated portion of the try-to-be kite into a much more symmetrical chart pattern that better resembles the traditional schematic of a girl's best friend.

And now even that diamond ha been penetrated to the upside – in principle a bullish signal. Yet, here it might just be the last fling of the bulls before new weakness set in. The reason for saying so is explained below, but we first must deal with another kind of chart formation – one that is traditionally associated with market reversals.

Rising wedges
We begin with a look at the chart pattern known as a rising wedge and explore the kind of market behaviour that would enable such wedges to develop.

A wedge pattern is a narrowing formation that develops at the end of a significant bull or bear trend. However, we are now dealing with not just another garden variety bull trend, but the culmination of the longest bull market in Wall Street's history.

Like the other narrowing formations – the pennant and the triangle – a wedge formation is an exhaustion pattern. It develops when a market divides into two groups that hold quite strong but opposing views – the typical bulls and bears. The kind of the behaviour that forms a rising wedge at the end of a bull market and a descending wedge at the end of a bear market is very similar, with the roles of the bulls and bears reversed.

During a major bull market, there develops very strong psychological forces in the market place that tend to keep the trend intact. Someone once said that "before the final reversal is in place and the new trend established, bull markets rise further and bear markets fall deeper and both last longer than anybody could begin to suspect", or words to that effect.

In this respect the media play an important role, particularly during a bull market.

Everyone develops a vested interest in keeping the bull alive. Printed media sell more copies during a bull market and journalists who write in an optimistic vein enjoy wider readership – and are perhaps better paid, but definitely in greater demand – than others who begin to believe that the market is posing risks to investors, particularly to people who soon have to rely on their investments as their source of continued financial survival.

The blind commitment of talking heads on the financial TV channels to sustaining the bull market, even through significant market corrections, consistently helping to propel prices new highs, has been obvious and commented on for a long time.

During a bull market nobody really wants to hear the contrarian view. Proof of the error of a contrarian attitude is of course easy to find – just consider for how long the market has shown contrarians to have been completely wrong. It is a moot question whether there are in fact still any contrarians out there with any significant credibility outside the small circle of fellow bears? Probably not.

And then, when the crash finally comes, the contrarians have to carry the can for having forecasted the catastrophe! At that time, the masses might actually feel sympathy for the blindly bullish commentators who helped to convert what was a good solid bull market into a typical unsustainable bubble through their outrageous expectations and forecasts – and their bullish professional advice to novice investors despite gross over-valuations.

When bearish sentiment at last begins to gain ground, it does so among investors at large. Currently, probably not among the day traders, if there still are some of them surviving into the second half of 2000. However, a time comes when a good number of the more conservative investors and fund managers who have been invested early during the bull market – in this case, those who have been as fully invested as they could be ever since the early to mid 90's, and not in the dot.coms either – are still showing very good profit indeed and might about now decide to pocket that profit given that there is developing greater uncertainty about the future earnings performance of the corporations.

These people are investors in the true sense of the word – they have a time horizon of at least 2 years and more like 4-5 years. They know almost instinctively that a slowdown in the economy is not a good climate for company earnings. Not ever, and particularly not now, where a slowdown in the economy and in the markets might just cause many households to decide this is the time to tighten the spending belt a notch and repay some of all that debt that made living over the past few years so exciting.

Traders and their advisors may still talk about, say, the Dow rising to 20 000 by end 2001, while conservative investors – managers of pension funds, for example – may already have decided it would be prudent to reduce their exposure to equities. From a market where probably 90%+ of investors were committed bulls, there seems to be a gradual change taking place as some investors stand ready to cash in and effectively move to the sidelines, their funds invested elsewhere, mostly in bonds.

Back to wedges in general. It is just such a change in market sentiment towards the end of a long bull market that establishes the two camps which then give rise to development of a wedge formation. On the one side are an increasing number of profit takers who are getting out of the market. In the bullish camp we have support from late arrivals who believe that there is still time to get into the market, while there are also successful investors who draw on fresh funds to increase their already profitable earlier investments.

We now find that whenever the price increases substantially, there is also an increase in profit taking. In the same way, every correction against the trend sparks renewed buying by the optimists.

However, since the active populations of both camps decline during each correction-rally cycle, the market action becomes more explosive and more tightly constrained as active participants become fewer. It is this exhaustion of both supply and demand that shapes the narrowing wedge formation. In due course, a point is reached where even many of the less conservative investors begin to think it time to take profit and the market finally peaks, typically on quite substantial turnover, as the last of the bulls are fed by the incipient bears.

It seems to be the nature of narrowing formations that it generally requires 5 legs or moves from one side to the other to complete the formations – be they triangles, pennants or wedges. At or not too long after the end of leg 5, the price breaks from the formation. In the case of triangles and pennants the break continues the earlier trend, while the break from a terminal wedge reverses the earlier trend.

The first chart of the Dow Jones shows the outline of the rising wedge that developed between mid-1997 and early 2000. The count of the legs are shown and it can be seen that the break lower from the wedge happened while the Dow was still on leg 4 of the pattern – a leg that should have been completed by reaching line X before turning lower again.

Over the years, observation has shown such premature breaks that result in an abnormal end to the chart pattern tend to be followed by steep and sustained moves. Yet here the break, which took place at the end of January this year, was followed by the mainly sideways trend consisting of quite volatile moves that has now lasted a further 11 months since the break from the wedge and which has not really taken the Dow anywhere.

So what is different now?
Let us look first at what happens when a rising wedge is finally broken and sellers begin to dominate the market. Buyers are not absent, but turnover is much lower than during the previous bull market. As prices decline, there are brief flurries of buying as shorts cover and previously frustrated buyers see prices return to levels where they were willing to enter the market and do so now.

Since the intention to take profit – and some people trying to get out without being hurt too much – has by now become more widespread, rallies do not last long before demand is swamped by new supply. Yet, the descent is generally reasonably contained and regular for two reasons. Firstly, because not all buying is absent and secondly, because many holders of shares had bought into the market at much lower levels and are at first willing to sit through the 'correction'. Which is why, there is seldom outright panic after a break from a rising wedge and during the ordered decline that follows. Unless of course some major bad news should hit the market while the mood is pessimistic, thus causing everyone to want to get out at much the same time.

Now, in forming the diamond that developed out of the wedge, the market went mostly sideways, not really going anywhere. This happened, initially at least, at ever increasing volatility. This "going nowhere trend" has a number of significant effects on market sentiment that differ from what happens when the reversal into a bear market is relatively quick, as what happens normally after a break from a rising wedge.

The diamond at first developed as a widening formation – or megaphone. Megaphones, as written earlier, also have two opposing camps behind their formation. But now the two opposing camps begin with stronger convictions and their populations grow over time as reinforcements are drawn in from the sidelines on every change in direction. Price movements get steeper and carry further before being reversed, typically on sharply increasing turnover near the trend reversals.

This high price volatility is thus accompanied by great swings in turnover as the market is dominated first by sustained buying (high volume), which is then followed by a period when sellers take to the sidelines (relatively low turnover), and finally high turnover again as sellers return in droves.

It can be speculated that the reason why rising wedge shown in the first chart was not followed by a sustained decline is because sellers lacked the keen aggression to keep on selling when prices fell below certain key levels. If prices dropped too low, sellers were content to retreat from the market, to sit on the sidelines and wait for more opportune moments to take profit.

The very long bull market – supported by a flow of almost exclusively bullish comments from the media – has made even more conservative investors confident that they can take profit at their desired prices; they do not have to sell at the bid in a declining market, but can afford to wait.

As an example of this, it was reported that for much of the time while Amazon.com fell from $113 to eventually below $30, Wall Street analysts almost unanimously listed the stock as a 'buy' or, at worst, a 'hold'. A recent article in Bloomberg's also mentioned that of 28000 analyst recommendations on 6700 US and Canadian stocks, less than 1% of the recommendations were a 'sell'. Can this be rational behaviour to have such widespread optimism during a time when the NYSE advance-decline line was mostly falling steeply, with a majority of stocks below their 200 day moving averages, and while Nasdaq was taking a real beating? Does this sound like objective analysis and unbiased reporting?

No wonder many holders of shares have been conditioned not to sell, but to sit through the mainly sideways market in the hope (certainty?) that there will eventually be light at the end of the tunnel and a chance to show a profit – even a very good profit.

Soon, however, the megaphone ended and the triangle began and thus the market entered a phase in which the psychology of the market changed.

During the formation of the triangle, more and more people became tired of being whipsawed by the market and perhaps concerned over its future. As they moved to the sidelines, this was reflected in ever lower turnover towards the end of the triangle. Some prospective sellers become concerned enough to start selling at lower prices, which caused lower highs to become evident. Yet, at the same time, since supply begins to dry up when prices fall, buyers have to come earlier into the market to make sure they obtain the stock they want. This keeps bottoms rising during this period.

However, since the populations of the two camps – the remaining active bulls and bears – are reduced by each swing in the market, with fewer reinforcements than before coming off the sidelines, turnover is declining all the time. Until the triangle narrows further and one of two things happen: either some event sparks a major new buying spree that takes off into a new bull market, or, some news that is not positive for the market motivates potential sellers to move off the sidelines and to sell more aggressively, which action begins the new bear market. In the case of the Dow Jones, we have just had a new post-January high that resulted in a minor break above the resistance line of the diamond.

This background takes us to the next chart, the by now much dissected diamond on the chart of the Dow Jones Industrial Index. We examine the chart of the weekly close.

Dow Jones. Weekly close.
In the previous analysis of the Dow Diamond back in June this year, it was mentioned that the diamond appeared more like a kite. The left hand side of the megaphone was symmetrical and had a much shallower gradient than the right hand side – the rather blunt looking triangle that gave the whole formation the appearance of a kite.

That situation has now been corrected by the passage of time and by the new highs that were achieved over the last two weeks (08/25 and 09/01), as shown here. The diamond now appears more symmetrical. The duration of the megaphone (38 weeks) is being approached by that of the triangle (31 weeks). Of course, the triangle is not yet at the point of closing, which means there is still more time available for further development of this pattern.

In fact, the triangle will only close in about 10 weeks from the 1st September – just right to take the diamond into the time of the US election.

The key questions are of course whether the Dow will really move right into the apex of the triangle before a break takes place and what the direction of the final break will be.

Master line M is the outright resistance line of the steeper part of the long term bull market. Line P was generated exactly parallel to M and is an accurate support line for the bull channel, M-P, and also the lower line of the triangular part of the diamond formation.

Lines A and B are shallower derivatives of line M – their common gradient is only 0.618 times that of the gradient of line M, where 0.618 is the Fibonacci ratio. Observe the false break below line B that might be repeating on the opposite side of the diamond with the current move higher above line A.

The view expressed in the previous article and here as well, is that diamond formations are reversal formations. They occur at the end of major bull and bear trends and develop because the market enters an extended period of indeterminacy – at the end of a major bull market sentiment might gradually turn from widespread bullishness to a more divided opinion, but for a long time there is no real widespread pessimism that would trigger sustained profit taking – only increasing concerns, with people waiting anxiously for new direction and, for many who had opened new position during the sideways drift, an opportunity to get out at a profit.

As a consequence, the market moves mainly sideways, reacting at least at first with increasing volatility to both good and bad news. Later, as exhaustion begins to set in and market players increasingly move to the sidelines to see what the market will do, turnover declines and market moves become smaller to form the triangular portion of the diamond.

One major difference from a rising wedge now becomes evident and it is this difference that finally should determine the direction of the break, as discussed below.

A rising wedge is a fleeting affair, in relative terms, while a diamond is a long drawn out saga – consider that the Dow Diamond has already developed over the past 69 weeks at current count, with perhaps as many as 10 weeks still to come, if the pattern shown here is valid. Consideration also of what this mean in terms of market psychology enables one to make a reasoned choice between two possible scenarios.

Scenario1: The Dow breaks upwards into a sustained new bull trend.

Scenario 2: The Dow breaks downwards in a sustained bear market.

Discussion: Factors that might influence the direction of the break In the relatively brief time that it takes for a rising wedge to develop and then break lower into a bear market, buyers are spread over a range of prices. The wedge shown in the first chart required 42 weeks to move from the end of leg 1 to the point of the break below line Y. This is quite a long time, but one should keep in mind that the Dow gained 40% over that period. A rate of 1% per week is very satisfying and keeps holders of shares, even recent buyers, quite content.

Then, should the market turn bearish outright, it would have to fall by almost 30% off the top before all the people who had bought during the preceding 42 weeks are in a losing position. During such a decline, holders of shares are not near simultaneously forced into selling to avoid a loss. Staggered selling as stops are progressively hit, particularly during the initial part of the decline, keeps the market quite evenly balanced between supply and the decreasing demand as prices fall.

By comparison to the 40% height of the wedge, the range of the diamond is only about 16% from top to bottom. However, the Dow has spent relatively time at the extremes and much more of the 69 weeks was spent in the central part of the range that is only about 6% wide. During this period a very large number of stocks changed hands.

Now consider how the people who had invested on Wall Street during this period and are still holding on to their positions are thinking about their investments. Many of them, if not the majority – particularly those who had borrowed to invest – must by now be quite impatient with the market trend. Given the time value of money, relatively few of them are breaking even at the moment. How are these people likely to react if either of two things happened now – namely the two developments mentioned in the Scenarios?

Assume a steep break lower takes place on some bad news – or simply in response to one of those strange events when investors act like a flock of birds or a school of fish and everyone does the same thing at the same time. What would these people do? Hang on for dear life in the hope that the market recovers again? Or sell at best?

If they should all start selling aggressively at about the same time, the flood of supply would cause havoc as it would totally swamp any reasonable demand, even that which could arise from the covering of large short positions. There would a substantial risk of a real panic developing as people try to salvage what they could.

On the other hand, if the market should break higher into a new bull trend, can one imagine these patient yet losing investors rushing out en masse to borrow more money in order to increase their positions in the market? Or would they rather just wait for a suitable price where they can finally get out with some dignity and sufficient profit to keep their accountants happy and to have something to tell their friends and colleagues about?

My own view is that even if the minor break of the past week continues further, there is substantial risk of sustained profit taking on a scale that will reverse the trend again. If the Dow dips back into the old trading range, this selling could perhaps trigger an over-reaction that causes the Dow to drop below the diamond, to turn the initial bullish break into a new bear trend – in which case the result would be exactly the same as when the initial break had been bearish. And perhaps even worse.

What, in fact, could trigger a significant break upwards and generate sufficient buyer interest to sustain the trend despite much increased profit taking?

A guarantee that the steep growth in the US economy and corporate profits will continue unabated for the next so many years, all still on low inflation?These assumptions are already factored into the market and is exactly the sentiment that had kept the market reasonably stable at these levels, so that the diamond has had time to develop. Indications are already that the economy is slowing down, not maintaining its high rate of growth.

News that the rest of the global economies are entering a steep growth curve? If that should happen, the flow of foreign funds into the US would soon reverse and what that development would do to US markets has been widely commented on elsewhere. The possibility that Wall Street would get a second lease on life under those circumstances and be able to begin a major new bull trend is rather remote.

News that the rest of the global economies are still in recession and likely to remain there? What has changed? If this is the case, one would expect, at best, the sideways trend in the Dow to continue.

What about the possibility of some bad news that could trigger a sharp fall? One could probably make a list of 10 news items, or more, that could conceivably occur to spook Wall Street into a major sell-off. And these quite real possibilities would not include the outside chances of an earthquake under Tokyo or an asteroid hitting Los Angeles.

Before a final choice is made, lets take a look at what volume on Wall Street can tell us.

Dow Jones. Volume analysis.

The weekly chart below shows the past 30 months of history during which the diamond took on shape. The diamond shown in the upper half is quite similar to the one showed in the previous analysis, except that the triangular portion is now not truncated. The line values are for the week ending 8th September.

The dPdV analysis in the lower half of the chart is a dual MACD – green bars for the price and blue bars for the volume. Like all MACD's, a value above the base line shows that price or turnover, as the case might be, has been increasing over the previous few weeks. If the bars are below the base line, price and/or turnover has been decreasing.

Changes in price and turnover, when examined in combination, reveal to some degree what the buyers and sellers are actually doing in the market. The points indicated on the chart are interpreted as follows.

A: In the second half of 1998, events in Russia exacerbated the concerns that had come to the fore earlier when South American economies were in trouble. The Dow lost 20% and panic was threatening when an injection of liquidity into the US markets coupled to much positive spin in the media triggered a sustained buying spree that saw high turnover for many months and set the Dow off on a bull run during which it would gain 44% in 35 weeks, from line M to line F.

B: After turnover dropped away following the initial surge in prices – an indication that sellers had retreated from the market – the Dow spent some time late in 1998 and into 1999 consolidating. In February 1999, new and again sustained buying had turnover rising again and the Dow hitting new highs, but volume soon declined as sellers again held back for better prices.

C: The top of the price MACD – indicating the steepest rate of increase in the value of the Dow – coincided with a spike in the volume MACD, which shows massive profit taking going on into the strong demand This also coincides with the top of the wedge shown in the first chart above. Normally, such a sell-off into strength would mean the end of the bull market and probably the start of the bear trend – and, if this had happened at this time, would have resulted in a normal rising wedge trend reversal into a bear market for Wall Street.

D: Following the high at C, the sudden and steep decline in turnover shows sellers did not persevere and sell aggressively until demand was completely extinguished, forcing the market into a bear trend – which is what usually happens at the top of a wedge. Many holders of shares probably were still imbued by some optimism that the market would offer better prices in the future and were content to sit and wait. Turnover (blue bars) fell away steeply while the price MACD topped out and returned to the base line in response to the mainly sideways trend in the Dow.

E: New and sustained buying, as fears of the Y2K problem receded, had the Dow rising steeply into 2000, the move starting again on a surge in turnover as new buyers hit the market and the improving prices at first had concerned holders taking profit into the run up into the new digital millennium. However, as usually happens, sellers soon retreated to wait for better prices, as shown by the decline in turnover between E and F. At this point, in mid January of 2000 prices hit a ceiling and reversed direction.

F: By late February, after the Dow had fallen by 16% from its January high, sentiment changed as quickly again and buyers were back in the market, looking for bargains. By now the megaphone has run its course and the sentiment that would form the triangle is gradually asserting itself – the switch from megaphone to triangle being flagged by this last period of sustained very high turnover on Wall Street.

G: The mainly sideways trend that followed the high volatility in April is associated with a sustained decline in turnover – typical of exhaustion that is setting in and helping to establish the narrowing formation that is the triangular portion of the diamond. The latter part of this period of course also includes the US summer vacation when turnover is lower than usual and volatility lower.

F: Recently there was a small increase in turnover that sparked the Dow to the new intermediate high that was reached on the 1st September – the highest weekly close since mid January. Note however that turnover has again fallen away, which could be read as an indication that there is no substantial follow through on this occasion.

Scenario 1: Good demand becomes evident as the US returns to work after the Labour Weekend and the current rally continues. Turnover on Wall Street at first also increases and the break from the diamond is confirmed by a sustained rise in the Dow on higher turnover. Bullish for the medium to longer term, provided volume falls away while prices are still rising to show that sellers are retreating from the market.

Scenario 2: The minor break above the diamond does not hold. Selling into new demand increases, as revealed by increasing turnover, and later becomes aggressive as more and more people who had opened positions over the past 16 months find themselves facing the risk of ever larger losses. Eventually, turnover decreases as prospective buyers run to the sidelines and prices fall steeply.

Preference: The existence and shape of the diamond is a fact, and so too is the fact that the diamond fits quite closely within a pattern determined according to the guidelines of Chart Symmetry. The close on Friday, 1st September, was 1% above the upper boundary of the diamond – sufficient to indicate a break, yet, given that a previous break from the diamond was almost 2%, the Dow still has a small distance to go before the break higher is fully confirmed.

The key to what will happen is whether profit taking into strong demand from frustrated holders of shares that bought into the market during the past 16 months will cap the current rally and then continue long enough to trigger a trend reversal – one that could then degenerate into a significant sell-off..

In other words, "Will the diamond again conform to its traditional role as a major reversal formation?"

The whole discussion points to a positive answer to this question and to Scenario 2 as the final outcome. However, the reader is invited to make up his or her own mind on what will happen – a clean break upwards, releasing a new bull market on declining turnover, or, alternatively, sufficient sustained profit taking by concerned holders, in which case Wall Street experiences high turnover and the Dow sooner or later breaks downwards from the diamond into a steep and sustained bear market.

Perhaps we will see both these events taking place, in that sequence.