The stock market as defined by the S&P 500 has been trading sideways in a descending pattern since the beginning of this year. What’s interesting is that, in most situations like this, the pattern breaks down, not up. In other words, whenever a technician/chartist sees a descending triangle pattern show up on a chart, the immediate assumption is a bearish one. However, like all market pattern and trends, a savvy investor must always search for additional evidence that either confirms the negative scenario – or contradicting evidence that suggests we’re being fooled.
Today, I believe the market isn’t what it seems on the surface. If you read back thru our old market commentary, I first started to mention the current market pattern on April 6th, which I followed up with some updates over the following weeks, with my last mention of the descending triangle taking place a few weeks ago, on April 27th. Since then, it’s been a waiting game to see how things play out.
Well, we finally got the breakout we’ve been waiting on… Below you can see the descending triangle pattern evolving over the last several months.
- The market bottomed in February, rose to a lower-high in March, and then re-tested the February lows in late-March/early-April before printing another lower-high in mid-April.
- RSI (Relative Strength Index), a momentum indicator, managed to remain above the 30-level, below which would’ve provided negative evidence to the future outcome of the market.
- It was crucial for the floor of support to hold (red line drawn below the two lows), and in order to see the market catch its breath, we wanted to see it break northward, out of the descending triangle
So again, we did end up getting the positive breakout, which is good. I would’ve liked to see it pop on higher volume (bars along the middle/bottom of the chart). However, the lower volume could be evidence of indecisive/nervous market participants looking to see whether or not this is a head-fake or the real thing.
What I want to see next is for the market to consolidate sideways (at worst), above the diagonal, descending line that represented the top of the triangle pattern. Then, I want to see higher volume on upward movement, which would confirm that the bulls are in control.
What I don’t want to see is for the market fall back into the triangle pattern. However, if it did, all is not lost.
If we observe prices falling back into the descending triangle pattern, then the floor of support becomes yet again, crucial. To be more specific, my line in the sand is the 2,500 – 2,550 zone on the S&P500, below which I’d likely be implementing drastic, defensive measures to protect capital in our clients’ portfolios.
<Nerd alert! If you’re already teetering on boredom and becoming sleepy, skip down to the end, just below the asterisks!>
With that all being said, let me share some statistics – specifically for my fellow nerds in the audience:
I had the pleasure of spending three days with Charles Kirkpatrick, II at his home in Maine a couple years ago, just to pick his brain. Okay, maybe I invited myself, but that’s beside the point.
Charlie taught me that the failure rate of a chart pattern should be determined by how many times price fails to reach a 10% gain from the breakout, and subsequently reverses to result in a -20% loss.
As such, a break-even failure rate would be equivalent to 33% because, if:
- Failure = -20% loss, then
- You need at least two, positive gains of 10% to wipe out the single loss, so
- 1 Failure out of 3 breakout signals (33%) = Breakeven
To simplify, a failure rate of < 33% is good. Conversely, a failure rate larger than 33% is bad.
So with that behind us, remember from above, that a descending triangle typically breaks down (i.e. – drops below the pattern in a bearish fashion, thus producing losses in the vast majority of cases).
However, in the less frequent occurrence, when a descending triangle actually breaks out to the upside, the performance averages around +29%. In addition, the failure rate (using the information above) is only 9%, which is absolutely exceptional.
So while we’re not out of the woods just yet, the probabilities of higher market prices from here are very good. For these reasons (and all those mentioned above), I feel pretty confident with what the market is showing me and that the bulls will end up winning this battle in 2018.
If you’d like to discuss this further, I invite you to get ahold of me anytime. I love talking about it, so don’t hesitate to write or call.
Have a relaxing, rainy weekend and we hope to hear from you soon!
Till next time…
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* Adam Koos, CFP® is a CERTIFIED FINANCIAL PLANNERTM Professional, as well as president and portfolio manager at Libertas Wealth Management Group, Inc., a Fee-Only Registered Investment Advisory (RIA) firm, located in Columbus, Ohio.