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Bulls Still Have the Ball, but Here's a Bearish Chart Pattern that Can't Be Ignored


There's nothing to indicate a turn yet, and the market appears poised to capture my third target zone -- but there's never room for complacency.

While I've been giving bulls most of the air time for the past few months, in this article, I'm going to touch briefly on an interesting pattern that "bears" watching.

Before I get into a bearish hypothetical, though, the reality is that there's just no sign of a reversal yet. Going back several weeks, my expectation was that this was to be a third wave rally. The third wave of a move is typically the longest and strongest, and third waves are notoriously unrelenting. R.N. Elliott (for whom Elliott Wave Theory is named) called third waves "a wonder to behold." There's a psychology to third waves, and the essence of it can be summed up as "a point of recognition for the masses." This awakening is what gives third waves their strength.

Generally, the majority of traders are positioned wrong headed into a third wave, and the wave thus generates a strong feedback loop. As prices rise, more traders are forced to cover shorts, which in turn drives prices higher, which then causes some traders to reverse long, which drives prices even higher, which causes some of the traders who sold early to chase back in long, which drives prices higher again, and so on.

The price action has matched my expectations, and presently momentum continues to remain strong. Obviously, and without a doubt, the wave will certainly end at some point, and some top-hunter will seem like a genius when it does -- but if I've tried to impress anything on readers all month, it's that I would not try to front-run a turn during a third wave. The market will let us know when it's ready, and while we might miss the exact turn by a few points, during third waves, the turns usually come from so much higher than expected that one ends up doing better with the more passive approach of riding the trend.

Below is the preferred wave count, which has evolved slightly to keep up with the action, but is little changed over the past month. SPX has modestly broken out above the black base channel, and if this breakout holds, there is (amazingly) the potential for further upside acceleration, as unlikely as that sounds. Keep a close eye on things here.

Click to enlarge

As tempting as it is to become complacent at times like this, it always bothers me to be too bullish when it seems "easy" to do so -- so let's talk a little bit about the bear hypotheticals.

The market still has some major price hurdles to overcome from an intermediate and long-term perspective, so I am remaining very cognizant of the proximity of critical long-term resistance. One of the things markets love to do is get you incredibly bullish or bearish as they approach key levels, in order to make you forget all about those levels. Ever gone long at resistance, right before the market started dropping? How about going short at support, right before a huge bounce? Yeah, I've done it, too. Then you back out your time frame (when I'm scalping, I trade off the 1-5 minute charts) and say, "D'oh! What the heck was I thinking?"

So in the midst of all the bull celebrations, let's not forget that the 2000 top was 1553 SPX, and the 2007 top was 1576 -- and these were major market tops. If you draw a trend line connecting the two, you come up with a figure just north of 1590. Now, that said, we're not there yet -- and it would be unusual for the market to top immediately here. I'm not "looking for a top" at the moment, given the present readings of several indicators, and the market seems reasonably intent on making a run at the levels just listed -- but there are a few hurdles along the way.

I've detailed a number of rising support and resistance levels on the chart below, as well as one argument against a top forming yet.

Click to enlarge

The next chart is one for the bears, as promised in the title. The pattern highlighted is called "Three Drives to a Top," and it's one of my favorite patterns. The fact that I'm sharing this chart doesn't mean I've stopped favoring the bulls -- presently, I remain bullish with an eye toward caution -- but I simply can't avoid mentioning it, because certain aspects of the price action of the past year fit the pattern amazingly well, though not perfectly. There are a couple conundrums for the bears in the form of the time component of the current rally, and the anomalous wave at the beginning of the move.

Nevertheless, I spent a fair amount of time detailing the chart below, so readers can make their own decisions about the validity of the pattern.

Click to enlarge

In conclusion, the thrust of the recent rally is rarely something that would turn on a dime. Odds favor a continued run higher, with 1510 as the next near-term target. Trade safe.

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No positions in stocks mentioned.
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