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False Break Ahead?


This breakdown looks like a doublecross.


Yesterday, I went over some data related to the "triangle" pattern in the S&P 500. The pattern itself isn't really that easily defined, but we took a stab at it by basically just looking for volatility contractions - two consecutive inside bars on the weekly chart (an inside bar has a lower high and higher low than the prior bar).

The current setup has got to be the most-written-about triangle since Britney Spears' unladylike car exit (can I say that?), and quite frankly I'm getting sick of reading about it.

Uhh... but not quite sick enough to not mention one more tidbit about it.

When we discussed this yesterday, we discovered that these volatility contractions do not necessarily lead to a one-month move in the direction of the trend. In fact, these triangles during downtrends actually led to better performance than those during uptrends, but it wasn't a wide enough disparity to say so with any conviction.

This morning I want to touch on a different aspect - the likelihood of a false breakout one way or the other. Over the past few years, we've looked at volatility contractions a number of different ways, and a consistent tendency was to see a longer-term move that was counter to the shorter-term one. So let's see if that's the case here as well.

Again, what I looked for as the setup was two consecutive weeks on the S&P 500 where the current week's high was lower than the prior week, and the current week's low was higher than the prior week.

When we got that setup, and then the next week's low violated the low of the past two weeks (i.e. a breakdown out of the triangle), then on average that week ended in positive territory only two times out of eight chances, and its average return was -1.9%. The average maximum gain during week was a woeful +0.5%, compared to an average maximum loss of -2.9%.

But what did that lead to? The results here may be surprising to some... buying at the close of the week when the market broke down and holding for one month, one would have had a winning trade six out of the eight times and an average return of +2.6%. The average max gain of +5.4% handily beat the average max loss of -2.1%.

If we restrict the study to only down-trending markets (i.e. a downward-sloping 50-day moving average), then we only get three prior instances. All three led to a negative return the week of the breakdown, averaging a stiff -2.5%. However, buying at the end of the breakdown week and holding for a month led to a positive return all three times, averaging a very healthy +6.4%.

If we flip the coin and look for breakouts to the upside, we're very limited - this pattern only led to two upside breakouts since 1950. That tells us something right there, but even so the upside breakout weeks ended in positive territory one time (+2.0%) and negative territory one time (-2.6%). Buying at the close of the week that generated the upside breakout and holding for a month resulted in two losing trades, averaging -3.2%.

The bottom line appears to confirm the conclusions from other volatility contraction studies we've gone over - while there is most often some short-term follow-through in the direction of the break, that short-term move is usually a "false" move that leads to a longer-term move in the opposite direction.

Out of the 12 triangle patterns I found in the S&P, the majority of them (73%) led to a negative week the following week, with an average return of -1.5%. But buying after that breakdown was usually a pretty successful strategy, and again confirms what we wrote about yesterday - I would not read anything special about our long-term prospects if we break down out of this triangle.
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