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Pattern of Deception

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We've now come to an interesting crossroads. Several of our short-term indicators have reversed down, while our intermediate and long-term indicators remain positive. At the very least we view the short-term deterioration as a warning shot, so to speak. But there is no guarantee that the short-term must turn into the long-term. Bulls are getting a bit nervous, and bears are salivating at their first real perceived opportunity in several months.

Last week we discussed the fact that, from a bullish perspective, pullbacks are welcome until technical damage begins to appear. From a bearish standpoint, identifying when bullish patterns fail is as important as identifying bearish chart patterns.

One of the advantages I find in using the point & figure methodology of technical analysis is that chart patterns produced on point & figure charts are for the most part very clear and easy to distinguish. In the most basic sense a stock is either on a buy signal or a sell signal. Of course, there are other considerations such as relative strength, the overall context of the pattern within the identifiable trends of the stock, etc. But, reduced to its essence, point & figure charts at any given time show either a buy or sell signal. There is no in-between… most of the time.

There is one pattern, however, that isn't what it seems. When is a sell signal not a sell signal? When the sell signal occurs in a pattern called a Shakeout pattern. Let's look at how this pattern is formed.

Step 1:
The first step of the shakeout pattern is to form two tops. The double top is not actually broken, only formed. Remember, in the point & figure methodology a broken double top is a good thing. It is the most basic type of buy signal. In the Shakeout pattern, however, the double top is formed, but is not broken. (Note: I understand this raises connotations of the bearish double top formation in bar chart terminology, but is not directly related.)



Step 2:
The second step of the pattern is a double bottom breakdown. This acts to "shakeout" the weak holders. The double bottom break is the most basic sell signal in the point & figure methodology, but in this context it is actually bullish.

Step 3:
The third step of the shakeout is when the stock reverses up three boxes. This tells us demand is back in control and new positions can be initiated. This also affords a good stop loss the potential new double bottom should the trade not work out. It is important that we wait for the reversal before initiating the trade. The reversal is the entry point and one of the few times we would choose to buy short-term strength as opposed to weakness.

Step 4:
The final step of the shakeout is the triple top breakout, in this example at 60. Buying on the three box reversal up gets you in earlier than waiting for the triple top breakout.

The reason I'm bringing up this pattern today is that scanning through the charts of hundreds of stocks the past couple of days I've seen numerous shakeout formations across a wide array of sectors. Stocks that are currently on shakeout patterns here include, to name just a few: Advanced Auto Parts (AAP), American Express (AXP), Beazer Homes (BZH), Capital One Financial (COF), and Mercury Interactive (MERQ). This is not a recommendation to buy these stocks, just a list of some of the shakeout patterns I've seen over the past couple of days.

As I also alluded to, while shakeouts are bullish formations, it is also important, from a bearish perspective, to pay attention to when bullish patterns fail. Pattern failure can tell you as much about market structure as pattern success, particularly when typically bullish patterns, such as shakeouts, fail en masse.

On a sidenote, the last time we saw a widespread failure in shakeout patterns was in August of 2000. There have, so far, been two high-profile shakeout pattern failures. The shakeout pattern for Countrywide Financial Corp. (CFC) and Verity (VRTY) both resulted in failure yesterday. Talk about your crosscurrents. Nobody ever said it was supposed to be easy.

(Illustrations courtesy Dorsey Wright)

No positions in stocks mentioned.

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