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Dissecting the Double Bottom


There is a powerful pattern all should understand that may actually be emerging at this very moment within the S&P 500.

Technical Analysis is often misunderstood and commonly viewed as a feeble attempt to game the market by studying pictures. For those that don't understand the art, it can be easily passed off as something that simply becomes a self-fulfilling prophecy due to those who follow its principals. Individuals should know that technical analysis is simply a graphic form of human emotion. As we stroll through the streets of TA-ville, there is a powerful pattern all should understand that may actually be emerging at this very moment within the S&P 500. Unfortunately we won't know until it is complete and in the rear view mirror, however understanding its potential may help an investor remain open minded and flexible. It is the basic, yet powerful double bottom.

The image below shows the S&P 500 for the past six months, each letter on the chart marks an entry or exit point by various groups of investors as I have laid out below.

Click to enlarge image

When a stock or index falls [A], it will eventually come to a point where supply no longer out-paces demand and a reversal sets in [B]. More often than not, it comes at an extreme point whereby a capitulation takes place and a majority of holders throw in the towel [C]. It is also during this time, however, that a few cut through the fear, choosing to step in and buy what others are in a panic to sell. These speculative players may have attempted to catch the bounce in the past but were early, or may have gotten lucky with their first attempt.

Regardless, it is this class of investors who reaps rewards as the market starts to climb out of the depths and advance higher [D]. During this phase those who sold at the bottom, or on its descent, begin to wade back in, taking the stock or average ever higher. However, it is often assumed that there is yet another class of investor who waits patiently on the sideline for another opportunity.

As the market advances and approaches the point where the previous signs of weakness had set in [E], those who caught the bottom are believed to be taking their quick gains, which ultimately sets the distribution process in motion once again [F]. Those who caught the bottom and are booking gains are accompanied by two other groups of sellers. Those who held through the entire slide and are now restoring their losses looking to sell out flat, as well as longer term holders who now believe a double top has set in and also start to sell.

Still another set of investors continue to wait patiently.

As the stock or average starts to turn over and head lower [G], all eyes start to focus on the previous point at which the market bounced. At this point however, those who caught the first bounce are prepared and emboldened to re-enter, in addition to the extremely patient longer term holder who has been waiting to re-enter assuming the level holds [H]. As the market approaches the key support level all participants with their carefully formed plan re-enter and the market once again reverses and starts to head higher [I]. Unlike the last time, this reversal is much less chaotic as it is not only bought by the speculators seeking another quick buck, but is also bought by patient investors actually seeking to re-enter for the longer term, with no plans to sell out in the near future.

Typically, as the market starts to move out, those longer term investors continue to buy as minor weakness sets in, picking up stock from those who once again take their quick profits. As the market heads higher [J], speculators continue to peel off believing the market will reverse where it did the previous two times. The difference this time however, is that supply is not nearly as prevalent as it was during the previous sell offs and rather, the new stronger hands sit tight. As the speculators sell out, there is not much buying power, however, a lack of selling creates a low volume rise and often is viewed as an advance that will surely fail. The stock or average continues to press on [K] towards the previous highs, and while it may stall briefly, will often push through those levels [L?], on lighter volume, throwing just about everyone off.

Ironically, it isn't due to a major force of buying that pushes a double bottom break-out, but a lack of selling. As the stock or average breaks above the previous resistance points and it becomes very clear that the market will not in fact reverse again, those weaker holders start to wade back in and ultimately start to push the stock or average ever higher. In hindsight a double bottom is identified and a new trend up begins.

The psychology of this pattern is always the same, however, unlike many other technical analysis patterns, can only be identified when it is over. Unfortunately, it isn't black and white and many will argue that the pattern is not a double bottom but a head and shoulders top. Regardless of how it turns out, the benefit to understanding the pattern however is so one can be open minded to its possibilities and potential.

At this very moment the S&P 500 has carved out the first few steps of a potential double bottom. The market started to see subtle signs of distribution or smart money supply early in the summer as the market advanced on light volume. Once the selling kicked in, complimented by a lack of buyers, there was no place to go but lower [A]. The selling picked up steam [B] and ultimately resulted in a capitulating reversal in mid August [C]. Slowly but surely, the market dug itself out of the depths [D] as traders and investors waded back [E] in.

However as with July, slowly but surely, those who caught the reversal also started selling their inventory [F] and once again a reversal set in [G,H]. In mid-November the S&P found its way back to the August lows [I] and while it didn't reach the ultimate low witnessed on August 16th when the capitulation and reversal occurred, it did reverse at the precise level of the closing lows during the August reversal [J]. Unlike the August bottom however, now it is believed that stronger hands have re-entered [K] along with the speculators accounting for this reversal. We are now well on our way to the previous highs and while it is still early [L?], if we do return to these levels, the S&P 500 will have traced out a double bottom and one can expect much higher prices in the future.

The biggest question that one can pose is that we have been on a 5 year run, how could someone possibly use the term double 'bottom' when we are in fact near all time highs? This is a great question and one I will address tomorrow.

Today, all eyes are on Big Ben and the rate cut, however, the individual investor may be wise to be more reactionary than anticipatory. The financial stocks will be the tell and I will be watching to see how Citigroup (C), Bank of America (BAC), Merrill Lynch (MER) and others trade once the cut is digested. Furthermore, once the Fed is out of the way, attention will shift to Thursday's earnings report from Lehman Brothers (LEH), which will be a further tell into how much we really know about the damage that has been done.

It will continue to be an interesting week, stay on your toes out there.
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