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'Wedge' patterns as predictors

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A chart pattern that is not seen all that much is a wedge, which is bullish like currently, when falling and tending to predict a bearish outcome ahead when rising. By far the better record at predicting comes with a bullish falling wedge.

I wrote about the bullish falling wedge pattern at times in recent week as price action in the S&P and the Nasdaq have traced out the pattern. Wedge patterns are relatively rare and more so in the indexes, but of course there are many more stock charts to look at over the years. The fact that there are more wedge type patterns in stocks to study means that there is less to go on in terms of numbers of outcomes after wedge formations develop in the INDEXES.

As to a rising OR falling wedge, the pattern of a falling wedge shows a better history of predicting a substantial recovery move after this type wedge is traced out.

Definition, Falling Wedge: A declining price trend, often steep, bounded by two down-sloping straight lines (trendlines) with the lower line drawn through the lows and the upper drawn through the rally peaks; the trendlines, extended out beyond present prices intersect at a point or time ahead. When drawn on a chart, either intraday (e.g., hourly), daily or weekly, the picture looks like a 'wedge' tilted downward. And example provided by the S&P 500 (SPX) daily chart is below.

Once prices pierce the upper trendline, there is a tendency for a rebound and the rise in prices often ends up carrying above the top of the formation; the run up in prices can be rapid, especially in stocks. There are also many instances where prices continue moving strongly higher and end up scoring outsized gains; I'll have a stock chart example of this further on.

WHY this outcome is a common question. In other words, what is this pattern showing in terms of behavior of market participants? About 2/3rds of the time for stock charts fitting the foregoing definition that Tom Bulkowski studied for his book, The Encyclopedia of Chart Patterns, act as consolidations of the prevailing trend. This doesn't appear to be the case in the current bear market unless the very VERY long-term of rising stock prices is seen over decades!

About 1/3 of the examples studied of the falling wedge pattern is similar to what happens with a spring being wound tighter and tighter. I also tend to think of it as the compression of gas and air at the end of a piston stroke. Either the spring unwinding or the piston can or will end up in an explosive move as conditions change; e.g., the extreme in bearishness driving down stocks becomes perceived as being TOO extreme such that shorts cover AND buyers move in.

Let me go back to what is seen in the wedge pattern. Besides the falling trendlines as seen in SPX, there is should be multiple 'touches' to the trendlines, at least 3 to one and 2 to the other. What's with the low that dropped below the lower trendline? An example of how an internal trendline is constructed by drawing the trendline with the MOST number of lows and which then often will ignore an occasional intraday spike low.

[Image 1]

Use of a line chart for SPX will show a clearer definition of 'unbroken' trendlines. You'll also can see that there are at least 6 collective 'touches' to the upper and lower trendlines; more, depending on how you count them. What is the expected outcome when prices pierce the upper trendline? The average rise in the stocks that Bulkowski studied was 43% as measured from the breakout point, with the most likely rise being between 20 and 30%.

Do I believe that we'll see SPX now rally a further 180 points or more? This would seem to be a more bullish outcome than could be 'supported' by current economic conditions and earnings forecasts; e.g., back up to 1100, maybe to 1300! Indexes don't often make moves equal to individual stocks, but a potential long-term double bottom low HAS set up in SPX and a 'minimal' fibonacci 38% retracement of the decline from the 2007 top to recent low would carry SPX back up to 1061.

[Image 2]

Speaking of stocks, next up is another falling wedge formation for the stock of Boeing (BA). An extreme example of how suppressed buying and 'compression' can affect a stock when buying starts to come back in due to changing fortunes or simply perceptions of it for the company comes back into play, BA's weekly chart traces out its bullish falling wedge. After the upper trendline was pierced, the stock had an enormous run up. My notation should perhaps refer to the gain AFTER breakout, to the ultimate peak for the period shown, years in this case. Hourly, daily or weekly, technical/chart patterns, no matter, all will tend to show similar outcomes in terms of the pattern.

[Image 3]

I'll show a closer view next of the period when the triangle forming the wedge pattern was traced out. Zooming in I see that the breakout point was actually closer to 28.5, not as I have it above at 29.3. An aspect of the wedge pattern that is of a general significance is where the apex is; i.e., where the two points converge and touch. The breakout move for Boeing came very CLOSE to the apex of the wedge.

It is more common for powerful moves to come when a breakout occurs at 50% to 80% of the distance from the start of the formation out to the apex or end of the triangle. This would make SPX's breakout (assuming it lasts) and what will be seen with the Nasdaq Composite next, closer to the norm for power moves, especially in stocks.

[Image 4]

I've outlined the bullish (implied) falling wedge pattern in the daily chart of the Nasdaq Composite (COMP) up next. COMP's recent upside breakout above 1500, in terms of implications of the wedge formation, would suggest an extension of the recent rally back up to the resistances shown, perhaps higher.

If the wedge pattern results in a future outcome similar to about 85% of stock examples studied previously and cited in the Bulkowski study there could be a further gain of 20% or more, although the S&P seems the more likely candidate for this much of a rise. If there is not a substantial move higher, it will suggest a 'failure' in the frequent outcome of the falling wedge.

The other possibility is that prices falter then fall back lower and stays within the trendlines. A later sustained breakout from lower levels then remains a possibility. Based on recent price action, although Friday was a low volume day, I'm anticipating a good-sized further advance although I can't predict what future fundamentals will be seen as warranting this. Stay tuned!

[Image 5]

I said that I would talk about the opposite wedge pattern, one that is a bearish RISING wedge. However, the outcome after this formation occurs is not as reliably bearish, nor are the declines that do come as great in percentage terms after a break of the LOWER trendline.

When it works out, such as seen with Apple Computer (AAPL) below, the average further decline from the breakdown point is in the 15-20% range. About 6 of 10 rising bearish wedge patterns end up reaching the 'average' decline. AAPL doubled that as you see next.

[Image 6]

I won't go further into the rising wedge. It makes more sense to go into it another time and particularly if/when an example is traced out in the major indexes. Examples of this pattern was NOT seen in the major tops of 2000 and 2007.


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