Does Anyone See A Pattern?

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The graph above shows the progress of the Dow Jones U.S. Total Stock Market Index from 1994 to present.  This capitalization-weighted index is comprised of all U.S. equity securities with readily available prices, essentially the entire U.S. stock market.  I have added the horizontal and slanted trendlines.  No graph shows conclusions, but rather presents a picture of the past from which the technically-oriented may choose to draw conclusions.

Each vertical line represents the monthly price progress of the index.  The two descending lines in the upper right hand corner of the graph depict the 7½% decline that the index has traced out since the beginning of May.  Because of the steepness of the trendline’s slope connecting the March 2009 and mid-2010 lows, the index is rapidly approaching that trendline just six weeks after hitting a new high for the current rally.  While there is no certainty that prices will continue down to or through the trendline, it is instructive to note how aggressively prices fell after penetrating the trendlines supporting the two prior multi-year rallies.

So persistent has the selling been over the past six weeks that most short-term measures are substantially oversold and in need of a rally to relieve that oversold condition.  Intermediate and long-term measures are not oversold and could certainly accommodate lower prices.  The lack of any meaningful rallies over that six-week span has produced short-term bearish sentiment readings that normally spawn a recovery rally.  Those bullish factors notwithstanding, if markets don’t rally when such conditions are in place, there is danger that investors panic and throw stocks on the market at any price, creating waterfall-type declines.  So while a short-term rally is the more likely prospect, there is danger that the rally might not materialize until prices descend far lower.  Next week should provide a resolution for this short-term tension.

The graph illustrates that the two prior major market tops in 2000 and 2007 took several months to develop.  One could argue that the current market has been building a topping formation since February, but it certainly looks less well developed than its predecessors.  Because so much of this rally has been based on confidence that the Federal Reserve would not allow the economy to fall back into recession, the rally’s durability is probably dependent on that confidence remaining high.  Should the deteriorating global economic condition undermine that confidence, market declines could unfold rapidly.

For those who look for technical patterns on graphs, it is easy to see this as a possible developing giant head and shoulders pattern.  I’ve drawn horizontal lines connecting what could be both shoulders and the neckline.  There is considerable symmetry in the pattern, with the 2007 head clearly at the top.  Obviously there is no necessity that prices decline beneath the neckline, but this would certainly form a classical picture, should that pattern unfold.  With numerous countries on the verge of bankruptcy and governments and central banks taking huge financial risks to keep them from default, almost any kind of market response is possible.  While it is conceivable that central planners will yet keep economies and investment markets afloat, the risks remain extremely high.