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Bear in Three Letters—DOW

Tuesday, 3 Feb 2009 | 1:23 AM ET

The three most powerful bearish signals in the market are a head and shoulder pattern, a rounding top and a down sloping triangle. It was the head and shoulder pattern on the Dow Jones Industrial Average that took the market to the first downside target of 11,200 in 2008.

The October 2008 plunge set a potential support area near 8,000. The last four months have seen a test and retest of this general support area. The optimists see this as proof that this support area can hold and suggest this is part of a consolidation pattern that may lead onto a strong rally.

Support is critical in a bear market but we should not ignore the behavior of the rally rebounds. Over the last four months, the rally rebounds have developed a pattern of declining highs. The first anchor point for the trend line was set by the rally peak near 9,600 in November. The failure of the early January rally near 9,000 established, a second anchor point for a new trend line.

A new downtrend line using these two anchor points is drawn on the daily Dow chart. This creates a down sloping triangle. This is a powerful bearish pattern in any market. In a bear market the strength of the pattern is increased. The pattern suggests there is a high probability of a downside breakout.

The down-sloping triangle is formed when a horizontal support line is intersected by a falling trend line. Price falls to the support level, where weak buying forces the price back. Buyers can bid less and still pick up stock. However, on each pullback, the fall is increased. Buyers can bid slightly lower to get the stock. This creates the falling trend line as each new decline is lower than the previous one.

When there are no more buyers at the support level, sellers must offer to sell stock. Often this means offering is substantially lower and the downside breakout takes place. This is a strong chart pattern and breakouts from the last third of the triangle can be very powerful.

The first feature to measure on this pattern is the height of the base of the triangle. This usually develops over one to ten days and contains price activity that predominantly moves in the same direction. The four-day base starts on October 7, 2008 with the drop from near 10,000 to 8,000. The measured base is around 2,000 points.

The value of the base is used to project upside and downside targets and sets a target near 6,000 for any downside breakout from this pattern. This is above long-term historical support near 5,600. A fall to this level moves the market out of recession territory and clearly into depression territory.

The down-sloping triangle provides a time frame for market developments. The apex of the triangle occurs in mid-April, 2008. This is close to the end of the U.S. tax reporting deadline. The market is entering the last third of the pattern development. Breakouts from this sector of the pattern can be very powerful and move very quickly to achieve their target levels.

There are three mitigating factors in the application of this chart pattern analysis. The first is the index itself. Chart pattern analysis is particularly reliable when applied to an individual stock. The chart pattern captures the psychology of the market. With an individual stock we are dealing with a defined group of people all with an interest in a single stock. The psychology is clear and unimpeded. An index is a collection of stocks and the psychological impact is diluted because there is a wider variety of participants and objectives. Pattern analysis on an index is applied with some caution. However, the broad bearish message of the pattern remains valid.

More From CNBC.com on the Dow

The second mitigating factor is the chart pattern on the Dow. The more consistent the pattern is with the 'ideal' pattern, the greater the reliability in terms of achieving projected targets. The support level near 8,000 was broken in November 2008. The pattern is not 'perfect' and to a small degree this detracts from the reliability of the pattern. It casts some doubt on exact downside target level, but it does not dilute the essential bearish message delivered by the chart pattern.

The third mitigating factor is the application of upside target projections. A successful break above the down-sloping trend line has a target between 10,000 and 10,600. The measured base of 2,000 points is projected upwards from the point on the trend line where any breakout develops.

The test and retest of support near 8,000 is not part of a consolidation pattern preceding a market reversal. It is consistent with a bearish down-sloping triangle pattern. The solution for survival in 2009 is defensive trading because there is no such thing as a defensive stock, a defensive sector, or a cyclical survivor in a depression market condition

If you would like Daryl to chart a specific stock, commodity or currency, please write to us at ChartingAsia@cnbc.com. We welcome all questions, comments and requests.

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