What will the U.S. market recovery look like? We don't know exactly, but the history of chart behavior suggests several patterns we should look for, and it involves an alphabet soup of L, V and W shape rebound patterns.
Several factors help shape the pattern. First, is what I suspect will be some form of a further quantitative easing (QE3), be it direct financial stimulus or a further debasement of the U.S. dollar which will help export industries.
Counter this against continued high U.S. unemployment rate of around 9 percent, unmanageable budget deficits and credit downgrades.
When the uptrend reversal pattern ends there is no set outcome. The downtrend may continue, or a consolidation pattern may develop. It's the nature of the consolidation pattern that points the way to the future trend development.
The Dow, for one, is in the early stages of consolidation.
There are five potential consolidation rebound patterns and most of them are bullish. This includes the V- and W-shaped rebounds from support and also the inverted head-and-shoulder pattern. These are low probability because of their directional bias.
The rebound patterns that include a margin for a bearish fall are the most valid recovery patterns in the current market condition. This is the L-shaped recovery pattern shown in the schematic chart (not an actual Dow chart). The trading band consolidation is a sideways movement in a trading band defined by support and resistance levels. Often the volatility within the band remains high, although the exceptional current volatility is unusual.
The breakout, when it comes, is rapid because it's in response to a major change in conditions. This might include a policy announcement such as QE3. The breakout target is calculated by measuring the width of the trading band. This can be an upside or downside breakout. Often these targets are associated with historical support or resistance levels. Once the target is achieved the trend often continues.
Applying this L-shaped pattern analysis to the Dow gives an upside target near 12,400 and a downside target near 10,000. These are calculated from the approximate width of the Dow consolidation band between 10,800 and 11,600.
The second potential rebound pattern is the cup pattern and this is a stronger reversal pattern. The volatility reduces as bearish pressure declines. Bullish pressure builds more slowly, giving the rounded shape to the index recovery pattern. This is a measured move calculation with the depth of the cup projected upwards. This is an initial target and often the trend will continues smoothly past the target level.
If the pattern fails then the downside breakout is usually slow. The pattern may develop consolidation near the upper right edge or lip of the cup. This creates a handle. It may effect the measurement of the upside target, but it does not invalidate the bullish message from this chart pattern.
Time will tell which of these patterns is developing with the Dow index. Early recognition of the emerging pattern makes it easier to select the best trading approach. '
Correction: An earlier version of this story incorrectly described the attached image as a "Dow weekly" chart. It is, in fact, a created example of the pattern development, and not an actual stock or index chart.
Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders –. He is a regular guest on CNBC's Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.
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