Four Horsemen to Identify a Possible Double Bottom

A caveat before I begin this post that deals with the perception of a double bottom pattern in market averages and indices... Charting, technical analysis, and the visual analysis of trends do not displace diligent understanding of risk and opportunity, and proper techniques of money management; nor should any user interpret their message as prediction. I like Carl Swenlin's denotation of technical analysis, "Technical analysis is a windsock, not a crystal ball."

After decades of sampling various studies of technical analysis, I whittled it all down to my core precepts, which I term my 4 Horsemen. Likely to strike some readers as simplistic (I contend elegant), these essential four tools are price, volume, area pattern, and trend. (The Greeks believed that 4 essences comprised all life -- earth, air, fire, and water. But greater even than those four lay the highest, rarest, and most important, the fifth essence, or quintessence.) The continuum is my quintessence, or 5th Horseman.

Price and volume would be constituent parts of area patterns, area patterns a constituent part of trends, and all four constituent parts of the continuum. Which means that, to me, the analysis of only one is done in a vacuum rather than placed within the context of its continuum, and therefore is incomplete, faulty, and likely wrong. To identify a possible double bottom, but fail to place that area pattern within its trend, and the trend within its continuum... Well, let me show you what I mean.

[click on images to enlarge]

We see, via the correctly placed trend line (A), the powerful uptrend in place since the 2003 low, the 4 year old trend's high trade, the building of a top (B, and next chart), the breach of primary trend line A in January 2008 (highlighted in yellow), and the gathering downward momentum since the trend line breach. Zooming in for a closer look...

Line 1, although not a trend line, shows clearly the market's loss of upside momentum (loosely captured by the direction of line 2); in fact, a top (area pattern A) builds due to this loss of momentum. Studies of price and volume within area patterns reveal subtle clues as to potential changes of the extant trend; for example, basic peak & trough analysis (in essence, lower highs and lower lows during a declining trend; higher lows and higher highs during a rising trend). Intra-day and inter-day volatility help define any area pattern, such as areas A and B above. Note that in area B (the possible double bottom), no short term trend endures for more than 3 days in either direction; a crucial tell. So what is happening in area B, the so-called "double bottom?

A double bottom (or, conversely, top) must conform to specific rules; most investors see two lows and perceive a double bottom. (Or, conversely, two highs, and see a double top.) Moreover, as with many area patterns, a double bottom occurs retrospectively; only the trade above the intervening high (~1400 for the double bottom we discuss) confirms the pattern. The pressure to tilt decisively downwards increases, however, as the 50 day simple moving average now trends down, begins to crowd recent prices, and acts as formidable resistance, just as it is formidable support during a rising trend. A double bottom tends not to crowd crucial support (at ~1270) at the second low, but instead bounds higher. In addition, distribution occurs on an almost daily basis within this pattern; individual price bars and area patterns suggest sellers grow increasingly anxious, while buyers tuck away their wallets. This situation -- sellers anxious to sell (at any price) while buyers go on strike -- represents a potentially negative outcome; the possibility for downside price gaps. NB: The yellow highlighted bars represent negative reversal days for the S&P 500 index; their increasing preponderance likely means this 4 month old down trend probably will worsen. Soon.

Of course, I hope I am wrong. Indubitably, the market is deeply oversold; unfortunately, when markets suddenly change directional trend, most investors fail to adjust their measurable ranges for what constitutes oversold and overbought conditions. In the current market, that would be to down from up.

But markets and trends do change. "Be prepared to adjust your tactics and strategy if conditions change." (Carl Swenlin again.) I admit that my opinion is only one among many, and that I am too often wrong. I have no problem being wrong. When investing, I would always rather have my portfolio loaded (laden?) with my Core Opportunities, and manage those portfolio positions, than watch the markets squiggle this way and that, hoping against hope that the next squiggle would ratify my market thesis -- while owning no stocks. My method fulfills the role of an investor -- to invest; the latter method is that of market seer. Investments and investing serve my interest to make money, they don't satisfy my emotional need to be correct.

As a professional investor, I prefer to seek investment opportunities, especially as the tendency for price declines is to be painful, dramatic, frightening... and fleeting. This is one reason I prefer to manage portfolio holdings, not market oscillations. So, yes, I would purchase Google (GOOG) for a contra-trend rally; every journey begins with a first step. But I never lose sight of that windsock.