Raymond Micaletti's  Instablog

After a 56% rally in the S&P 500 (from the March lows to the August highs) and similar rallies across global equity markets, wondering whether risk assets are about to melt up now might be precisely the kind of (recency bias) sentiment that defines market tops. And, admittedly, only a day or two ago we would have thought such a question silly. But after Friday's close, a cursory look at various charts spanning multiple asset classes strongly suggests that an intense rally in risk assets may be right around the corner--that is, if textbook chart patterns resolve in textbook ways (if not, then financial market are deviously setting us up with one extremely impressive head fake).

We'll begin our tour of risk assets with the U.S. dollar--for no other reason than the fact that the direction of the dollar will likely drive the direction of all other asset classes, should recent market correlations continue to hold. With that in mind, taking a look at the chart of the dollar index, we see what appears to be a descending right triangle formed over the past several month, with support in the vicinity of 78 and successively lower highs:




Such a pattern suggests there is demand for the dollar index in the neighborhood of 78, but that supply is steadily coming online at lower and lower price levels after each successive bounce off 78. Because the successively lower highs indicate increased selling pressure, a descending right triangle generally indicates a bearish bias. Consequently, despite the relatively extreme bearish sentiment on the dollar (as delineated here), the chart pattern of the dollar index seems to indicate that the dollar could quite easily break below 78 and potentially below its interim low of 77.428 relatively soon. Of course, the dollar breaking to new lows would likely jumpstart risk assets worldwide and potentially cause panic buying in hard assets such as gold, silver, and crude oil.

If we're being honest, the descending right triangle in the dollar index isn't the cleanest of descending right triangles--and until recently one may have construed the chart as having formed a descending wedge--a pattern that has bullish implications. So perhaps our bearish interpretation of the dollar's chart is flawed. One way to corroborate this interpretation is to look at additional assets that would benefit from a weaker dollar and see if their charts are unambiguously bullish. To that end we will look at gold, eur/usd, and crude oil--and it's in these charts that we see the strong potential for a rally in risk assets.

Let's start with gold. Gold has the exact opposite pattern as the dollar (that is, if we accept that the dollar is in a descending right triangle), i.e., it's in an ascending right triangle, as one can see from the following figure:



From the figure we can see that gold has resistance at 1000, but is successively making higher lows on every pullback, suggesting increased buying pressure on every retreat. The textbook interpretation of an ascending right triangle is bullish--once the supply at 1000 gets absorbed, gold is likely to continue higher.

Moving on to the euro, we see a similar ascending right triangle pattern:




In the above chart, we see that resistance for the euro resides in the neighborhood of 1.44, and the currency has been tracing out successively shallower pullbacks each time it flirts with the 1.44 level. Again, if one buys the standard textbook interpretation of ascending right triangles, the outlook for the euro appears to be bullish.

Turning to crude oil, we see that, as with gold and the euro, the October contract is in an ascending right triangle:



Unlike gold and the euro, however, crude oil is not knocking on the door of its resistance at $75, rather it's making a successively higher low from its recent drawdown from the $75 area. One additional (moderately) bullish overtone for crude oil is that the October contract printed three straight doji candlesticks from Wednesday to Friday of last week after a short-term downtrend. Such a pattern is referred to as a bullish tri-star pattern and, according to candlestick charting lore, has bullish implications as a reversal pattern with moderate reliability.

Consequently, in light of the rather unambiguously bullish chart patterns for gold, eur/usd, and crude oil, we feel a bit more comfortable with our prior bearish interpretation of the dollar's chart pattern (despite the potentially extreme bearish sentiment for the dollar). What's even more impressive, however, with respect to a potential melt up in risk assets is that the bullish charts don't end there. In fact, the Nasdaq 100 may have the most bullish chart of any right now.

With little fanfare on Thursday and Friday, the Nasdaq 100 broke through what market technicians would almost surely have to consider major resistance (and that might even be an understatement). Which resistance would that be? None other than the primary downtrend line that connects the all-time high in March 2000 with the highs in October 2007, March 2008, and August 2008. Here is the long-term view:



Here is the close-up to show the trendline break:



One has to wonder: if such a dominant, primary trendline for the NDX cannot contain this rally, what can?

This breakout for the NDX also raises the question as to whether the S&P 500 is corroborating this move. While perhaps not having as overtly bullish a chart as the Nasdaq 100, the S&P 500 also has some very interesting recent patterns that suggest further upside.

For starters, the S&P formed a "morning doji star" last week, a bullish reversal signal with strong reliability:




Second, the S&P 500 has essentially changed its behavior since about the middle of July. Prior to that time, the index had reliably behaved in a mean-reverting way since the early 1990s (that is, up days tended to follow down days or at the very least, oversold and overbought conditions tended to generate short-term countertrend rallies). However, since July 13th, when the ominous head-and-shoulders pattern was demolished, the index has been behaving in a clearly persistent (i.e., momentum-driven) way.

For example, during the most recent four consecutive down days for the index (spanning August 28th to September 2nd) , the first three of those down days saw larger drops on each subsequent day (see the chart below). When the index rebounded on September 3rd and 4th, the rally on the 4th was larger than the rally on the 3rd. Without getting too technical (though one could indeed quantify these assertions with the statistic called the "variance ratio"), this is the hallmark of momentum-driven markets. Even visual inspection of a chart of the S&P 500 will show that prior to the middle of July, the chart was decidely jagged (indicating continual short-term reversals of each interim uptrend and downtrend), whereas from the middle of July onward, the chart has been excessively smooth (indicating up days are begetting up days and down days begetting down days). The upshot here is that if recent patterns hold, the S&P 500 may be in for a rally on Tuesday that ends up being larger than the rally on Friday.




Finally, turning to the VIX: if one is generous, it also appears to be tracing out a descending right triangle, suggesting further downside:




Of course, should the VIX break decisively below 25 with the S&P 500 Index continuing to behave in a momentum-driven way, higher equity prices are almost certainly on the way.

Thus, regardless of what one thinks of the fundamental situation with respect to the economy--and there are certainly very strong bearish arguments in that regard, which we subscribe to--if one only considers the broad technical situation of financial markets as illustrated by the preceding charts, it's hard to escape the conclusion that risk assets priced in dollars could very well be on the verge of a melt-up.

One caveat to an unrestrained bullish tilt, however, is that last week the equity markets saw a high volume selloff early in the week and a subsequent low volume rally to end the week (presumably many traders were taking time off before the unofficial end of summer). As a result, should market participants come back in full force after Labor Day thinking markets have moved too far, too fast (a not unreasonable belief), we may see moves that obviate the aforementioned bullish patterns--indicating that what we've just witnessed may have been nothing more than a head fake; albeit one that would make Larry Bird proud.

Disclosure: Author is long gold futures.

Congratulations to those who have been on the right side of this market's relentless rally. Regardless of the persistent questions as to whether the recent uptrend has been just another bear market rally or the origins of a sustained bull market, your gains are real.

Now it's time to protect them.

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