Technical analysis can be beautifully simple. Literally joining two peaks on a chart can lead to a profitable trade. But it can also fail, and over time, most people will find simple techniques lead to frustrating results.
The reason many technical trades fail is because the context is wrong. Shorting resistance during an uptrend is an obvious example. I wrote about this in more detail in my article "Why Technical Analysis Won't Make You Rich", but to cut a long story short, when you have some sort of idea of the drivers, the direction and the magnitude of a move, technical analysis has much better odds of working.
This is why I love the chart in this article so much. As a general guide to the S&P 500 (NYSEARCA:SPY) and Dow Jones (NYSEARCA:DIA) moves over the last two years, I don't think I have seen better. For me at least, it's "the best chart of the last two years".
Rather than just slap the chart here like I just happened across it, I think it is important to set context (that word again). There is a story attached, and it builds trust in what this chart has to say.
Here is the first time I tweeted it back in on October 23, 2015:
The way the S&P 500 had fallen through its long-term channel, tested support and rallied back for a re-test was very similar to how the German DAX (EWG) acted a year previously. It seemed a good bet the S&P 500 would react in the same way as DAX and sell off back to the lows.
Of course, there were no guarantees, but when two charts have such similar structures, positioning and sentiment are comparable and participants will likely react in similar ways. It's like a head and shoulders pattern, but with all the patterns before it matching too.
A few months later and 250 points lower, I then tweeted this update:
If you read the linked tweet, you'll see I thought it could drop into the 1,700s (it bottomed at 1,807), but I was clearly looking to buy for a big blow-off move higher. In terms of setting context, the chart worked very well. And there was some logic to it; the US indices had made a rounded top in 2015 while the DAX made a blow off move inspired by the ECB QE program. I figured this euphoric move was still due in the US, and DAX was the guide to how this may take shape.
Fast forward 18 months and 650 points, and this is what the comparison looks like today (I am using the DJI in this chart):
Zoom in and you can see exactly how closely the DJI has followed the DAX's blow off move over the last 18 months.
The DAX comparison called not only the direction but also the magnitude and structure.
However - and this is the point of this article - if the similarities continue, it now suggests the blow-off move from the 2016 lows is nearing an end. In both scale and structure, the DJI looks very much like the DAX when it topped in 2015. A decline of the same magnitude would take the US indices first to the pre-election lows, then to the 2016 lows; a fairly logical path for a large correction.
How tops are made
Bears have been searching for catalysts for a top for years. Yet, more often than not markets reverse on good news and euphoria.
When the DAX topped in April 2015, it was under precisely these conditions. The reversal was slow and sneaky; few people thought the trend had turned downwards and traders kept trying to buy the dip until the August 2015 flash crash wiped them all out.
The way the DJI tops could again be similar, and zooming in to compare the structures reveals the DJI looks nearly the same as the DAX even on smaller time frames.
I am much less certain of this short-term comparison than I am of the longer-term comparisons, but if we see this particular pattern continuing, it would be exciting and potentially very profitable. The DJI (and the S&P 500) could therefore top on the next high.
Regardless of how the DJI moves in the next few weeks, the DAX comparison is an interesting and potentially helpful guide over the medium term. It tells us the US indices are likely at the end of this blow-off move. It also shows us how a top and decline may take shape.
This is the context I am working with when I do my analysis and make my trades, and as we know, context is key.
Disclosure: I am/we are long EWG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long the DAX for a short-term trade.