Fractals are patterned shapes that exist at different temporal scales. They are ubiquitous in nature, such as the large-scale outline of a continental coastline, and the close-up outline of a smaller chunk of the coastline; both show the same shape but at different scales. It is not clear why fractals appear in the trading numbers of the stock market, but then again, the reasons for their existence do not affect their utility. The reality is that fractals repeat and can be used to gauge possible scenarios in the future. Their existence may have something to do with the consistent nature of human behavior; en masse, humans tend to repeat the same actions. It goes hand in hand with the effect that investor sentiment consistently has on stock markets.
In our October article on this subject, we compared both the broad and the close-up views of the fractals present in the "Tech Bubble" of 1999-2000 to the present bull market. In this piece, we revisit the two markets and see where we stand now with respect to the fractals.
The pink rectangles on the chart below, show the similar trading patterns of the S&P 500 and the dollar index between 1995-2000, and 2012 until the present. In both time frames, the SPX and the dollar rose in tandem before the dollar entered a trading range (horizontal dotted lines on the chart), and the SPX experienced a double-bottom correction (blue rectangles on chart).
The green circles on the dollar chart, highlight the similar “bottom bouncing” pattern exhibited by the dollar at the end of 1998 and 2017. The dollar may be setting up for a rally that mirrors what happened in 1999-2000 and which could, once again, take the S&P 500 to euphoric highs late in 2018 or early in 2019.
A Closer View
The two charts below show a closer look at the S&P 500 trading during 1999-2000, and 2015-2018. Both markets began with double bottoms and then proceeded to make a series of rallies (R1 through R5 on the charts below) and corrections (C1 through C5). The patterns are similar, but the sizes of the moves are different; the rallies have been bigger and longer-lasting this time around, and the corrections have been smaller during the present bull market than during the Tech Bull market. This reflects the historically low volatility experienced by the current market.
Because the expected 5%-10% correction has failed to materialize, we are still in what is considered rally 4 (R4). The price to earnings ratio has stayed elevated, but the general downtrend pattern persists (red dashed line). It is impossible to know how much longer the market can continue to rise without a break, but the longer it goes, the closer a correction becomes.
Investor sentiment can help us get a better idea of where we are relative to the anticipated correction. Market tops, both minor and major, tend to occur when bull sentiment is above 50% and bear sentiment is below 30%. While this correlation is a necessary condition for tops, it is not a sufficient condition. However, bull sentiment above 50% increases the likelihood of minor tops.
The first chart below shows the fractals from the tech rally along with the American Association of Individual Investors (AAII) sentiment survey results. Notice that the bull sentiment was generally lower prior to rally 3 (R3), and then generally higher after that (red ovals) as the market worked toward its euphoric major top late in 2000.
On a finer scale, notice also that the top of rally 4 (R4) in 2000 coincided with a spike in bull sentiment above 50% (green ovals in chart above), and that the bull sentiment has spiked during the last two weeks (green ovals in chart below), which may indicate that we are close to the expected correction.
If these fractal patterns continue to play out, we would expect to see generally higher levels of bullish sentiment as the market works its way toward a euphoric major top in the next year or two.
In conclusion, the fractal patterns we are monitoring suggest that while a 5%-10% correction is close at hand, a major top to the current bull market is still many months away.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.