Warning Flags in the Stock Charts: Reversal Ahead?

Stock traders at NYSE
Stock traders at NYSE

Flags are flying in stock market charts, and they're warning that last week's indecision will be decisively broken shortly by either the bulls or the bears.

The flag pattern (also called a pennant or wedge by some chartists) is formed when prices narrow into an increasingly smaller range. This occurs when each day's trading range narrows: The day's highs are lower than previous days, and the day's lows are higher. Drawing lines connecting the highs and lows form a triangular shape reminiscent of a flag or wedge. If the pattern is long and narrow, chartists refer to it as a pennant.

Whatever you name it, the pattern indicates an extended period of indecision that's generally broken by a strong uptrend or a sharp downtrend. Of course, which way it will break makes all the difference -- and that direction can often be discerned by other technical analysis clues.

Let's look at charts of the three major indexes in the U.S. stock market: the S&P 500 (SPX), the Dow Jones Industrial Average (DJIA) and the Russell 2000 small cap index (RUT) for evidence of which is more probable -- a bullish continuation or a bearish reversal.

If we glance at the chart of the S&P 500, we see three bearish indicators: RSI (relative strength) and MACD (moving average convergence-divergence) are both declining, and volume has hit the skids. Rising volume is often called "the weapon of the bull" because higher volume reflects strong demand for stocks -- demand that overpowers selling, which can push stocks higher. Conversely, declining volume reflects lower demand for equities -- a clear sign of a weakening market.

Another bit of technical evidence can be found by examining the previous peak in August. The market wandered trendlessly for six days before breaking down. If we look at the candlesticks in this six-day period, we find some similarities to the candlesticks formed last week.

Candlestick technical analysis has its roots in 17th century Japan, and so some of the names are Japanese. One is "doji," which describes a trading day that sees price oscillate up and down but closing at or near the opening price. This is a classic sign of indecision: The bulls couldn't keep the gains of the day, and the bears couldn't keep prices down.

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Some candlesticks have colorful names, for instance "hanging man." This occurs when price drops dramatically during the day but recovers at the close. The price drop is drawn as a long tail. A hanging-man candle is considered a bearish reversal signal. In both periods (August and the last week of October), you'll find both dojis and hanging-man candles, which suggest technical similarities between the two time frames.

Another strong parallel connects these two periods. Notice just how unusual it is to have five or more days of indecisive, trendless trading.

That the market broke down at the end of the last period of indecision while RSI and MACD were both declining should give bulls pause.

The Dow Jones industrials exhibits the same flag pattern and an ominously steep drop in volume. Note how the lower flag border is about the same as the 20-day moving average (MA). Last time price broke below the 20-day MA in August, the market fell over 400 additional points.

In other words, the 20-day MA is a line in the sand: If price falls below this line, it typically continues declining.

Continuing on the Russell 2000 chart, we observe the same flag pattern: Both the large-cap Dow stocks and the small-cap Russell 2000 stocks are behaving almost exactly the same, as are the broad-based S&P 500 equities. That lockstep indecision tells us this concern isn't limited to small-cap or large-cap stocks, but to the entire market.

On the Russell chart, we see that the last flag formation broke bearishly in August, and the strong uptrend that's been in place since early September has been broken by the last week of extended indecision.

Though the 50-day moving average rose through the 200-day moving average in a classic "bullish cross," price has not confirmed this positive signal.

Given the declines in volume and key indicators such as relative strength and MACD, and the similarities to the flag formation in August, the preponderance of evidence suggests these flags are signals of caution -- and perhaps even a significant warning of a reversal just ahead.