Section 10:

Market Phases

 

Bull Alert

Trading bullish reversal patterns is the best bet during Bull Alert markets.

The Bull Alert market is one that is transitioning from an extended bear market to a stabilizing market to eventually a bull market. Investor sentiment is extremely negative in a Bull Alert market. The broad market averages, such as the S&P 500, are trading at least 10 to 20 percent lower than recent highs. Investor fear is relatively high. Broad market oscillators are in deeply oversold levels. Many more stocks are reaching new lows than new highs.

But even during the worst depths of an overall bear market, some stocks will be showing signs of life. Some stocks will be tracing bullish reversal patterns such as triple bottoms and head and shoulders bottoms. It is during the depths of a bear market that bullish reversal patterns will lead to the biggest gains.

Figure 10.1

Example:

A great example of a Bull Alert in the broader market is illustrated in Figure 10.1 in the S&P 500 ($SPX) between July of 2002 and March of 2003. Notice the erratic, extremely volatile price action that occurred during this period. The market was swinging wildly, up and down.

During this period investor sentiment was extremely negative. Most stocks, sectors, and broad market averages were extremely oversold. Investor fear levels were extremely high.

Notice the head and shoulders bottom that formed in the S&P 500 during this period. The formation of this particular pattern reinforced the Bull Alert conditions and pointed to much higher prices in the future.

Bull

Trading bullish continuation patterns is the best bet during Bull markets.

A Bull market is one in which there’s still some skepticism towards higher prices. Yet the broad market averages continue to plow higher, week after week. Investor sentiment is somewhat skeptical during Bull markets. Broad market averages are off of their lows and in a well-defined bull market as identified by one of the methods for determining trends. Investor fear is elevated, but down from recent highs. Broad market oscillators are pointing higher, ideally at mid-range values. The number of new highs and lows is sometimes equal or slightly favoring new highs in a Bull market.

The stock market tends to move higher over time; therefore, it’s a good bet to focus on trading bullish continuation patterns in bullish stocks most of the time. This obviously isn’t an encouragement to trade nothing but bullish continuation patterns. There will be times that it doesn’t make any sense whatsoever to go near a bullish continuation pattern. Be prepared for these times. But the majority of time in the stock market, trading bullish continuation patterns will improve the probabilities of success.

Figure 10.2

Example:

An example of a Bull market is shown here in Figure 10.2 in the S&P 500 from the beginning of 2004 through the end of 2006. The broader market continued higher along a path of higher highs and higher lows.

Notice at several points along the bullish trend that there were periods during which the S&P 500 appeared to have stopped going higher and even reversed its bullish trend after the formation of bearish reversal patterns. Yet the index continued moving higher and higher over the course of many years. This is an example of how Bull markets can last for long periods of time.

Neutral

Trading a balance of bullish continuation and reversal patterns, and bearish continuation and reversal patterns is a good bet during Neutral markets.

Neutral markets occur often enough. They are marked by periods of uncertainty or change. Investor sentiment is somewhat mixed, or uncertain. The broad market averages might be ten percent from recent highs or lows, or trading within well-defined ranges of support and resistance. Investor fear is generally within a trading range. Broad market oscillators are usually pointing in directions opposite from the broad market averages, or trading in the middle of their own ranges. The number of new highs and lows is generally equal.

Figure 10.3

Example:

An example of Neutral market is shown in the S&P 500 in Figure 10.3. For the first ten months of 1999, the broader market chopped back and forth; the market didn’t have a clear trend. This was a difficult period during which to make big profits. Trading a balance of bullish and bearish positions was one way to avoid the whipsaws that accompanied this Neutral market environment.

Bear

Trading bearish continuation patterns is the best bet during Bear markets.

A Bear market is one in which the trends of most stocks and the broad market averages are decidedly down. A bear market is usually a precursor to an economic recession or the result of an exogenous event. Investor sentiment is deteriorating, but not yet to extreme levels. The broad market averages are pointing lower, and are at least ten percent from recent highs. Investor fear is elevated from recent lows, and rising. Broad market oscillators are pointing lower, but have not yet reached extreme levels. The number of new lows is greater than the number of new highs.

Bear markets are rare. But they can be devastating. That’s because stocks tend to fall faster than they rise. Enormous reversals from bullish to bearish trends can take place in a matter of weeks.

Figure 10.4

Example:

An example of a Bear market is illustrated in the S&P 500 as shown in Figure 10.4. This particular Bear market was a devastating one. It ran from late 2000 and into the early part of 2003. This was a unique bear market in that it lasted for such a long period of time and saw such steep declines in the broader market averages. This bear market accurately predicted a recession in the U.S. economy.

Observe the formations of many erroneous bullish reversal patterns throughout this bear market. There were several double bottoms and triple bottoms that formed, but were eventually rejected as the S&P 500 continued along its path of lower lows and lower highs.

Bear Alert

Trading bullish reversal patterns is the best bet during Bull Alert markets.

The Bear Alert market is one that is transitioning from an extended bull market to a leveling out to eventually a bear market. Investor sentiment is extremely optimistic in a Bear Alert market. The media is regularly broadcasting the excitement surrounding the market. Major publications are running cover stories about the vast amounts of wealth being made in the stock market. The broad market averages are most likely trading at all-time highs. Investor fear is non-existent. Broad market oscillators are in deeply overbought levels. Many more stocks are reaching new highs than new lows.

The stock market moves through cycles, plain and simple. It’s easy to forget this point when stock after stock is screaming higher, and everyone is talking about how much money they’ve made on XYZ. But even during the best of times in the stock market, some stocks will be showing warning signs. Some stocks will be tracing bearish reversal patterns such as triple tops and head and shoulders tops. It is during these heady times that bearish reversal patterns will lead to the biggest gains.

Figure 10.5

Example:

An example of a Bear Alert market is shown in the S&P 500 in Figure 10.5. Investor sentiment was near all time highs of optimism. The media were regularly running stories about the boom in stock prices. The bull market was many years old before this Bear Alert phase. Most stocks and sectors were extremely overbought leading into this phase.

Notice the extreme levels of volatility in the S&P 500 during this Bear Alert. The broader market, sectors, and individual stocks traded very violently from one week to the next, making it difficult to make money.