While stocks have languished over the past two weeks, long-term U.S. Treasury bonds have been rocketing higher. The popular iShares 20+ Year Treasury bond ETF (TLT) formed a cup and handle technical pattern last week, which implies that there may be even more room to the upside.
A cup and handle pattern typically interrupts a long-term bullish trend with a bearish correction that forms a rounded bottom over a period of more than a few weeks. Traders look for the price to consolidate into a flag or pennant pattern near the prior highs before breaking out again to the upside, which is what happened last Wednesday.
In my experience, a minimum initial price target can be created by using a Fibonacci retracement anchored to the top and bottom of the "cup" portion of the pattern. In this case, the initial target for TLT was approximately $128.95 per share, which was met on Tuesday and exceeded today.
The traditional price target for a cup and handle pattern is equal to the full depth of the cup projected above the top of the pattern; that is $130.56 per share in this scenario. For those of you that would like to see another, very similar pattern to this one on TLT, you can find it by pulling your chart back to the fourth quarter of 2014.
A technical pattern like this has value to investors evaluating momentum in the bond market and among bond ETFs, but it also provides information about the broader market environment. As I mentioned in both the Monday and Tuesday Chart Advisor issues, the bond market's yield curve is continuing to signal a rising probability of an economic downturn in the next 10 to 18 months. One of the factors driving that signal is rising long-term bond prices.
In the meantime, the S&P 500 has now completed its bearish head and shoulders pattern. A similar targeting methodology can be used with head and shoulders patterns, which is in the 2,705 range on the S&P 500. As I have mentioned previously, bearish reversal patterns have a very high rate of failure in the stock market, so even this kind of breakout should be viewed skeptically while we wait for additional confirmation.
Risk Indicators – Bearish Confirmation
Charles Dow (of Dow Jones fame) developed a set of technical analysis concepts we call "Dow theory" more than 100 years ago. One of the core principles of Dow theory relates to confirmation between indexes. Specifically, investors should be wary of a breakout in one index that isn't confirmed by a similar breakout in another index.
Traditional bullish confirmation consists of a large-cap stock market index reaching new highs with a transportation index. In my experience, confirmation can provide a helpful signal to the downside as well. If the S&P 500 (large caps) is making new short-term lows and transportation stocks break support at the same time, the outlook should be much more cautious.
A signal like that is just starting to form. In the following chart, I have applied a moving average convergence divergence (MACD) technical oscillator to the Dow Jones Transportation Average Index. As you can see, the price of the index was making higher highs in February and April while the MACD was making lower highs. This is called a bearish divergence and indicates a higher-risk environment.
In the stock market, most bearish signals tend to only indicate a short-term correction, so the most common price target for a pattern like this is the low between the two highs at 10,000. That initial target was reached on Tuesday and may still act as support if the price begins to rise again this week. However, this is also a valid inflection point that could provide one-half of the confirmation of a bigger decline if support is firmly broken in the short term.
Bottom Line – Bearish Trades vs. Risk Control
In today's Chart Advisor, I have pointed out a few negative technical signals that are adding some weight to a more bearish forecast in the short term. However, I would urge patience at this point. Although these signals are worth monitoring, they are still within a provisional range for breakouts that could still be reversed with a bullish whipsaw. Because the failure rate of bearish patterns in the stock market is so high, I usually recommend that traders consider even the most compelling bearish signals as a timing indicator for enhanced risk-control, rather than shorts or bearish trades.
For example, many professional investors will reallocate to more conservative positions, hedge with put options, or sell premium with short calls when bearish momentum builds. If momentum really does accelerate to the downside, then more aggressive tactics are warranted. Just keep in mind that, historically, the risk of incorrectly identifying a bear market too early is much higher than missing the true bearish moves completely.
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