Market on Verge of Major Breakout

Market on Verge of Major Breakout. 

Bow tie chart pattern suggests big upside move is coming

By Sam Collins, InvestorPlace Chief Technical Analyst

On Monday, stocks fell for the third straight day as the European debt crisis resurfaced and China’s economy continued to slow. Europe’s bourses hit the skids asSpain’s 10-year bond yield popped to over 7%, a level that most economists consider unacceptable.

At the close, the Dow Jones Industrial Average was off 36 points at 12,736, the S&P 500 fell 2 points to 1,356, and the Nasdaq lost 6 points at 2,932. The NYSE traded 649 million shares and the Nasdaq crossed 395 million. Decliners led advancers by 1.3-to-1 on both exchanges.

Much has been written recently about a fairly obscure chart formation called a “bow tie.” I must confess to being ignorant of the formation until it was recently highlighted by Jeffrey Saut of Raymond James.

“A bow tie is created when there is a confluence of moving averages into what looks like a bow tie,” Saut said. “The configuration does not tell us which way the stock market is going to go, it does tell us there is the potential for a move of some substance.”

The more volatile indices that have led the market since early last year have been the small-cap and midcap ones. Thus, if the bow tie has significance, I would think that these indices would provide examples. The convergence of the 20-day, 50-day and 200-day moving averages on the Russell 2000 in early August 2011 led to a dramatic 20% collapse of stocks. Are we seeing such a convergence again, but on the upside?

A graphic example of the bow tie exists in the chart of the more staid NYSE Composite Index. Adding a 10-day moving average (purple line) results in a convergence in December 2011 that led to an advance of almost 12% by March 19.

But of the illustrations of this formation that I’ve reviewed, the convergence of four moving averages that now appears on the NYSE chart has the highest visual impact. The tight squeezing together of the 10-day, 30-day, 50-day and 200-day moving averages is very rare.

Conclusion: Our internal indicators (MACD, stochastic, momentum, RSI) offset each other. But the sentiment indicators (AAII and Letter Writers) are bullish. What to do? When in doubt, always go with the major price trend — and that is up. Thus, the bow tie tells us that despite the recent correction, we are on the verge of a major upside breakout.