Bear Flag or Bear Trap?

07/12/2012 4:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

The action in the stock market from the June 4 lows has divided Wall Street into bull and bear camps. There are fundamental and technical arguments on both sides, and a clear understanding of each should give you an edge.

From the charts of the S&P 500, the flag formation is easy to see. If it is completed by a break below the late June lows, the major averages should drop back to (or likely below) the early June lows. Those bearish on the market have therefore been looking to establish short positions on the rally.

The alternative view is that the early June lows were more significant, and that they mark the start of a new intermediate-term uptrend. From this perspective, the current rally will serve to trap the bears on the short side of the market and provide the fuel to push the market higher.

The confirmation of the bullish divergence in the NYSE Advance/Decline line in June put me firmly in this camp, as the action suggested that the intermediate-term uptrend had resumed. The markets and technical indicators now need to move above the early July highs to confirm this view.

I have always tried to be as objective as possible in my analysis, and whenever I make a recommendation I look carefully for the price or technical signs that will either confirm my view or tell me that I am wrong. This process makes it more difficult for one to ignore evidence that their analysis is incorrect.

Of course, if you are placing your stops correctly, being stopped out will often, but not always, tell you that you are on the wrong side.

In this article I will look at the evidence that supports both the bearish and bullish case, and point out the triggers that will confirm either view.

I think it is important to understand some of the common features that are characteristic of bear flags. Of course, bear flags can form in bear markets, but also in bull-market corrections.

In June 2008, I wrote the article “Bear Market Rallies—Part 1," where I reviewed some past examples of bear-market rallies in both the US and overseas markets. In addition, I focused on the current market action, as it was my view than that the rally from the March 2008 lows to the May highs was a bear-market rally that was setting the stage for another decline.

Since this was such a classic example of both bear flags and bear-market rallies, it is a good place to start.

The weekly chart of the Dow Industrials (from the original article) covers the period from June 2006 through early June 2008. On the bottom of the chart is the 14-week RSI index developed by Welles Wilder in the late 1970’s

While this is an indicator that I have written about frequently (read Accurately Analyzing RSI Divergences), I generally don’t include it in my daily charts column, but refer to it often to see if it is in agreement with the other technical studies.

Like all of the indicators I use, it is more valuable when used on weekly data. The weekly RSI made its high in early June 2008, and when the Dow Industrials made a higher high in July, it formed a lower high. This negative divergence was followed by the sharp stock-market decline into the middle of August.

In October, the Dow Industrials made a new high of 14,198, but the RSI made another lower high, as indicated by line D. This negative divergence was confirmed the week of November 9 (point 1), when the RSI broke its support (line B). The weekly RSI stayed below its WMA from October 19, 2007 through March 20, 2008.

The sentiment on the economy and stock market had become quite negative by February 2008, and so when the stock market began to rally in March, many stayed out.

The Dow’s rebound from the March lows slightly exceeded the 50% retracement resistance at just under 13,000, but failed below the 61.8% resistance at 13,232. A move above the 61.8% resistance would have been the first sign that this was more than a bear-market rally, but the 78.6% level had to be surpassed in order to confirm a new uptrend.

As stocks were peaking in May, the sentiment had shifted, as many in the financial media were claiming that the economy was not in a recession, nor were we in a bear market.

The action in the RSI painted a different picture. The RSI had just rebounded back to the former uptrend (line B) and the bearish divergence resistance at line D (point 3). After the RSI failed at this resistance, it then dropped back below its WMA, consistent with a rally failure.

In determining the trend of the market, the Advance/Decline line is my favorite and most reliable technical tool. The NYSE Advance/Decline line has been in use for much longer than the relatively new A/D lines on the different market averages.

The NYSE A/D line peaked on June 4, 2007 (point 1), then formed a lower high in July (point 2). The decline from the July highs pushed the A/D line well below significant support and its WMA.

The ensuing oversold rally took the SPY to a new high in October (point 3). The A/D line just rallied back to its bearish divergence resistance (line a), and formed another negative divergence.

At the March 2008 lows, the A/D line did not form a positive divergence. But by April 1, a new uptrend was underway, as it was above its WMA and had formed higher highs and higher lows. By the middle of April, an uptrend (line d) was evident, as was a flag formation on the price chart (lines a and b).

For the Spyder Trust (SPY), one could identify the key Fibonacci retracement resistance levels using the October 2007 high and the January 2008 lows. The 38.2% retracement resistance at $138.04 was overcome in early April, but the 50% resistance level of $141.76 was not surpassed until May.

The rally reached a high of $144.30 and tested the upper boundaries of the flag formation (line a). This high was still below the 61.8% Fibonacci retracement resistance at $145.48.

The A/D line slightly surpassed the long-term downtrend (line a) before reversing. The uptrend in the A/D line (line d) was broken on June 9, which corresponded nicely with the signal from the weekly RSI on the Dow Industrials. This confirmed that the bear flag formation had been completed.

So what about today’s market? The weekly RSI analysis of the SPDR Dow Jones Industrials (DIA) supports the bear flag scenario, as it paints a more negative outlook for the stock market.

The weekly RSI has formed lower highs over the past year (line b), and has diverged from the price action (line a) .The weekly RSI did form a bullish divergence at last October’s lows (line d). This was confirmed by the move through the downtrend in the RSI (line c).

The RSI dropped below its WMA in April. Then, as DIA was making a new high in early May, the RSI formed a lower high (line e). The Dow Industrials A/D line also formed a negative divergence at the May highs. The RSI has just rallied up to its WMA, and needs to move above the downtrend (line e) to turn positive.

The daily RSI analysis is still positive, as it formed a positive divergence at the June 4 low (line i) that was confirmed two days later when the intervening high was overcome. The move through the RSI’s downtrend (line h) was also positive.

The RSI has formed higher highs, and as of Tuesday’s close, it was back below its WMA but still above the June lows and the key bullish divergence support (line i). 

The long term weekly chart of the NYSE A/D line shows that it has made higher highs since 2009. This is a strong sign that the major trend is up. It was also one of the factors that put me in the bullish camp at both the September 2010 and October 2011 lows.

The Spyder Trust (SPY) violated the major 38.2% Fibonacci retracement support last October. There is important weekly support (line a) now at $111, with the 50% retracement support at $104.70.

The weekly A/D line peaked in late April (line b) and then dropped below its WMA for three weeks before reversing to the upside. The A/D line did turn lower last week, but is still well above its WMA.

A drop below the June lows and the near term uptrend (line c) would signal a deeper correction. The major long-term support (line d) that connects the lows from 2008 and 2010 is still well below current levels.

The daily chart of the Spyder Trust (SPY) shows that the upper boundaries of the flag formation were tested last week, as SPY peaked at $137.80. This was well above the 61.8% Fibonacci retracement resistance at $136.45. A move above the key 78.6% retracement resistance at $139 will confirm a new rally phase. The daily downtrend (line e) is now at $140.50.

The lower boundary of the flag formation (line g) is now in the $133.20 area, followed by important support at $130.85, which corresponds to the late June lows. The now-rising 200-day MA is at $130.60.

The daily NYSE A/D line formed a bullish divergence at the June lows (line j) that was confirmed by the move above the late May highs on June 15. The A/D line moved above the April-May highs in early July (line h), and has been acting much stronger than prices.

The A/D line is currently declining. This chart is updated as of July 10, but as of the close on July 11, the A/D line was still above its WMA and the uptrend (line i). If these are broken, there is important converging support now (lines j and k).

The current sentiment picture is also more characteristic of a bear flag, as too many are bullish from both the AAII survey of individual investors and the financial newsletter writers. There seem to be more negative analysts on the financial TV shows, but this is difficult to quantify. The sentiment is likely to turn more negative this week.

Often, the completion of a bear flag formation will be telegraphed in advance by the RSI, OBV, or A/D line breaking key support ahead of prices. The key levels to watch now are the lows made on June 25. A close in the RSI and NYSE A/D line below those lows will confirm the completion of a bear flag, suggesting a drop to the early June lows.

Since the NYSE A/D line is positive from an intermediate-term standpoint, a drop below the June lows is likely to be well supported. It is also likely that the A/D line will form further positive divergence if the SPY drops below the June low at $127.13.

To support the bullish or “bear trap” case, SPY needs to turn higher in the next several days, and more importantly the A/D ratios need to be strong on any rally. A rally on weak A/D numbers will be negative.

The SPY needs a close above the 78.6% resistance at $139 to confirm a new uptrend. On any rally, it will be important that the daily technical studies are able to move above the highs from July 3.

Of course, I will update you in the daily ‘Charts in Play” column when the current pattern in the stock market is resolved. I hope that this more detailed analysis of the stock market will help you better navigate not only the current market, but also serve as a reference for you in the future.

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