Crouching Bear, Hidden Bull

Let's look at the Dow chart first. From a distance, we can see the two-year parallel price channel running against the long uptrend. This is not a complicated pattern. Most traders know it as the common bull flag. If this is true, then all we need to do is apply standard rules that we use every day to trade these simple congestion patterns.

What do we know about bull flags? First, we expect them to break out in the direction of the prior trend. So an eventual breakout is more likely than an eventual breakdown. Second, the pattern usually completes after price strikes each channel barrier three times, in alternation. Third, price should pull back on the third strike to a classic Fibonacci retracement level, such as 50% or 62%. Finally, when price breaks out of the pattern, we should see vertical movement. Now let's peek again at the Dow chart.

The Asia low in late 1998 marked the beginning of the Dow's dramatic rally through 10,000. The move ended just above 11,500 shortly after Y2K, and the index has been pulling back ever since. Notice the "hits" at the parallel lines. The first two at each end are easy to see. The third hit at the channel's bottom took place at 2:50 p.m. on March 22 of this year. It also printed right at a classic 62% retracement of the rally off the 1998 low. Perfect so far, huh? But the third strike of the upper parallel line is a lot less clear. Did it already happen earlier this year or, will it occur on the next pass?

I like the alternation rule when it comes to bull flags. Simply stated, since the first and second hits printed at the parallel lows, the third must start at the lows as well. The quick decline that shook the Dow last October never reached the lower channel, so the next rally to the top channel shouldn't be counted. In any case, what's a good buy signal without a few caveats thrown in?

The weekly S&P 500 chart offers fascinating clues to the start of a possible new bull leg. It tracks a highly predictive variation of Elliott's 5-Wave Decline, and you don't have to be a rocket scientist to figure it all out. The Master Swing Trader dubs this complex pattern the "TOP-1-2-DROP-UP." T12DU is drawn from a high that fails through two steep declines. A major washout takes place at the end of the last selloff. This generates a double bottom that eventually breaks through the downtrend into a significant new rally. If I didn't have to say it by now, the S&P 500 has faithfully drawn each aspect of this complex pattern except for the final breakout.

Draw a declining trendline across last year's double top (1) and the failed January rally (2). The recent decline ripped right through Fibonacci and channel support, but then printed a small double bottom and bounced strongly. Now is the time to watch the trendline closely to see if the index can break through. Some technicians argue that violation of the 62% Fibonacci level signals that an uptrend has failed. But not this technician. When a major price level breaks down but then remounts support, I see a climax, and impending long-side opportunity.

Of course the eventual fate of the blue chips is still in doubt. Price is now caught between the boundaries of these classic patterns, and may have its own twisted logic in mind. But the earlier that traders can anticipate an important shift in market direction, the better they can capitalize on the opportunities it will bring.