The Year in Crayons

The last week of 2011 in the markets was mostly uneventful as price action basically drifted sideways finishing the week right around where it started, capping off a year that also finished right around where it started. Of course, while the action this week was fairly quiet on low holiday volume, most of this year’s sideways action was done in a much more spectacular fashion as bulls and bears both were trapped on several occasions resulting in explosively volatile moves up and down the charts as the markets figured out the edges of our broad range of consolidation.

Looking at a chart of the e-mini futures contract for the S&P 500, we can see that this year’s action was littered with several bull and bear traps as we probed the key levels of our wide trading range. We can basically divide the year into two periods;

(1)The massive head and shoulders pattern we formed in the first eight months of the year.

(2)The two staged recovery during the last few months as the bulls clawed their way out of the huge hole formed during the breakdown from period one.

Dividing the two phases of this year’s action is the slightly rising neckline of the head and shoulders pattern which supported price action strongly during phase one, but ultimately became a key level of resistance as it became a price ceiling during the second phase of the year. Keep an eye on this trendline as it figures to affect the direction of future price action as we open trading in 2012.

In examining the first period of trading of 2011, one important point to keep in mind is the context under which it took place. We had rallied sharply over the previous two years after a disastrous plunge during the back end of 2008 and there was quite a bit of debate as to whether the markets could break past the highs we formed just prior to the 2008 crash on the back of quantitative easing or if we would drop back down to new lows on a “double dip” move. Each of the key points of the head and shoulders pattern were moments where either the bulls or the bears became convinced that their scenario would win out only to see the market “inexplicably” run away from them. Of course, eventually in late July, the bears finally won out after a strong hammer candle fooled the bulls into thinking that the neckline would indeed hold on the “too obvious and easy” to see head and shoulders pattern.

This spectacular fall led to the second phase of our year’s action in which the previously shell shocked bears now dared to dream of a double dip while the bulls desperately tried to recapture the gains they had made during the previous year’s rally. The markets first attempt at stabilizing after the steep drop we experienced in late July and early August occurred during a volatile two month stretch that featured several swift moves as bulls and bears repeatedly fooled each other as price sharply fluctuated between the extremes of the short term range. In late september, price action finally exited this range to the downside, but ultimately failed as the market instead formed a double bottom as price quickly reversed course and headed higher. The bear trap formed during this false break down can be viewed as the sister move to the bull trap that led to the breakdown from the neckline and amazingly led price back to and through the level from which we had initially broken down from to begin the second phase of the year. Even more amazingly, volatility actually expanded during this tremendous squeeze and even continued for another month as price spectacularly failed at the new price ceiling formed by the neckline from the head and shoulders pattern and threatened to break down back to our lows after several days of repeated distribution with no buyers in sight. However, the bulls eventually stepped in and were able to push the markets back to ground zero to end the year and form a big doji candle on the yearly chart.

Below is a yearly chart of the SPDRs S&P 500 trust etf (SPY) showing the action of the last couple of decades. As we can see, this year’s action formed a doji candle reflecting the indecision that marred most of the year’s trading. This was to be expected after three years of strongly trending action (one down, two up) and is likely to be followed by more indecisive behavior as we are firmly in the middle of a fifteen year range that has now had two major tops and two major bottoms defining it.

The two multi-year tops occurred during the overly exuberant heights of the dot-com era and the real estate boom. The two bottoms occurred during the desperate depths this country experienced shortly after 9-11-01 and after the financial collapse/debacle that led to our most recent recession. These are all MAJOR events and traders should keep in mind that price will likely stay contained within these parameters until there is a proper catalyst to push it through. Of course, part of the reason why trading was so erratic this year is because the threat of major catalysts has become pervasive during the current environment. For instance, the last three years of free money can be construed as the third “good times” era of the last couple of decades and may end up culiminating in another major top if we continue to fall back on quantitative easing. On the other hand, the continued threat of insolvency across the world can ultimately lead to a calamitous drop either to or below this multi-year range and ultimately lead to another major bottom at some point in the next few years.

As we close this year and look towards the next, traders should step back and look at the big picture as they develop their game plan for the coming year(s). Good luck as you enter 2012.

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Posted in Charting & Analysis, Charts, Commentary, Futures, General Trading, Indicators, Stocks