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Mar 01

Is It A Megaphone? A Broadening Top? No, It’s An Uptrend

There’s been a lot of talk recently about a broadening top pattern in the Dow. It’s not something I give much credit to as I believe it’s impractical to trade and we should follow the evidence of price and trend rather than try to predict, but it’s given the pundits and commentators something to talk about, as fear is so much easier to sell.

Now, given I’m a CMT, before I get accused of some form of treason or hypocrisy in questioning the merits of some technical tools, I try to be what all technicians and fundamentalists should be in their analysis; objective, and I recognize that to do a job well it often takes more than one tool, and those tools are only effective when in the hands of someone who knows how to use them.

So let’s take a look at what’s got everyone hyperventilating.

AlphaCapture

There it is. And as we shall discover later I’m being very generous drawing the top trend line in this manner.

Now, if you’re anything like me you’re already looking at the entire big picture and just seeing a strong uptrend, but we want you to concentrate on that top right corner. Although it looks like a form of consolidation to me, one that usually resolves itself in the direction in which it first entered, there is some history to this pattern that leads people to believe it signals the end of this rally.

Let’s first turn to Technical Analysis – The Complete Resource For Financial Market Technicians by Kirkpatrick and Dahlquist for a definition:- (Bold caps and italics my emphasis.)

“A broadening pattern exists when we take the standard rectangle pattern and draw the boundary lines diverging from each other into the future rather than converging as in a standard triangle…. Broadening formations are the LEAST useful patterns for a number of reasons. First, they are relatively rare in occurrence and are often difficult to identify. Second, and more importantly, they are difficult to profit from. Because the boundary trend lines are separating over time, the breakout lines are constantly moving away from each other. In an upward breaking broadening pattern, this means the upper breakout level is getting higher and higher along the upper trend line…. not only is it using up much of any potential gain after a breakout, but it is also moving farther away from any realistic protective stop level, thus increasing the risk. Finally, the raw performance statistics show that performance of a broadening pattern is average at best, and its failure and trap rates are above average…”

What I find particularly interesting is they only ever refer to a ‘broadening pattern’ not a ‘broadening top’, and the chart that accompanies the description is one showing an eventual breakout higher from the pattern. You can also understand the practical implications of that pattern. The lines diverge forever into the future, we could go to 14,500, then back to 13,500, then 15,000 and still be calling it a broadening top, couldn’t we?

Let’s check with the other technicians bible: Technical Analysis Of Stock Trends by Edwards and Magee.

Here, they conclude that broadening formations are “definitely bearish in purport… that while further advance in price is not ruled out, the situation is nevertheless, approaching a dangerous stage. New commitments should not be made… and any previous commitments should be switched at once, or cashed in at the first good opportunity.

Sounds pretty ominous, but is that really the pattern we have here? Let’s read what they say specifically about the ‘orthodox broadening top.’

This particular form appeared at the 1929 tops of many of the active and popular stocks of that day… The Orthodox Broadening Top has three peaks at successively higher levels and, between them, two bottoms with the second bottom lower than the first… it is completed and in effect as an important reversal indication just as soon as the reaction from its third peak carries below the level of its second bottom.”

So there you have it. As ominous and scary as that sounds, I’m not sure that’s what we have here at all. On the first chart I was being very generous joining the last high to the 2/1 high. Had I have joined the peaks prior to that it would show we’ve already broken higher. And therein lies the problem, with every successive high the line gets redrawn and you still get to call it a broadening top. Let’s look at a chart of the Dow showing just closing prices.

AlphaCapture

The pattern as described by Edwards and Magee (shown in the chart) isn’t what we see here at all. It hasn’t moved cleanly away from each peak, it’s instead continued to edge higher with last week’s reaction lower swiftly retraced, and again unless you keep redrawing the top trendline we’ve already broken higher from what looks more like a consolidation pattern, not a reversal pattern.

Let’s for a moment just play devil’s advocate and assume this is still part of a broadening top that hasn’t unfolded in an orthodox way. What should you do about it? The answer is not a lot. It won’t be confirmed until it goes below the second bottom, and it still could, but until it does, let’s stop calling it a broadening top and just call it what it is – an uptrend.

Ignore the noise. You can’t trade it anyway. Stop looking for a top, stop fighting the tape, stay with the trend.

 

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