Cold Weather And Dark Cloud Cover Seen Over Wall Street

• Dark cloud cover explained
• What enhances a dark cloud signal
• How long is its bearish effect likely to last?

Dark cloud cover explained

The weather forecast this morning was for wintery weather on the East Coast. However, a more sobering non-meteorological message has been given by the stock market. Tuesday’s action for most equity indexes reflected what is known in candlestick speak as “dark cloud cover”. An example for the NYSE Composite is shown in Chart 1. These two-day patterns develop after a rally. The first day traces out a fairly wide real body, which is the distance between the open and close. The second, gaps up and opens above the high of the first. It may move higher during the session, but the important thing, is that this second candle closes more than half way down the first candle’s real body. That kind of action tells us that a market that had heretofore controlled by buyers has now, at least temporarily been subjugated to sellers.

Chart 1

Chart 2 shows that Tuesday’s action could also be interpreted as a bearish outside day, where its trading range totally encompassed that of Monday. Outside patterns are quite effective but more common than dark cloud cover.

Chart 2

What enhances a dark cloud signal

Not all dark cloud formations are created equal. An Edsel and a Porsche are both cars, in that they possess similar characteristics such as a steering wheel, brakes and four wheels. However, there is no mistaking which is the superior vehicle. The same is true for dark cloud patterns. They may support similar characteristics but are not born equal. Some patterns represent stronger aspects of the same thing and are therefore more likely to experience a more significant reversal than others. I emphasize the word likely, because in technical analysis we are dealing in probabilities, never certainties. Even if there is a 99% probability a specific indicator generates a valid signal there is still that 1% probability it won’t work.

There are several characteristics that Tuesday’s dark cloud cover has to recommend it as an important chart inflexion point. First, it is a reversal pattern, so logic tells us it must have something to reverse.  In this case there is a lot. Chart 3 for instance, shows that prices in the S&P 500 Index have been moving up quite sharply of late, with daily price ranges getting progressively wider and the price action taking on parabolic characteristics. That means there are lots of traders who are anxious to take profits. Also, the gap higher opening and disappointing closing indicate that buyers are exhausted, so it looks like it’s time for a much awaited correction. The width of the second day of the pattern is also important as this wide trading range reflects a massive battle between buyers and sellers. We see a complete reversal in dominance during the session. First buyers push the price significantly higher. Then sellers take over and force a lower closing.

Chart 3

Third, expanding volume, though influential is not a requirement. However, when volume picks up noticeably it emphasizes the size of the battle between the bulls and bears. It also implies that there is a sizeable number of buyers taking home a loss, and that could weigh on prices in future sessions. Chart 4 indicates that volume did expand on the NASDAQ Composite ($COMPQ), but not to the kind of levels that get me excited.

Chart 4

How long is its bearish effect likely to last?

Sometimes we can look back and see that a dark cloud cover, appeared at the top of a major intermediate advance, which suggests that it is extremely powerful. However, our normal expectation from a one or two-day pattern, such as dark cloud cover, is for something more akin to a 5-10-session correction. The fact that some dark clouds appear at important juncture points is more of being in the right place at the right time. In other words, their development takes place when the short and intermediate oscillators are in the process of rolling over.

Chart 5 shows a great example of a piercing white line on the $SPX, the bullish equivalent of a dark cloud, developed in October 2011, and was later followed by a major rally. It was not the piercing line itself that caused the rally. More the fact that it halted the decline at a time when it gave breathing room for other indicators, monitoring intermediate trends a chance to turn bullish.

Chart 5

Major tops are usually formed after a lengthy period of range bound activity, underpinned with weakening momentum. We do not see much in the way of that kind of action at present. There is no disputing though, that many indicators are way overstretched and well overdue for a correction. For example the $VIX, as shown in Chart 6 has started to perk up again. If it rallies above the red trend line, say to the 14 level that would suggest that it had begun a rising trend, greater volatility being associated with lower prices.

Chart 6

Chart 7 again features the $VIX, but this time the two EMA’s have been plotted inversely. They are clearly overstretched on the upside, and the negative implications from this week’ dark cloud cover/outside day may well be enough to reverse it to the downside.

Chart 7

Finally, Chart 8, which features an indicator (!PRDIFDOW) that monitors a basket of Dow stocks in a positive trend, is also precariously balanced at a very elevated level. The red arrows show that short-term declines or sideways corrections typically follow downside reversals. Again, this week’s exhaustion action suggests that that could well be the case.

Chart 8

Good luck and good charting,
Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Group of Walnut Creek or its affiliates.