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January 27, 2007

The Jaws of Death
by Robert McHugh

There is a stock price pattern that has appeared before most of the great plunges over the past century. It looks a bit like an open shark's mouth with teeth exposed. Once the mouth is opened it widest, it snatches it prey, swallowing months and years of previous stock market gains in short order. In fact, it deserves a name, since it appears so often as a precondition for plunges. We call it The Jaws of Death.

Let's make clear at the onset that the appearance of this pattern is no guarantee that we are about to get a major plunge. However, when it appears, the risk to longs has increased significantly since this pattern has shown up so many times in the past before major stock market plunges. One of the problems with this pattern is we can't be quite sure when it is complete. That is because the upper boundary can extend. So we supplement the Jaws of Death pattern by studying additional technical conditions to more fully weigh the timing of oncoming risk. This article will focus just on the Jaws of Death pattern itself.

We continue to keep a watchful eye on the current Jaws of Death pattern, as it bears a striking resemblance to some rather famous historic tops. The current pattern looks mature. The textbook name for the pattern is a Broadening Top or Megaphone pattern. Key is that it has symmetrical diverging upper and lower boundary lines. Wave e is the extended wave. The downward sloping bottom boundary line is drawn off the declining lower bottom points of either wave b or d down or both. The upper boundary line is drawn as a mirroring equal-sloping line. Prices will top somewhere along that slope-generated line -- not above nor below it -- which is fascinating when you think about it.

The Broadening Top formation is a Bearish pattern. Thomas Bulkowski, in his Encyclopedia of Chart Patterns, suggests this pattern has only a 9 percent failure rate after a breakout. He mentions the average decline is 18 percent, with the highest probability decline being 10 percent. A rule of thumb for measuring a downside target is to use half the formation's height. That measuring stick has a 91 percent success rate. But as we will demonstrate, there have been much larger declines than 18 percent.

This pattern appeared in the multi-year period from 1998 through 2000, just before the 1987 stock market crash, in 1986, just before the 1972-73 26.5 percent one-year plunge, just before the 1957 crash, and just before the 1929 crash. We are not suggesting a stock market crash is coming. We are simply showing a Bearish pattern that has shown up before many of the most serious declines of the past century. This is a risk factor for those invested heavily in the stock market.

A 10 percent decline -- the most likely result according to Bulkowski -- would take the Dow Industrials back down to the 11,400ish area. More decline is possible. Using the rule of thumb of half the formation's height would target the 11,200ish area. The examples shown on the subsequent pages show declines were at least to the bottom boundary, which would target at least 8,500ish, but that risk would carry a lower probability.

The above chart is another instance that we just discovered when the Broadening Top "Jaws of Death" pattern showed up, in this case just before the major top of 1973. The pattern began in 1972, warning that a recession was coming. After the Broadening Top pattern completed on January 11th, 1973, the Dow Industrials quickly fell 17.1 percent through March 23rd, 1973. The decline continued, and by May 21st, 1973, 21.9 percent of the Dow's value had been shaved, in a little more than four months. By December 5th, 1973, it was clear the economy found itself in a major recession, and the market had crashed 26.5 percent.

Here's what is striking about the 1972-73 pattern: It is incredibly similar to the current pattern shown at the opening of this article. Let's compare the 1972-73 pattern with the current 2002-06 pattern: In both patterns, the bottom downward sloping boundary is drawn off the points of lower lows within wave b down. In both instances, wave c is shallow, but slightly higher than point a. In both instances, point d is higher than point b. In both instances there was a fake-out top about two-thirds the way through point e's wave, before the rally resumed. In both instances, as in all the Broadening Top patterns, wave e is by far the longest. In both instances, as is the case in all the Broadening Top patterns, there is perfect symmetry, perfect mirroring, of the upper rising boundary line with the lower declining boundary line. The slope of ascent and descent is the same. 1929's pattern is also identical.

Again, this is no guarantee we are about to get a major plunge, however the risk to longs has increased because this pattern has shown up so many times before major plunges. The Jaws of Death must awaken our senses, since it appears so often as a precondition for plunges. However, risk of a major top is higher if New Lows are rising, if a Hindenburg Omen occurs, if the Advance/Decline Line diverges, and if our Purchasing Power Indicator generates a new "sell" signal (it has been on a "buy" signal since July 19th, 2006). We cover these and other technical conditions as part of our regular paid subscriber services. Conservative investors can lose months and years of gains in a matter of weeks and months once one of these occasional Bear markets hits. That is why we stay focused on risk. On the other hand, we have key trend-finder indicators that are objective, and are actually on "buy" signals for longer stretches of time than they are on "sell" signals, as Bull markets tend to last longer than Bear markets. We watch for both.

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with the Holy Spirit and with power, and how He went about doing good,
and healing all who were oppressed by the devil;
for God was with Him.
And we are witnesses of all the things He did both in the land
of the Jews and in Jerusalem.
And they also put Him to death by hanging Him on a cross.
God raised Him up on the third day, and granted that He
should become visible.
Of Him all the prophets bear witness that through His name
everyone who believes in Him receives forgiveness of sins."
Acts 10:38-40, 43

If you are a trader, we offer market timing signals. If you are a conservative long-term investor, we manage our Conservative Balanced Investment Portfolio, and publish our transactions on a regular basis.

Robert D. McHugh, Jr. Ph.D.
Main Line Investors, Inc.

Robert McHugh Ph.D. is President and CEO of Main Line Investors, Inc., a registered investment advisor in the Commonwealth of Pennsylvania, and can be reached at www.technicalindicatorindex.com. The statements, opinions and analyses presented in this newsletter are provided as a general information and education service only. Opinions, estimates and probabilities expressed herein constitute the judgment of the author as of the date indicated and are subject to change without notice. Nothing contained in this newsletter is intended to be, nor shall it be construed as, investment advice, nor is it to be relied upon in making any investment or other decision. Prior to making any investment decision, you are advised to consult with your broker, investment advisor or other appropriate tax or financial professional to determine the suitability of any investment. Neither Main Line Investors, Inc. nor Robert D. McHugh, Jr., Ph.D. Editor shall be responsible or have any liability for investment decisions based upon, or the results obtained from, the information provided.