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December 23, 2005

DJ World Stock Index Emulates Pre-Crash Nikkei
by Dan Basch

Introduction

As stock markets bobble and weave through time, they create intricate fractal patterns in their journeys. Often they create patterns that appear remarkably similar to their own earlier time periods, or other markets altogether. This is the basis for studying market models: to have history provide clues to potential future moves in the hopes that we can profit from the hard right edge of today's chart.

For a recent example, the NASDAQ bubble burst followed a remarkably close trajectory with the DJIA from 1929-1932, and to date has also mimicked the initial crash rebound from its respective bottom. There are other similarities as well: both were roughly 30 years old when they had their nervous breakdowns, both declined about 80% from tippity-top to bippity-bottom, and both marked the end of an era of limitless optimism. Like father, like son. With a nod to Mark Twain, the charts document that when it comes to the mass encephalograph of human psychology, history does indeed rhyme.

It appears that today's world index has generated a similar chart pattern which correlates to another technical example of topping behavior.

The Setup

From 1997 through 2000, Japan's Nikkei index made a pattern which today's world index closely emulates. Across the ocean, a completely different country with a completely different people who have a completely different culture, language and currency, had a remarkably similar experience in their stock market's journey in relation to today's Dow Jones World Stock Index (DJW).

The DJW is a massive index with truly global coverage. It contains thousands of companies in virtually every country, market and sector in which our planet has to invest and can be considered the ideal barometer for the overall health of global markets.

The reason why this model is important is that shortly after completing this formation, the Nikkei initiated a massive and utterly relentless decline. Today's charts are telegraphing the possibility that world markets may be in a similar precarious position, and could be nearing the top of a doomed rally. Could the DJW index be preparing to end what has been to date a spectacular run with a commensurately steep decline?

While only time can answer that question, this essay seeks to provide a comparison between the two, and highlight their similarities with the purpose of demonstrating to the reader that, should the Nikkei's past become prologue for the DJW, the world's markets may not be as sound as they would otherwise appear.

The Nikkei 1997-2000

Let us first look at the historical model on which to base the comparison: the weekly chart of Japan's Nikkei Index from 1997 through 2000. During this time, it was locked in a lateral trend channel which oscillated between a bottom of roughly 14,000 and a top of 21,000. The annotated chart shows a topping pattern called a Diamond Top, followed by a decline which ended in a technical pattern called a Diamond Bottom, which is bullish, inversely from the Diamond Top. It then began a powerful rally to the top of the channel reaching nearly the same level in April 2000 as it had in June 1997, forming a Rising Wedge. As always with market psychology, the mood was dreary and glum at the bottom, and predictably, wildly optimistic at the top.

Notice also that as the Rising Wedge continued its ascent, the MACD indicator developed a negative divergence as if to be the proverbial Doubting Thomas. In other words, it was telegraphing that as the market continued to rise, at some point ahead, a decline could reasonably be expected. And boy, was it ever right. The Nikkei ended its spectacular rally with a Bearish Advance Block candlestick pattern and then began what would become a protracted decline with a huge down week in April 2000. This chart shows a decline to similar levels of the Diamond Bottom, however the decline continued much past this, down to levels not seen in over a decade.

[After the descent began, another Diamond Formation completed (annotated in gray) which proved to be a continuation pattern that measured to target, as indicated. This is not as important to the comparison as it occurred post-decline, however it is indicative of its severity.]

Today's Dow Jones World Stock Index

Today's DJ World Stock Index is strikingly similar, however at roughly a 2:1 timeframe ratio, meaning that two weeks on the DJW chart is equivalent to one on the Nikkei.

First, the Diamond Top formation declined in a highly similar pattern to form a Diamond Bottom from which it had an extended powerful rally, just as on the Nikkei. The ascent from this bullish formation was intense throughout 2003 and then formed a Rising Wedge which is so close in comparison that the bobbles are numbered correlatively to those of the Nikkei.

Second, note the relative slope of the line from the bottom that became support for the Rising Wedge is nearly identical to that of the Nikkei.

Third, the MACD oscillator is showing a similar negative divergence as it seems skeptical of the price chart, just as on the Nikkei.

Lastly, note the oscillator labeled "Price Relative to SPY", in which it is compared to the price action of the S&P 500 SPDRs, an exchange traded fund (ETF). The indication is that today, the market is at a similar relative level as it was shortly before it topped out and began the Millennium Crash.

Conclusion

With such a similarity to the Nikkei from 1997-2000, the situation appears grim for today's Dow Jones World Stock Index as it is now at a point that appears highly correlative to Japan's Nikkei shortly before it began a severe decline. Ironically, today's market commentators are exuberantly bullish for 2006, nearly unanimously declaring this to be a wonderful time to buy and hold for the long term in both domestic and international markets. The events of the Nikkei and the strikingly similar progression thus far on the DJW paint a much less enthusiastic picture: that their capital may instead be at greatest risk.

If nearly all other facets of the charts are correlative, can the DJW also expect to reverse large swaths of its gains within the span of a few weeks at some point ahead? Would this cause a cascading international market panic as investors rush the proverbial fire exits to recover their capital from one part of the world to the next, a la 1998? Is containing a global market crisis going to be the first challenge to incoming Fed Chairman Ben Bernanke as the crash of 1987 was to Alan Greenspan?

No one can be certain of the future, and this is especially true of the stock market. This particular comparison may assist in finding opportunities for profit, or to preserve capital by limiting exposure to international markets. Market models aren't perfect by any means and can completely diverge, therefore one should consider this essay an amateur's observation of a technical anomaly which may or may not play out, and of course none of the above should be construed as actual financial advice of any kind.

If you would like, please visit my free public website on StockCharts.com, Black Magic Charts, for both tactical and strategic views on the NASDAQ 100 and corresponding leveraged mutual funds. This is offered for entertainment purposes only and contains no advice to trade with real money.

Thank you for your time and I hope you are having a pleasant Christmas season.

Dan Basch

Copyright © 2005-2009 Dan Basch

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