Diamonds and Gold Are Seriously Suggesting a Market Top

And there is also that MICE chart ...

• A diamond formation indicates a multi-decade trend change—and that is a big deal.
• One of the benefits of a diamond, as opposed to a head and shoulder pattern (of either variety) is that the signal tends to come earlier.
• Sloppily formed diamonds usually aren’t worth your attention.

I'm already seeing plenty of chatter about how the sell-off in stocks is over, and it's back to buy, buy, buy. Yeah, well, I don't think so.

Below, I present the current charts of a variety of important indexes, each divided by the price of gold. This representation of equity values, in real money terms, provides a more honest and meaningful portrayal of value.

Here's the all-world index which, like about every other item, shows the price action cleanly within the confines of what could be a massive topping pattern. A topping pattern indicates the end of the rising price pattern, meaning prices will or could fall. This rounded top is like the two that preceded it—but vastly larger.

The same goes for the Dow Jones Composite, which had an analogous pattern at the start of the millennium.

And the same can be said for the Dow Financials Index.

A similar argument can be offered for the small caps, by way of the Russell 2000. In this instance, the small-cap stocks sport something more akin to a diamond pattern than the rounded tops above.

Diamond patterns explained

While a rounded top is fairly intuitive, the diamond pattern merits a definition.

A diamond pattern is formed on the left side by a series of higher highs and lower lows and, once past the midpoint, a series of lower highs and higher lows. The security loses its ability to trend (becoming increasing wide in its range) and then begins tightening its range again, suggesting it is losing its mooring. This inability to sustain a clear trend is why this kind of pattern often accompanies a reversal, and it is more common for the reversal to happen at a market top instead of a market bottom.

One way to think of a diamond pattern is as a head and shoulder with a V-shaped neckline (for a top) or an inverted head and shoulder with an A-shaped neckline (for a bottom). Although most patterns require a discerning eye trained by experience, diamonds require even more of an “eye" because they are difficult to spot, particularly without the benefit of significant hindsight.

Sloppily formed diamonds usually aren’t worth your attention. As with other patterns, the cleaner the pattern is and the wider a timespan it traverses, the more potent it is as a predictive tool. Measuring the price movement potential of a diamond consists of measuring the spread between its highest and lowest points and then adding that value to the price point where it breaks outside the diamond. Thus, if a diamond spans from $60 to $70, and it breaks down at $65, then you can target $55 for the price movement downward.

For diamond tops, volume usually greatly increases during the formation of the pattern, largely because the amount of “churn” increases as the bulls and bears struggle over the direction of the stock. One of the benefits of a diamond, as opposed to a head and shoulder pattern (of either variety) is that the signal tends to come earlier. This is because of simple geometry: a price will break below an ascending line (or above a descending line, as the case may be) much sooner than a horizontal line, so the amount of move you can “capture” is that much larger.

Stocks are not ready to roar

One more perspective to add to this idea that the equity markets are not ready to roar to life again is expressed with the chart below. This graph, which I sometimes called MICE (most important chart ever), shows the S&P 500 divided by the 10-year interest rate for the past half century, This ratio chart had been confined within this tidy channel year after year, decade after decade, until just recently.

The drop of this ratio below the price channel represents, I believe, a sea change in the markets. A combination of weakening equity prices coupled with rising interest rates caused this historic breakdown, and one cannot brush off as inconsequential the failure of a channel that lasted so long. On the contrary, I think the effects of this channel break will be felt for years to come.

Keep in mind that, as a ratio chart, two directions are expressed at the same time: (1) the direction of stocks, which has been positive for most of this chart; and (2) the direction of interest rates, which generally has been down for most of this chart.

With the dividends (stocks) rising, and the divisor (rates) falling, the ratio chart climbed steadily for decades. The final "burst" of rising stock and plunging rates happened Aug. 4, 2020, and in the 37 months since then, stocks are somewhat lower and rates are radically higher, thus leading to the failure of the channel

In the world of technical analysis, it is axiomatic that the longer any given "object" (be it a trendline, a pattern, a Fibonacci line or anything else) persists, the more important it becomes. Thus, the fact this channel spans decades means its failure is even more important. The failure cannot assure stocks will fall and rates will rise but suggests that for the intermediate term. Simply put, this trend change of a multi-decade channel will, in hindsight, likely matter a great deal.

Tim Knight, a charting analyst with 35 years of trading experience, hosts Trading Charts, a tastylive segment airing Monday-Friday. He founded slopeofhope.com in 2005 and uses it as the basis of his technical charting and analysis. Knight authors The Technician column for Luckbox magazine.

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