Gosh, this is exciting! The Dow Jones Industrial share index peaked at 11,722.98 on January 14, 2000. Its rise in the past few weeks has brought it within shouting distance of the best known of all stock charting patterns, the double top reversal. If you believe the charts, the stage is being set for a stock market collapse of truly historic proportions.

According to the educational material supplied on the specialist website Stockcharts.com, in order to form a double top reversal, the price must decline from the first peak on fairly low volume, then rise against steadily increasing resistance to a peak within 3 percent of the first high. For the Dow Jones index, this would imply a closing price of between 11,371.29 and 12,074.67. If a second peak is formed within this range, after which the price drops below the range, a double top has been formed. Friday, the Dow Jones Industrial share index closed at 11,279.65, it is thus close to the range within 3 percent of the 2000 peak where a double top peak may be formed.

Once the double top has been achieved, prices decline on an increase in volume and/or an accelerated descent, perhaps with a price gap or two. The double top is completed when the price breaks through the support level of the lowest point between the tops, in this case the October 9 2002 closing low of 7,286.27. This low then becomes a resistance level, above which the price is unable to rise, so the decline continues, until it reaches a level as far below the support level as the peak was above it.

In other words, the price target, if the Dow Jones Industrial Average forms a double top, is an index value of 2,849.56, a decline of more than 75 percent from the peak. THAT would rattle a few windows on Wall Street!

Do we believe this mumbo jumbo? Well, partly, yes. When I first read about chartist stock picking techniques at business school, I regarded them as the equivalent of astrology, a harmless but irrational fad by which many people chose to live their lives, making essentially random decisions in doing so (the Random Walk theory was already popular.)

However, shortly after business school I got involved with a lady astrologer, who convinced me through the appropriate casting of her and my horoscopes that the time was ripe for investment in stocks dealing in scarce metals. Pooling our resources, we bought a grand total of 9 shares of Molycorp, then known as Molybdenum Corporation of America (new MBAs weren’t paid then what they are now!) Much to my surprise, four months later Molycorp was taken over, and we doubled our money (it was later divested again.) I drifted apart from the lady astrologer, so have never invested by that method again, but it has to be said that, for me, astrological investment has a great track record!

Chartism has somewhat more of a theoretical basis than astrology. It has now been demonstrated that stock market price movements are far from random. While institutional investment managers are unable to beat the market, their failure is largely due to their incompetence, greed and herd instincts, and to the large percentage of the market that they represent rather than to any randomness and unpredictability of stock prices.

Stock price movements, being driven by investment decisions that are behaviorally governed, are not random but chaotic; they move in a way that is unpredictable and irregular, but subject to hidden underlying dynamics. Generally those dynamics take the form of a power equation, including terms to the second, third and fourth powers, that typically produce “cusps” and other curve types unknown to economists used to dealing with simple linear and exponential forms. That doesn’t make such prices any easier to forecast, since we don’t have in-depth knowledge of their underlying dynamics, but it means that they follow certain well defined patterns, recognizable to the outside observer and similar to patterns observed in previous episodes where similar underlying dynamics obtained.

Of those patterns, the double top and the triangle are the most clearly recognized. The double top is produced by the battle between buyers and sellers as the underlying environment for a stock, or in this case an index, deteriorates steadily from an initially favorable state. In this case the balance between buyers and sellers, initially a preponderance of buyers, becomes first an equilibrium and then an overall preponderance of sellers. This produces two peaks, the first when seller pressure first appears in volume sufficient to match the buyers, the second at the point where the buyers are finally overwhelmed by the steadily growing volume of sellers.

Similarly the triangle occurs when the factors affecting a stock’s value remain constant for a lengthy period, during which the stock price’s oscillations grow less and less violent and it converges to an underlying equilibrium, before being disturbed either up or down by some new piece of information. Both these patterns, which were recognized by “chartist” market observers long before the advent of chaos theory, are quite common and can be reproduced empirically through the interaction of simple underlying equations.

To determine whether the Dow Jones index is in the process of forming a double top, other than by simply observing whether or not it does so, we need to examine the factors likely to be driving stock prices. Chartist theory says that once the market breaks above 11,371.29 there are really only two possibilities: either it continues well beyond 12,074.67, forming a further major leg in a long term uptrend or it peaks between 11,371.29 and 12,074.67, forming a double top, after which a major decline takes place. Intermediate possibilities, such as the index remaining close to its previous peak, rising only marginally above the peak’s range or declining moderately, are not possible.

If the bulls are right and the latest rise in the Dow index is simply part of a much longer term uptrend, a continuation of the 1982-2000 bull market that can be expected to carry the index far beyond its previous levels, then after a pause close to its 2000 high (likely because of the “stale bulls” who bought close to that level) the index should break out above the 2000 high and move decisively into higher territory above 12,074.67, the point at which a double top formation as defined by Stockcharts.com becomes impossible.

If the bears are right, and the index peaks over the next few months between 11,371.29 and 12,074.67, then it can be expected to undertake a major decline thereafter, well beyond the 7,286.27 at which it bottomed in 2002, probably at least for a short period falling close to 2,849.56. A forecast drop for the Dow Jones Index below 3,000 may appear extreme, but it must be remembered that the index was lower than this in real terms until about 1986, and that such a drop would be somewhat less than the drop in Japan’s Nikkei Dow Index from its 1989 closing high of 38,915.90 to its 2003 closing low of 7607.88. At 2,849.56, with earnings of its constituent companies once more compressed by tight money and recession, the Dow Jones Index would probably appear fairly if conservatively valued.

A double top in which the two peaks are over 6 years apart would be most unusual, but we are here talking about an index that represents the entire market, and a potential decline that would have huge economic consequences, so perhaps such a “jumbo” formation is to be expected.

So which is it to be? Do we have the situation of a steadily deteriorating environment, with selling pressures steadily increasing until they overwhelm buying pressures, in which a double top formation is likely?

Examination of the U.S. economic environment over the last decade suggests that a steady deterioration in the fundamentals underpinning the stock market is indeed the situation we are facing:

• The U.S. trade deficit now exceeds $800 billion per annum, and is being financed by short term funds flows from Asian central banks and hedge funds. This cannot continue
• The federal budget deficit remains consistently in the $400 billion per annum range, close to an all time record and the recent behavior of Congress and the George W. Bush administration suggest a lack of resolve to address the problem. This will become a huge problem in any economic downturn.
• Inflation is currently running at 3.6 percent year on year and trending upwards. Even Thursday’s figures, hailed by bulls as evidence that inflation was no longer a problem, hid in their details a rise in the Cleveland Fed’s “Median Consumer Price Index” to an annual rate of 3.5 percent
• The yield curve between short and long term U.S. Treasury interest rates is close to inverting at today’s Federal Funds rate of 4.5 percent and will be fully inverted once that rate rises to 5 percent as almost all commentators expect in the Fed’s May meeting. Since interest rates in real terms remain very low a 5 percent Federal Funds rate will not be the peak in short term rates if inflation is to be contained. The market is not expecting interest rate rises beyond 5 percent and won’t like them when it gets them.
• Reported U.S. corporate profits are at historically high levels, driven by easy money, high immigration (which artificially depresses the cost of labor) lax accounting and rising asset prices. Reversal of these trends without a drop in the stock market would sharply affect market price-earnings ratios, already higher than at any time except 1999-2000.
• Dividend yields remain below 2 percent, and are increasingly uncompetitive with money market interest rates.

That looks like the market preconditions for a double top reversal to me. Better hope that the Dow doesn’t climb above 11,371.29 – or we all may be in for a very bumpy ride indeed.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.