Last month the Dow had a very rough month, but if you look at a monthly chart you’ll see a rather ominous formation – a bearish engulfing pattern.
You can read more about this pattern here, but simply put it occurs when a candle ‘engulfs’ the previous smaller candle. In the world of Japanese candlestick charting (which I’m a big believer), this is a rather bearish development.
So do we run for the hills? Let’s take a look at history to confirm this is indeed a worry or not.
There have been 16 other monthly bearish engulfing patterns since 1980 and the results aren’t that bad. Slight underperformance near-term (as you’d expect), but going out 3- and 6-months it is actually rather bullish.
Here are all the instances. What really stands out here is in 2008 the returns were very poor a month later, but most of the others weren’t too bad a month later.
The next question though is this bearish pattern developed at a new all-time high. That could be very meaningful. Since 1980, this has happened just six times and incredibly it isn’t bearish.
Here are those six instances and the returns. The last time it happened lead to a huge 15% drop the next month back in 1998. Yet again, the other instances all lead to some strong bounces that next month.
So, in the end, I’m not nearly as worried about this pattern as I was when I started this study. As I recently discussed with Matt Nesto on Yahoo! Breakout, September could be a surprise rally because so few are excepting it. This study does little to change my opinion.