Signup for our free newsletter:

How to trade on Pipe Formations

Written By Briton Ryle

Posted March 3, 2015

“Pipe-Tops” and “Pipe-Bottoms” – the charts are riddled with them. The Dow Jones Industrial Average has just today put in a Pipe-Top which could be a sign that the market is at the beginning stage of a pullback.

But how long might it last? Is this the beginning of a protracted correction, seeing as the Dow Jones and S&P 500 recently booked new all-time highs, with the NASDAQ breaking through 5,000 for the first time in over 15 years?

A look at pipe-formations and some recent economic data shows that while a pullback is most likely in the making, it shouldn’t last long at all, and in fact presents investors with an excellent buying opportunity.

Pipe Formations Turn Markets

While the exact definition of a “pipe-formation” varies considerably from one market technician to another, the basic gist of it is simple: when one day’s movement on the market is completely reversed the following day, the market usually turns in a new direction. When plotted on an OHLC graph (open-high-low-close), the two days form a pattern that look like a stove pipe where the two vertical lines are almost identical in length. Hence the pattern’s name.

In the following graph of the Dow Jones Industrial Average we notice at least 9 such pipe-formations over the past six months, although we can easily see more if we broaden the definition of a pipe-formation.

For the formations boxed in red, one up day was immediately followed by a down day of equal or greater measure – usually the very next day, though at odd times the reversal may come on the second day after. Almost all of these “pipe-tops” were followed by a market pullback. Thus, a pipe-top signals that the market has turned in a new direction from up to down.

The formations boxed in green, by contrast, mark “pipe-bottoms”, where one down day was immediately followed by an up day of equal or greater measure. Almost all “pipe-bottoms” are followed by a market rally, with the formation signalling that the market has turned in a new direction from down to up.

Pipe formations 1


Currently, the Dow is in the process of forming a pipe-top with yesterday’s closed of some 157 points up and today’s move of 135 points down as at the time of this writing – almost a complete pipe-formation. Again, it all hinges on the definition you adhere to. If today’s market closes near this level or below, the rest of the week could see more downward movement.

But traders aren’t simply trading on these formations directly. Something caused today’s reversal to begin forming in the first place, and it was most likely the handful of negative economic reports released yesterday.

Markets Digest Recent Bad Data

Three negative reports out Monday morning seemed to have been ignored yesterday, but may have finally been reacted to today, they being:

1) Weaker consumer spending which fell 0.2% in January over December. This came after December’s consumer spending was also down 0.3% over November, marking two consecutive declines in consumer spending after nearly an entire year of increases. This comes as a bit of surprise for two important reasons:

First, low fuel prices have saved consumers money at the pumps, and second, personal incomes increased in January by 0.3%. This means that while most Americans were earning more, they were simultaneously spending less, meaning that extra cash is either being stashed in savings accounts or is being used to pay off debt – neither of which does anything to stimulate the economy.

“To a large extent, Americans pocketed the gain in income,” reports MarketWatch. “The savings rate jumped to 5.5% [in January] from 5% in December, marking the highest amount since the end of 2012.”

Why is this a bad thing? Because “the low rate of spending in January could cause the U.S. economy to grow somewhat less than expected in the first quarter, some economists say,” MarketWatch answers.

2) The Institute for Supply Management (ISM) Manufacturing Index for February fell to 52.9%, down from 53.5% in January, marking the fourth consecutive monthly decline since reaching 57.6% in September.

Since a reading over 50 denotes manufacturing expansion, while a reading below 50 represents contraction, the nation’s manufacturing activity is still growing, having been at 50 or above for over two years since October of 2012. So it isn’t as if factories are shutting down. It simply means growth isn’t as fast as it has recently been.

What is the cause for this slowing in U.S. manufacturing? Ted Wieseman of Morgan Stanley explained the likely cause in a note to clients obtained by MarketWatch:

“While the [strikes at Los Angeles] ports have been the major complaint brought up by manufacturers recently, export orders have meanwhile been rolling over hard, likely reflecting to a substantial extent dollar strength and global growth and not just West Coast port disruptions.”

The strong dollar has made U.S.-made goods more expensive for overseas markets which have cut back their orders, in addition to even more order declines caused by slow growth in foreign markets to begin with.

3) Construction spending in January fell by 1.1%, marking it the second decline in three months, and the fourth decline in 12 months, as graphed below.

Construction spending is quite the market mover, since so many industries rely on construction, from home building, to building materials, to home furnishings, to appliances, and to financial institutions who issue loans on most of such purchases. A slowdown in construction triggers a chain reaction that ripples throughout the broader economy.

Pipe formations 2


A Better Year Ahead

But while such negative data over the recent winter months’ activities might give markets a reason to pause and pullback a bit, any upcoming dip should be short-lived and shallow, given another manufacturing report that paints a prettier picture.

February’s Markit Manufacturing Index compiled by the global financial information and services company Markit Ltd shows that the second and final reading of U.S. manufacturing measured 55.1, which was up from February’s preliminary reading of 54.3, and up from January’s final reading of 53.9. Like the ISM Manufacturing Index described above, readings over 50 indicate expansion.

While the winter months’ activity was a bit of a downer, investors can look forward to stronger markets going forward as spring and summertime economic activities generally pick up, as graphed below, where the first half of the year is generally up while the second half is generally down.

Right on cue, U.S. manufacturing is currently putting-in an upward curl on its activity, which looks set to continue rising over the coming months.

Pipe Formations 3


Investors, therefore, should not be overly concerned over any pullback this month. As I explained in yesterday’s article, March is generally turbulent, with a routine sell-off in the second half of the month leading into end-of-quarter rebalancing.

Yesterday’s economic reports along with today’s pipe-top formation on the charts seem to give rise to the likelihood of a pullback soon. But this should be bought-into, not sold out-of. The remainder of 2015 as well as the following several years promise a continuation of this multi-year bull run with little cause for concern.

Joseph Cafariello