It didn’t happen overnight. Actually, the dénouement was a long time coming. The infection took hold in January 2007, over a year ago; but if anyone recognized the signals then, it wasn’t widely broadcast.

The clues had nothing to do with “fundamentals.” It might very well be that the fundamentals of Bear Stearns’ business in early 2007 were solid and that the future looked bright. But quite apart from the fundamentals, the charts of Bear’s stock prices told a very negative story when viewed from the standpoint of Japanese Candlesticks technical analysis.

We know that the Candlesticks display stock prices in a pictorial form which the eye and the brain instantly recognize and comprehend. There are only a dozen or so Candlesticks patterns which need to be memorized at the outset of the learning curve; and the education process is easy, fast, and intuitive.

The patterns occur in every time frame. One of the beautiful aspects of the Candles is that they excel in helping the observer to spot reversals of trend. One of their most significant patterns is a three-bar setup, in which the first bar shows a decent price move within an “up” day at the end of an established uptrend. The second bar typically displays prices in a narrow range, above the close of the first bar. The tight span between the open and the close of that bar indicates that investors are “reining up” for the moment, taking a good look around, thereby constituting a warning that the upmove in prices might stop and reverse. The third bar will show a substantial decline in prices within a “down” day. The three bars, together, are called an “Evening Star,” which is bearish.

The second bar in the three-bar Evening Star might itself be a “Shooting Star,” so named because it looks just like a real shooting star. This single-bar pattern, all by itself, is bearish. So, an Evening Star within which the second bar is a Shooting Star carries a doubly bearish implication.

The “Bearish Engulfing” pattern is another important bearish Candle pattern. This formation is just a single price bar in which the “body” of the price action (i.e., the price range between the open and the close) “engulfs” the prices within the body of one or more previous bars, and it must be a meaningful “down” day, to boot. As the name implies, the Bearish Engulfing pattern is, indeed, bearish in its implications.

Let’s look now at the charts of Bear Stearns (BSC) in very early 2007 – not 2008, please note, but 2007.

The Daily chart shows a Bearish Engulfing pattern on January 18 (the arrow points to it):

Note that, on January 18, prices opened at the top of thick black part of the Candle (the thick part being the “body”), reached to make a new high, reversed downward, and then closed in a “down day” at the point which is marked by the bottom of the body. In so doing, the black Candle completely engulfed the price action within the bodies of the previous three days’ price movement. This was the first bearish signal.

A little over a week later, on January 26, the Weekly chart showing the second, third, and fourth weeks of January, considered together, displayed an “Evening Star” pattern – not perfect, to be sure, but nevertheless recognizable as an Evening Star:

This was a bearish signal, all the more so because it confirmed the Bearish Engulfing pattern which had appeared earlier on the Daily chart.

At this point (January 26) an observant investor might have considered the two then-in-place bearish signals in light of other evidence, and could have concluded that he had seen enough to justify opening a bearish position.

The capper arose at the end of February, when by viewing the Monthly chart for BSC the investor would have seen that the Monthly Candlestick bars for December, January, and February (together) had produced an elegant Evening Star bearish pattern; and the icing on the cake was that the middle bar was a beautiful Shooting Star, which, as aforementioned, is itself bearish. Here they are:

(The bars within the box are the Monthly bars for December 2006, January 2007, and February 2007. The middle bar is the Shooting Star. Do you see it?)

We can therefore conclude that on March 1, 2007 an observant investor would have had very powerful evidence at hand to justify taking a short position in Bear Stearns. Thereafter, the trend was downhill nearly all the way. If he had stayed with it for a little over a year, he could have bought his loved one the Timex watch she’s always wanted.

The seeds were planted way back in early 2007. Important signals for a downturn were there in plain sight, at that time. Perhaps no one could have anticipated how close we eventually came to total paralysis of the financial system because of the equivalent of a “run on the bank;” but it is inaccurate to say that a major falloff in Bear shares was not predictable. In point of fact, the Candles predicted precisely that.

William Kurtz March 22, 2008

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