If you’re going to trade the markets using technical analysis, get acquainted with Japanese candlesticks. Simple bar charts don’t offer as much or as detailed information on price patterns. Nor do they have the history and experience of this centuries-old Japanese method.

Candlestick charting began in the 17th century and was used primarily as a tool to trade rice. Since then it has become the preferred method of chart analysis for most active traders and technical analysts the world over.

We’ll start with a simple pattern that has popped up on a wide array of charts in the last week – a pattern that shows a number of sectors, if not all, have reversed course and are now turning bullish.

Here it is:

This is the last three months of trading on the NASDAQ.

The chart is bullish technically on account of

1. The higher lows set roughly two months apart (noted in green) – July 15th and the latest reaction lows from last Thursday at roughly 2200.

2. The bullish engulfing pattern that appears at the far right of the chart.

Let’s look at the latter a little more closely.

What is a Bullish Engulfing Pattern?

An engulfing pattern is considered a reversal pattern among candlestick chartists. The pattern emerges at the end of a downtrend, opening below the last day’s close and closing higher than its open. Here’s a diagram of it:

The white candle thereby completely engulfs the previous day’s black candle.

How does this play out with the NASDAQ?

• The fact that our chart shows a large body engulfing a much smaller body enhances the signal. It tells of a downtrend that was running out of steam; while the subsequent uptrend has started with force.

• An additional enhancement is the fact that our engulfing day’s candle engulfed the entire previous day’s trading – including the wicks (or shadows) – another sign of a powerful reversal in trend.

• Also, the larger the gap down at the open (from the last day’s close), the more powerful the signal. Here, the gap lower was over 1% – a significant drop.

• The only other enhancement we could have hoped for would be a large pickup in volume on the engulfing day. A glance above shows that, unfortunately, this didn’t happen. Volume was above average, but should have been higher than the previous day’s – at least – in order for us to jump around and start to froth.

Not bad, though, all things considered.

And what did occur on the following day was also very constructive.

On Friday the chart formed a second, very bullish pattern known to the Japanese as a Three Outside Up bullish pattern.

What is a “Three Outside Up” bullish pattern?

This pattern follows on the bullish engulfing pattern with another white candle that closes above the engulfing day. It is a far more reliable bull reversal indicator than the simple engulfing move. It looks like this:

With the third day’s trading we have confirmation that the buyers have taken over, and the psychology of the market has been altered in favor of the bulls.

Our NASDAQ chart shows us a very clear Three Outside Up pattern (see above). Because of the volume issue mentioned above, we would wait until the declining trendline is bested (at approximately NASDAQ 2350) before we considered the deal sealed.

In the meantime, however, there are a significant number of stocks and sectors exhibiting this same candlestick formation. Here are a few of them.

• Pulte Homes (NYSE:PHM), whose stock doubled in January after a Three Outside Up pattern. Pulte was recently featured in Oxbury’s Residual Income Report.

The stock has since retested its January lows and moved on to new highs. Pulte appears to be a leader in the current homebuilding rebound.

Another noteworthy “Three Outside Up” pattern occurred last week in the S&P 500 proxy, SPY. The chart, for all intents and purposes, is no different from the NASDAQ

chart above – with one exception. There was a clear volume spike on the engulfing reversal day – with almost 30% more shares in play.

No confirmation needed here. The S&P 500 is in full buy mode. As are Wells Fargo, J&J, The Southern Company (a beautiful “Three Outside Up” formation here!), and many others.

And don’t let the doomsayers convince you otherwise. This market is a scared rat. And that’s exactly why it’s going to climb faster and farther than anyone imagines.

Lehman Bros.?

AIG?

Ford and G.M.?

Fanny and Freddy?

That’s right. They look like a batch of losers, capable only of causing a meltdown.

Time to panic?

Not a chance.

Time to make money. Big fat wads of it by having the cohones to get it on when everyone else has run to the shelters.

A wall of worry.

A big fat rally!

Eat it up,

Matt McAbby
Analyst, Oxbury Research