Editor's note: Click any image to enlarge.
I decided to continue last week’s article with another technical update as of today. Last Tuesday’s 90% down day (more than 90% of stocks on the NYSE – common stocks only – were down) that enveloped 10-days worth of gains was the kickoff to a short-term correction. Major indices have failed to reach higher highs after that sell-off. The market’s long-term and intermediate-term outlook has had little change since last Tuesday; although cracks are beginning to surface along the trend. All major indices are trading above their 50-day moving average except for the Dow Jones Industrial Transport Index. The 50-day moving average is now acting as resistance to that index, which has bearish implications for the intermediate-term. It also implies the Dow Jones Industrial Index may follow suit. So while most of the major indices are all trading above the 50-day moving average, the Transport Index trend is now in question.
Trendlines 101
Last week, and above, I’ve been talking about moving averages to determine trend. There’s another way: trendlines. I see novice and intermediate technical analysts use this technique improperly in emails and web blogs. Here’s the skinny and how to draw correct trendlines. The proper use is the connection of two or more peaks or troughs. The more peaks and troughs that are connected, the stronger the trend. Trendlines don’t float aimlessly from the bottom of a trough or top of a peak without another point of reference. So the key is you need at minimum: two points.
Which points? There’s some debate on whether to use closing price or intraday lows/highs. If you look at trading volumes, most of the day’s volume occurs in the morning hour and the afternoon hour – a u-shape if you look at a volume histogram for the day’s trading range. Is the intraday low in which 100,000 shares traded more important than the closing price where 5,000,000 million shares transacted? I don’t think so, but from time to time, I’ll use an intraday low if I find that level matches up with other technical support/resistance levels or as it’s written above, more trough/peak price points. The idea here is to use common sense; however, the traditional sense has been to use the closing price on a line chart.
When a trendline breaks, it can signal reversals or corrections. Here I see many investors read too much into trend reversals and do not consider consolidations. As soon as we get the first sign of selling pressure (as on last Tuesday) the perma-bears come out in full force and I get emailed pictures of baby bears. A trendline break signals the end of a trend. The result can lead to reversals or sideways consolidations. Don’t let your internal biases lead the market. Let the market lead you.
Trendlines 201
As a trend develops, the slope can accelerate or decelerate. The steeper the trend, the more vulnerable it is to a break. Remember again, however, that just because a stock is rising at a steep ascent, a break does not signal a reversal in trend. More than likely, the steep ascent represents the powerful fundamental underpinnings that support the rise in price and are unlikely to subside on one day’s market action. Steep trendline corrections usually result in quick corrections and retests of former highs/lows. If a bullish trend begins to decelerate or a bearish trend begins to decelerate, signaled by a “fan” of trendlines away from the original trend, then the underlying trend is weakening and a reversal or consolidation is likely. *The fan principle states that the breaking of the third fan line signals a reversal and that a new trend is about to begin.* Let’s look at the same Transportation Index chart above, however, now with accelerated trendlines and fans.
Another principle that often holds is once a trendline is violated, a trend can reverse its role from support to resistance, and vice versa as the trendline is extended out. This is often how corrective fans are created! Take the Transports Index chart above. Once the purple accelerated trendlines were broken from above, price could never return to the previous accelerated slope. Instead, the old trendlines acted as resistance.
Looking at the gradual trend on the S&P 500, it has been violated as of Wednesday. After extending the trendline out, notice we couldn’t hold above it today?
A corrective fan develops in the Nasdaq Composite as January took a swipe out of its momentum.
The last subject to talk about when talking about trendlines is the trend channel. Trend channels are formed by extrapolating a parallel line from the original trendline and moving that trendline to the peaks in rising trends and troughs in declining trends. I like trend channels for two reasons: 1) the derivative trendline can show resistance in rising trends and support in falling trends and 2) because if price fails to reach those derivative trendline levels, it signals a weakening trend. When derivate trendlines are broken, it signals acceleration in trend. Let’s take a look a beautiful trend channel in the Transports Index.
Summary
While the 50-day moving averages are holding for many indices and stock securities (minus the transports), accelerated trendlines are being broken and trendline fans are signaling a deceleration in trend. These are some worrisome changes that are suggesting there may be more to this short-term correction than the minimal movement we saw in November and January; however, not enough technical evidence is there to suggest a long-term reversal is in the cards (referencing my article from last week). The market is clearly overbought as I wrote last week with more than 85% of the S&P 500 securities above their respective 200-day moving averages; however overbought markets don’t always signal tops as long as a market is trending. A break in trendline does not mean we’re now going back to 666 on the S&P 500, it means that a reversal OR a consolidation is likely. The main statement when a trendline is broken that can be made is that the current trend is over, and that is all.
To establish a new trend we need two points of reference: two peaks or two troughs – i.e. trendlines 101. Looking at the Transport Index, if the slow and gradual trendline near 4800 holds, this is still a cyclical bull market for the transports; however, the corrective fan principle is warning this trend is over. The 50-day moving average turned back the transport rally over the past three days suggesting it is now in an intermediate corrective mode. Additionally, the breakout in the transport index to new highs mid-February looks like a false breakout, i.e. a bull trap.
Currently, the S&P 500 is down 2.75% from its high on February 18th and this short-term correction looks like it’s happening quickly and furiously in a short amount of time. That typically happens in bull markets. If the amount of time rising is far greater than the time the market is correcting, that’s a bull market. I’ll continue to look towards this short-term correction for more clues on the long-term trend, and I’ll keep you abreast as best I can.
