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A Gap in Logic

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On Thursday, December 1, the SOX concluded its test of the descending trendline off the summer high. At the open, it gapped higher, posting a strong gain that continued that day and the next. The gains punched the SOX past 500, a psychological barrier, moving it into a support/resistance band spanning from about 493-520.

With investors spurred into buying by a positive result in the October semiconductor sales figure and looking forward to a positive update by Intel, an outlook that was to reverse before the Intel report ever appeared, the SOX looked poised to make further gains.

There was a gap in that logic, however: specifically, the gap that occurred Thursday morning. That was at least the third gap in the SOX's rally off the October low.

Annotated Daily Chart of the SOX, as of 12/02:

Gaps come in three types: breakaway, measuring or continuation, and exhaustion. Breakaway gaps occur when prices gap out of a consolidation pattern. Breakaway gaps occur because accumulation or distribution has been occurring during the consolidation, and demand or supply has overwhelmed bears or bulls. Price gaps up or down, depending on whether a rally or a decline is beginning. Prices often do not retest these gaps. Prices never retreated into the breakaway gap marked by the numeral "1" on the SOX's chart, for example.

Measuring gaps tend to occur about halfway through a movement, although they are not required to be at the exact middle of a move. Although they often occur after another consolidation, they sometimes appear in the course of a straight-line rally or decline, and so are sometimes also called runaway gaps. These sometimes are retested, but if that retest doesn't occur during the next day or two after the gap forms, they often will not be reversed until the rally or decline has ended. Prices did not move back into the gap marked with the numeral "2," either.

Annotated Daily Chart of the SOX as of December 2:

Once a movement has racked up a breakaway and a measuring gap, as the SOX did in its rally off the October low, the possibility rises that the next gap could be an exhaustion gap, the last in the series before a reversal or consolidation period, the "last gasp" of the bulls, as technician John J. Murphy calls it. It need not be a sign of a major reversal, but it does signal to bullish investors that protective measures should be in place. Highly leveraged investors might want to lower their exposure by taking partial profits. This advice was provided to Market Monitor subscribers beginning Thursday, December 1.

Although charting services usually do not provide accurate volume figures for the SOX, volume considerations can help judge whether an exhaustion gap is occurring in equities. A small-range move on large volume suggests that the gap may be an exhaustion gap. Even without the volume figures, it's clear that the SOX's gap on Thursday, December 1 did not fit that parameter, however, because the SOX's price range for the day was large. Still, this gap occurred just where an exhaustion gap might have been expected and so should have been suspect.

Just as a rapidly moving car will not come to an immediate stop as soon as the driver stops pressing the accelerator, prices can move beyond an exhaustion gap. Confirmation of an exhaustion gap occurs when prices close back below the gap.

The presence of a potential exhaustion gap gained special relevance with Texas Instruments and Intel mid-quarter updates scheduled for the week after the gap appeared, and with the SOX having attempted a breakout of a long-term rising regression channel in which it had been traveling off the 2004 low. Depending on how that channel was drawn, the SOX had either ended the week on December 2 at the resistance of that rising regression channel or just above it.

Annotated Weekly Chart for the SOX as of December 2:

The opportunity for a pullback to retest the descending red trendline existed.

The third and probable exhaustion gap provided an alert that the SOX might be topping. A fitted Fib bracket and the resistance at the top of a long-term rising regression channel corroborated that evidence. The next week, the one just concluded, was to produce further corroboration that the gap might have been an exhaustion gap.

Annotated Daily Chart of the SOX:

With the likelihood increasing that the gap might have been an exhaustion gap, those long the SOX or semi-related stocks have further warning to protect profits. The spring up from gap support and follow through on Friday, December 9 clouded the ultimate picture, perhaps leaning toward a possibility for sideways consolidation rather than a deeper drop, but another chart presents evidence that might be watched closely.

Annotated 60-Minute Chart of the SOX:

The next time a gap occurs and some call it bullish or bearish, check for other gaps. If more than two exist, there may be a gap in that logic.

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