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Is It Time Yet?

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Everyone seems to be asking this question. Is it time for the SPX rally off last summer's lows to end? Many market-related publications have recently featured articles predicting just that. Others take the opposite tack, predicting a rally that will extend far into this new year.

An article I wrote last summer discusses the corrective fan principle, a principle that can help pinpoint the end of a trending move. It's time to revisit that article and see what the corrective fan principle might have to tell us about current market conditions.

A little background might be appropriate for those who didn't read that article last summer or don't remember its premise. In TECHNICAL ANALYSIS EXPLAINED, Martin Pring notes that trending moves tend to establish three trendlines. This is true of downtrends as well as rallies, but both that article last summer and this one will be focusing on rallies.

The first trendline is established as prices explode off a new or relative low. That first trendline can be too steep to be maintained, so that prices eventually break through the first trendline. My article last year employed charts of Callaway Golf (ELY) to illustrate the corrective fan theory. This break through the first trendline happened with ELY when prices climbed off the low in the fall of 2004 and then broke through that first trendline in April of 2006.

Some market watchers erroneously assume that a new downtrend has been established when that first trendline is broken, but that's often not the case. The corrective fan principle explains why. Although the first trendline might have been too steep to be sustainable, a new uptrend is often established.

The second trendline is likely not as steep as the first. Prices sometimes climb this second trendline into a new or new relative high. Sometimes the first trendline serves as resistance as prices zigzag high. Prices may appear at times to climb the underside of the first trendline although they find support on pullbacks at the newly established second trendline. Because there's been a break of the first trendline and because it continues to serve as resistance, some erroneously assume that those new or relative new highs won't be hit, but the corrective fan principle alerts chart readers that three separate rising trendlines may comprise the full trending move.

Even the second trendline's slope may be too steep to be maintained, however, and prices will eventually break through that line, too. At the time of the article last summer, ELY had just broken through the second trendline, after climbing it long enough to form a new relative high. One of the charts from last summer's article is found below, complete with its annotation from last summer.

Annotated Weekly Semi-Log Chart of ELY:

The corrective fan principle suggests that a third trendline will then be established, one with a slope not as steep as the second's. It's not until then third trendline is established and then broken that the rally has completed.

If that corrective fan principle was to hold in ELY's case, the principle suggested last summer that ELY should still form a third rising trendline. It wouldn't be until that third trendline would be broken that a change in trend--either to sideways consolidation or a downtrend--would ensue. The long rally from the fall of 2004 would have been completed.

Did ELY establish a third rising trendline?

I've changed charting services since last summer, so the chart will appear a little different, especially since I have not been able to successfully switch to a semi-log chart for a stricter comparison. This chart was prepared early this week, so does not capture all the price action from last week, but as you'll see later, I'm glad that the chart and its annotations was prepared early, before Friday's action, so that it's conclusions become more important.

Annotated Weekly Semi-Log Chart of ELY:

Friday morning's action points out the importance of not assuming that ELY's rally attempts are finished before that third trendline is violated. Friday morning, ELY gapped higher, with prices sitting at $15.64 as I type. That turns the pullback from November and early December into a potential bull flag.

Prices are now well above their level last summer when that article was written and the first chart snapped. At that time, my article concluded that while ELY's prices were in a short-term downtrend, they would likely rise along a yet-to-be-established new rising trendline. The correlative fan principle suggested that the rally might be on its third and final leg as it established that third trendline, however, and that anyone long the stock ought to take care to protect profits.

That's where it remains today, and I would assume that the second trendline will now serve as resistance and that, since ELY has now established its third trendline, gains remain suspect at this point.

What does this corrective fan principle have to tell us about the question everyone has been asking, the question that began this article? Is it time yet for the SPX's rally off last summer's low to end? Let's take a look at some possible rising trendlines that can be drawn off that rally's beginning.

Annotated Daily Chart of the SPX:

I'm not entirely sure that the first, aqua-colored trendline is valid. I could just as easily argue that only two trendlines could be drawn from this rise off last July's low, and that the third is yet to be established. Unfortunately, although the corrective fan theory was correct in its predictions about ELY last summer, it's not giving me clear insight into what's happening with the SPX. To help validate the three trendlines, I tried looking at them in combination with another indicator, the RSI.

Remember that the following charts were also captured at the beginning of this week and don't feature end-of-week price action.

Annotated Daily Chart of the SPX:

That first, somewhat improbably sloping trendline was mimicked by a rising trendline on the RSI, too. The RSI broke through its trendline and also through a tiny H&S formation's neckline at the same time that prices broke through that first rising trendline. This concurrent RSI action does appear to give some validity to that trendline.

The second trendline's break was also mimicked by a simultaneous RSI break through a second rising trendline. RSI has already broken through its third trendline, however, with that break occurring as the SPX stopped testing the red trendline from the underside and fell back further away from that sharply rising trendline. Sometimes RSI breaks anticipate a price break, so that's not necessarily a sign that the third trendline is not valid. In fact, I would definitely argue that both the red and the blue trendlines are valid.

Another interpretation still questions the validity of that first trendline, however.

Annotated Daily Chart of the SPX:

Drawing trendlines is as much an art as a science. In this case, the art is more subjective than is typical, as an argument could be made for either variation of three rising trendlines. What we're left with is this: we know that the blue trendline is a valid one, so the SPX really should not close much higher the rising blue trendline, allowing for a bit of error in this best-fit trendline's construction. The possibility exists that the blue trendline is the third and that it has already been violated, so that a period of sideways movement or a decline might be in the making. However, if that theory is refuted by the formation of a new third rising trendline, we will have clear evidence of when the rally mode might end. That will occur when that third trendline is violated, and a RSI break of its own new trendline occurs either before or concurrently with a price break.

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