A couple of months ago, a Trader's Corner article posed the question everyone had been asking: Was it time for the SPX's rally off last summer's lows to end? That article employed the corrective fan principle as described by Martin Pring in TECHNICAL ANALYSIS EXPLAINED to examine the trending move that had developed as the SPX moved off last summer's low. Several charts demonstrated the principle. It's time to revisit those charts.
First, those who didn't real the original article should read it now to acquaint themselves with the basics of the corrective fan principle. The article can be found in the "Trader's Corner" section of the newsletter on January 20, found at this link.
For those of you who didn't read that article and don't intend to follow the link, either, the premise of the principle resides in the fact that many trending moves tend to occur in three movements: a sharp first trending movement, up in this case, with the move too sharp to be sustained. The first established trendline is violated, at which time many erroneously assume that the trend has ended. However, the trend may be forming a second trendline. The first one, when extended, now often serves as resistance, so that although prices still trend, they tend to trend along the underside of that first trendline.
Eventually, the second trendline is violated, too, and a third forms. That third trendline doesn't slope as strongly as either the first or the second trendline. In other words, the absolute value of that trendline's slope is typically smaller in value.
This may be somewhat confusing when we consider the case of so-called parabolic moves that tend to end a rally, for example. However, those parabolic moves are price movements that are bouncing up from that trendline and they tend to find resistance at the second trendline. The slope of the third trendline is not determined by those so-called parabolic moves.
The study of the SPX's chart proved somewhat unsatisfactory in that first article, because the decision as to where trendlines would be placed was complicated by a first potential trendline that looked so sharp and short that it was uncertain that it was a valid first trendline. Two interpretations of the various trendlines could be pinpointed, each potentially backed up by RSI action.
The first interpretation, complete with the original annotations from that January 20 article, can be found below.
Annotated Daily Chart of the SPX, First Interpretation:
This chart displayed one interpretation, in which three trendlines had already been delineated as of January 20, with the third trendline just having been broken. RSI evidence corroborated the three trendlines, although that first, aqua-colored one still appeared so short and sharp as to create some confusion as to its validity. Certainly, in late August, the SPX rose along its underside and fell back, so it was lent further validity by that action, but I still wasn't entirely convinced as of January 20 that this was the most valid interpretation.
The second interpretation, complete with the original annotations from that January 20 article, can be found below.
Annotated Daily Chart of the SPX, Second Interpretation:
Some guideposts existed for considering these three trendlines the more valid interpretations. The article concluded that the drawing of the trendlines had proven more subjective than was usually true.
"What we're left with is this," the article ended. "[W]e 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."
What has happened since that article was written in late January? Certainly, something has!
Note: Remember that my articles are typically prepared a week or two before publication, so charts are often not current, as this one will not be.
Annotated Daily Chart of the SPX as of Friday, March 2:
This chart tells us that I was right to doubt the validity of that first sharp, short rising trendline. As the corrective fan principle suggested would happen, the blue trendline continued to serve as resistance during the intervening period from January 20 until late February, when prices began tumbling. In fact, the location of the resistance suggests that I had drawn that blue trendline too steeply.
The third trendline is correct as drawn, however. RSI confirmed the break, as I had told readers to expect if a newly forming trendline was to be considered valid.
Unfortunately, what we're also told is that the rally from last summer has probably ended. One of two types of actions should result: either a prolonged consolidation, perhaps in the form of a rectangular consolidation pattern or even a triangle that starts out wide and then narrows to the right; or else a new trend, this one a descent.
Since last summer, bulls have been rewarded for buying each dip, and shorts have been scalded for holding on once the most minor of bounces begin. Bulls may keep trying to find the bottom and shorts may be quick to cover, resulting in some volatile and equally sharp bounces. A period of disorganization may result. However, Pring's corrective fan principle would warn would-be bulls that any buy-the-dip action should be considered countertrend until proven otherwise. Bears should remain alert, too, that they don't get taken out of positions by equally short, sharp rallies if consolidation-type triangles or wedges set up next.
As mentioned in that January 20 article, drawing trendlines requires some art as well as some science. RSI action could have seen as corroborating that first interpretations of three trendlines but it also questioned it, since RSI began setting up an alternative third trendline interpretation before that trendline even began to form.
In this case, the corrective fan principle wasn't as easy to apply as it is in many, but it still lent some warnings. It still told traders where the SPX would likely find resistance and that, if a third trendline should form, the violation of that trendline would perhaps spell the end of the rally off last summer's low.