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Trader's Corner

Time to Reassess

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Early this year, I began a series of articles on the corrective fan principle. Every few months, I check on the conclusions suggested by that principle, seeing if the market has behaved in accordance with expectations.

It would seem that they're not. According to the corrective fan principle, the rally off last summer's low ended in February. Oh, yeah? Tell that to any bear trying to short the markets from mid-March through mid-May. Tell it to anyone in an SPX or OEX bear call credit spread in April. Or May.

Let's look, though, at what the principle says and what has happened. Basically, the principle suggests that any trending move establishes three separate trendlines. The first sharp move up from a low or down from a high tends to be too steep to be maintained. Prices fall through the first ascending trendline or break up through the first descending one. A less steep second trendline is established. Prices bounce from that trendline for a while, too, but it's also too steep to be maintained, too. A third trendline is established.

When that trendline breaks, the principle suggests that the trending move is kaput. In the case of a rally such as the one off last summer's low, the break of that third trendline suggested that either a period of disorganized trading or else a downtrend would follow.

That hasn't exactly happened:

Annotated Daily Chart of the SPX:

Note: That chart was snapped about 12:25 EST Friday afternoon and so doesn't indicate Friday afternoon's activity.

So, what happened? At least four possibilities exist:

1. I drew the trendlines incorrectly.
2. The current action isn't a continuation of the uptrend.
3. It really is different this time.
4. The corrective fan principle didn't work this time.

Let's start with number four. The corrective fan principle works on many time frames and across many kinds of markets. However, no system, no indicator, no nothing works all the time. In April 1997, the SPX began climbing off a low, establishing a series of three trendlines. The third wasn't broken until August 1998, and it was followed by a steep decline that, like February's, lasted only a few days. After rising for about a week, then dipping swiftly to retest the August low, the markets were off again, rising into their early 2000 highs.

The corrective fan principle didn't work that time. There's the possibility that the corrective fan theory just didn't work this time, either, other than to predict that the break of that third trendline would be steep. It was.

What about the possibility that "it," the markets' behavior, really is different this time? Anyone tuning into CNBC has certainly heard enough theories about why that might be true. The flood of money into equities is global, commentators will tell you, and not just the commentators appearing on our version of CNBC. CNBC Asia and Europe both feature commentators saying the same thing.

I can't help it: I almost groan when I heard that "different this time" statement. How many personal fortunes through how many centuries have been wiped out by people who believe that it's different this time? I'm sorry. I just don't believe that. I can easily believe that a formation break failed to produce the expected result, that the corrective fan theory just didn't work this time, just as a triangle breakout is sometimes quickly reversed and prices head in the opposite direction. Formation breaks sometimes don't deliver on their expectations. I also believe that momentum can sustain a trend far beyond the time when it would have died a natural death, but I don't believe that market behavior has truly changed.

That leaves the first two possibilities to be discussed. Is it possible that, as much as our eyes tell us that this is a continuation of an uptrend, that our eyes are deceiving us?

Annotated Daily Chart of the SOX:

The possibility exists that the entire post-February rally is nothing but the prelude to something like what happened on the SOX. We'll just have to wait and see, but the negative breadth measurements while the SPX has been climbing over the last couple of months beg that we at least keep this possibility in mind.

So does the SPX's dead stop on that neon-green third trendline (first chart) each time it's been hit. (Note: the SPX had again been stopped by that trendline Friday morning, but this article will be submitted before Friday's close, so it's possible that will have changed.) Unless Friday afternoon's move produces a big climb, that shows us that the trendline has some validity, bringing up the question of whether I just made a mistake drawing the first or second of three trendlines in that SPX chart. Maybe that third trendline isn't the third, but a second one.

Drawing trendlines is as much an art as a science. Knowing that, I made every effort to ensure that the trendlines were valid, as you might remember if you read the original articles on the corrective fan theory. For example, I correlated price trendline breaks with RSI trendline breaks. The first chart of this article demonstrates how I did that.

I could give some credence to the choice of the three trendlines, too, when February's break of the third one resulted in a strong downdraft. Something happened differently with the break of that third trendline than happened with the break of the first two. What happened was exactly what would have been expected if the corrective fan principle were holding in this instance: a steep decline at the break. It's what's happened since that's in question.

Where does all this leave us? Normally, I would be the first to blame myself, to say that my trendline-drawing skills were at fault, but that February action argues against that conclusion. I just don't believe in the "it's different this time" paradigm, so I'm rejecting that one out of hand. I tend to believe, then, that either this is one of those times that a formation just failed to perform as expected or that the whole climb off the March 2007 has been part of a different pattern, a consolidation or other pattern, that we just can't see yet.

And that's the purpose for this article. Keep that possibility in mind. Stare at the SOX's chart, the second in this article for a while, long enough to convince yourself that it's always wise to be prepared, to have an exit plan in mind, to not allow oneself to get sloppy when protecting profits. If a huge triangle were to be set up, the chopping back and forth within the formation can be death to directional options positions and the essential getting-nowhere results of a narrowing triangle can be death to those that depend on a big movement because each movement is quickly reversed at the as-yet-unseen boundaries of any such triangle.

I'm not saying this will happen. I'm saying that you need to plan how you'll address trading options in case it does.

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