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A Look Backward and Forward Using the Corrective Fan Principle

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As I've been doing every few months all year long, it's time to follow up on my series of articles on the corrective fan principle. Did the corrective fan principle correctly predict the end of the rally? If so, what does it have to say about the current state of the markets?

For those who have not read my previous articles on the corrective fan principle, that principle's evidence concluded that the rally off last summer's low ended in February.

Oh, yeah? the last article in the series asked. That article was written in June and included the following chart, complete with the original annotations written in June.

Annotated Daily Chart of the SPX in June:

If the rally ended in February, why did the SPX reach higher right into July? the article asked. My conclusion at that time was that the "possibility exists that the entire post-February rally" was similar to the SOX's rally in early 2006. When seen in hindsight, that early 2006 SOX rally had been nothing but the setup for a prolonged choppy period that eventually resolved, rather dramatically, to the downside. Traders needed to plan how they would address such a development on the SPX, too, the article concluded because it was possible that the last leg of the SPX rally wasn't truly "rally" but merely a setting up of the eventual decline.

I hope some did plan.

So, for the benefit of those who haven't read the previous articles, what is the corrective fan principle? The principle, expounded upon by Martin J. Pring in TECHNICAL ANALYSIS EXPLAINED, 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. 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 SPX break of that third trendline in February suggested that either a period of disorganized trading or else a downtrend would follow.

What we've gotten so far is a period of disorganized trading, in my opinion, followed by a possible beginning of a decline that will be organized along the corrective fan. The climb to test all-time highs was accompanied by poor breadth. It climbed the underside of the trendline defining rally support.

Can the corrective fan principle tell us something about when the downtrend since late July will end?

Let's take a look. This chart was snapped Wednesday, August 15, after the close of trading, and I wanted to keep it and my further comments so you can test those conclusions and see if you agree. I'd be the first to tell you not to trust anyone else's conclusions if they don't fit yours, even if that "anyone else" is me. So, let's test this chart I snapped Wednesday evening and the following commentary, also originally written Wednesday evening.

Annotated Daily Chart of the SPX:

As the chart notes, it's possible that the first descending trendline, red on this chart, has been formed and broken to the upside. If that trendline is a valid or true trendline, then it should now serve as support on any downside tests, as it had twice done before the late-day test on Wednesday, August 15, when this chart was snapped and this commentary first written.

What does all this mean? First, let's address what it does not mean. While it's possible to draw a trendline and even two, and to find supposed corroboration through using the RSI, we're not sure that these are valid. It's still possible that markets are just churning in a disorganized manner without a clear downtrend in place, although many would dispute that as a possibility. The drawing of two trendlines on a chart, particularly when one has as awkward a fit as that first one does, does not prove that a new downtrend exists.

However, the other possibility, of course, is that a new downtrend has begun, replacing the rally that has now concluded, and that the two trendlines drawn above may ultimately prove valid. If so, the breaking of the first too-steep descending trendline does not mean that prices can't go lower than they have. Wednesday proved that. Just as prices could climb the underside of a rising trendline during the prolonged rally, they can slide down along the topside of a descending one. That first descending trendline can provide support for every daily close until the descent is over, but prices could be sliding lower all the time. Still, if it's a valid first trendline, we do at least know that it should now serve as support on pullbacks.

The descending blue trendline has only two touch points so far, and so is not yet well established. I wouldn't trust it yet, but would consider it a possible candidate for the second of the three descending trendlines that form the corrective fan in a downtrend. Until it's better established, it's still possible that the choppy trading behavior will establish a second trendline with a slope a little less steep. Even if RSI predicts or corroborates an immediate break up through that blue trendline, it may not yet be well enough established to provide support on pullbacks. However, if it is tested a bit more and continues to provide resistance, and only then is broken to the upside, complete with RSI corroboration, it's likely that prices will either bounce from it or slide along it on future tests.

If a new descent is forming and organizing itself along Pring's corrective fan, we've still got at least one more descending trendline to form, sometime after the second one is broken to the upside. That's not happy news, of course, but we'll take a look now and then and see what's developing.

For now, look for the red trendline to form support on daily closes on descents, even if that support is a sliding-lower one. Consider the possibility that resistance will hold at the blue descending trendline, at least until RSI breaks through its own blue descending trendline. When that happens, watch for price to break up through its blue trendline, if it's not happening concurrently with the RSI breakout. RSI sometimes anticipates a move or predicts it, but do remember that any signal that moves ahead of a price break can sometimes give false signals, too. For now, though, it will likely be the best signal you'll receive of a short-term or intermediate rally, on the way to forming the third and final trendline. Don't get too fooled by any such rally, as new lows could still result.

That concluded the commentary that I had written as of Wednesday night, so let's update it and test the conclusions that were written then. To ensure that I'm not just editing this to fit my supposedly already written commentary, the next chart will be the one included in Thursday night's Wrap, with the commentary that written Thursday night, so that you can double check it and make sure that I'm not just editing to fit what has happened as of Friday.

Annotated Daily Chart of the SPX as of Thursday's Close:

How did Thursday's action fit with the corrective fan theory? Although the red trendline, one with a fit that I still find suspect, was pierced intraday, it did indeed form support on the daily close. Perhaps it's valid?

Even if it is, Thursday's action again proved that although prices have now broken above the first of the three trendlines and that trendline appeared to hold as support on daily closes, prices can and did slide lower along that trendline. The breaking of subsequent trendlines to the upside will not necessarily mean that prices will move higher.

However, as I noted Thursday evening in the OptionInvestor, when prices pierce this trendline during intraday periods, short-term bears should consider the possibility that prices will bounce back to or above that trendline by day's close. The other admonitions about watching RSI, also included in the annotations on the last chart, remain valid for now, too.

Let's check back in a few weeks.

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