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Trader's Corner

Time for a Checkup

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Volatility has ruled the markets lately, especially since the November 26 Trader's Corner. That was when we last looked at what the corrective fan principle was telling us about the downtrend.

What was the conclusion of that November 26 article? "The conclusion is that, if RSI breaks through that [second] descending trendline [off the October RSI high], a relief bounce might ensue. If so, traders should trade that bounce only if they're comfortable trading a rally that's occurring in the context of a downtrend that appears to be intact so far, at least according to the corrective fan principle. Others should watch for rollover potential, either at the dotted or solid blue trendlines, if prices should rally that high."

Let's take a look at all those trendlines mentioned. Keep in mind that the article was written the middle of last week and so charts do not reflect current values.

Annotated Daily Chart of the SPX, Snapped 12/12/07

At the time of the November 24 article, RSI had not yet broken up through its first (lowest) descending blue trendline. The article speculated that, if it did, a relief rally might ensue and that rollover potential existed either at the descending dotted blue line or at the solid blue one. The confusion existed because, at the time, the RSI setup and other chart characteristics suggested that the dotted blue line might be the second trendline of the three that are usually formed in a corrective fan. This wasn't a classical setup of the fan, as all three fanlines typically radiate from a single high. The action since has clarified the fanlines a bit, at least in my opinion.

The corrective fan principle suggests that any trend, either an uptrend or a downtrend, forms three fanlines or trendlines radiating from a single swing high or a low. The first trendline is formed in the early days of the trend, and it's the steepest. It's too steep, its slope too extreme, to be maintained.

Since we're looking at a downtrend, I'll use downtrend examples in my explanation. In a downtrend, prices eventually break up through that first too-steep trendline. Some bullish traders who have been following the downtrend exult in that break through that first trendline. The downtrend is over, they reason. Indeed, the upside break through that first trendline is often accompanied by a steep relief rally.

However, Martin Pring, author of many texts on technical analysis, would caution that the exultation is a bit premature. When explaining the corrective fan principle, he explains that all that's occurring after that first break is the establishment of a second and more sustainable descending trendline with a slope that isn't quite so steep. Prices will find resistance at that second trendline.

RSI and price breaks through their respective trendlines in late October resulted in the formation of that solid blue trendline. The breaks also began the process that resulted in the confusing and non-classical descending dotted blue trendline.

That solid blue trendline was the one tested this week, as prices rose ahead of the FOMC decision. Prices in fact overran that fanline or trendline a bit, but the sharp pullback from the trendline validated its authenticity as the second trendline or fanline of the corrective fan principle.

What does that mean? First, if the principle holds true again, as it has several times over the last 12-18 months that we've been examining it in these articles, the downtrend off October's high hasn't been concluded. According to that theory, a third descending trendline or fanline will still be established.

The principle suggests then that while relief rallies can still be abrupt and sharp, we're still in a sell-the-rallies mode on the intermediate term. Rallies that drive up to the blue trendline or fanline might fail at that point, but even a casual glance at that chart shows that such rallies can be sharp.

The possibility exists that the pre-FOMC breakthrough of the solid blue trendline was not a simple momentum-driven overrunning of resistance, but rather was the beginning of the establishment of a third trendline or fanline, shown in dotted green on the chart below:

Annotated Daily Chart of the SPX, snapped 12/12/07:

Remember that this chart, too, was snapped midweek. Since then, the SPX has consolidated beneath both the top trendlines. We'll check back later, in another article, to see how it's behaved into the future. For now, consider the possibility that the last month's sharp rally was nothing more than a relief rally up to the second of three descending trendlines or fanlines that will eventually form.

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