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Key 'Technical' Aspects to the Recent Reversal

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I wrote this column last Thursday about a couple of principles that fall mostly under what is considered to be technical analysis, that of chart 'gaps' and 'bellwether' stocks, indexes and sector indexes.

I say 'mostly' that fall into what is technical analysis, as the concept of 'bellwethers' is not exclusively the purview of technical analysis. However, saying that hitting a significant technical resistance followed by an apparent trend reversal in the bellwether New York Stock Exchange Composite Index (NYA), also suggests a top in the other indices, is more of a 'technical' analysis. Technical analysis only makes predictions based on PRICE and volume inputs and not on such factors as earnings, interest rate and consumer spending trends. I leave the aforementioned 'fundamental' analysis to our excellent Market Wrap analysts.

It happened that the recently red-hot Nasdaq 100 (NDX) Index reversed sharply the other day its prior downside price 'gap', which is an area where overnight events caused there to be NO trading between the one day's Low and the next day's High. Overhead (downside) gaps, when approached later on, often turn our to be an area of renewed selling/resistance and that's what happened recently as highlighted in my first chart below, which simply reflects updated prices to a chart I used last week in the 5/15 OI daily newsletter.

There is more to say on my first chart, reflecting another important technical chart principle, which is that the 'fibonacci' retracements of 38, 50 and 62% of prior declines tend to act as resistance areas. If a retracement of a prior move in an index or stock exceeds 38%, prices often continue up toward 50%; if a retracement exceeds one-half of the prior decline, the move often will reach a fibonacci 62% or a little bit more.

The 'little bit' more is important and reflects a retracement idea from legendary 20th century stock trader WD Gann, who thought that the 1/3rd and 2/3rd retracements were also important future resistance or support. I often find that strong retracements of around 62 percent will hit 66%, a 2/3rds retracement, before reversing, assuming there is going to be a downside reversal.

NOTE: MY CHARTS REFLECT CLOSING LEVELS AS OF YESTERDAY, WED 5/21. It's my last Trader's Corner article from a time zone (London) that is way ahead of the New York close!

Another technical principle that can be quite significant in forecasting a possible trend reversal is the concept of overbought and oversold and I find the 13-day Relative Strength Index (RSI) is the best measure of when a stock or an index gets to an 'overbought' extreme as seen above with NDX. The combination of the three technical factors related to the prior chart gap, retracement amount and RSI extreme occurred in tandem and strongly suggested at the VERY LEAST that it was time to take profits on index calls.

By the way, if retracements EXCEED 66%, a next move often equals a 100% retracement or a 'round-trip' back to the prior top or bottom. The 2/3rds retracement level at 2050 in NDX can be seen as a test of whether the rally from the mid-March low is a COUNTER-trend move only OR a RESUMPTION of the prior major (up) trend.

The bellwether NYSE Composite Index (NYA) showed the same reversal pattern at the 66 percent retracement level (of the October to mid-March decline) and an overbought RSI, as was seen in the Nasdaq 100 (NDX) index.

I also wrote last week that "The 13-day RSI has not following prices to a new closing high, giving a small divergent note to today's renewed rally. It may be NYA gets to near 9700 and a significant top made there." This statement was not genius analysis, just 'technical' analysis. That's why I use and write about it.

Another bellwether stock index that is often a better than average predictor for the overall market and one of the two Dow averages that are part of 'Dow theory' analysis, is the Dow Transportation Average (TRAN). Amazingly enough, given the sharp climb in fuel costs, TRAN recently hit a weekly closing high that was equal to the prior ALL-TIME high and setting up a possible (likely?) DOUBLE TOP.

Stay tuned on whether we have a major top in place, but I thought that it defied reason to think that TRAN was going to keep climbing. TRAN's double top also suggested to me that the overall market had formed another significant price peak. A good bellwether is useful for what it shows about the broad market.

The STARTING point in beginning a retracement measurement or which prior high or low to use, is a consideration in using a retracement-charting tool. I used as my starting point the October top in the NDX and NYA daily charts above, which was of course the absolute top. The recent highs in NDX and NYA retraced 66 percent of the entire October to mid-March decline.

Experience also suggested looking at the retracement levels of the major stock indexes for the big downswing measured from the December high. The big part of the decline was the December to mid-March downswing and IF the recovery move went beyond 62-66% of THAT move, it was a good bet that the recovery rally at least could make it back to the December high.

When the retracements were measured using the December-March declines, there were consistent patterns: the big downside reversals in the S&P 500 (SPX), the Dow 30 (INDU) occurred after the indexes recovered a key 2/3rds or 66% of the major down leg from the December highs to mid-March lows.

In SPX, the rally peak in early-May reversed at the 62% fibonacci retracement level. The second and most recent high spiked up to the 66% retracement level around 1435, before the index experienced a downside reversal.

An interesting and telling added take on the recent reversal was that the move to a new relative high in SPX occurred on declining 'relative strength', which is visually highlighted by the up sloping trendline on the price portion of the chart above and by the sideways to down sloping trendline drawn on the Relative Strength Index graph below SPX's daily price history. This pattern is a bearish price/RSI divergence and provided another clue as to a possible trend reversal situation that was developing.

The Dow 30 (INDU) chart shown next has the same reversal pattern as SPX occurring in the area of the 62-66% retracement area. In terms of ITS price pattern it however also has a double top formation. Technical patterns and indicators make a stronger prediction when there are multiple technical aspects pointing toward the same resistance or support and possible trend reversals.

While the INDU Relative Strength Index did not also reach what I consider to be 'overbought', which starts typically at a reading around 70, the last run up in INDU was accompanied by a significantly lower RSI to what came before, which also qualifies as a divergent 'sell signal'.

My last chart is that of the Nasdaq Composite (COMP), which at the risk of being redundant and boring you all, shows the same reversal as SPX and INDU after a 66% retracement, showing the consistent outcome of these similar patterns in these indexes.

The difference between the Nasdaq Composite and the Nas 100, is that COMP didn't get as high as resistance implied by the downside gap highlighted on the COMP chart below; at the yellow circle. Relative to which aspect, chart gap or retracement level, is the more 'significant', it's the later.

You can e-mail me at Click here to email Leigh Stevens support@optioninvestor.com with any questions or comments. Just put 'Leigh Stevens' in the Subject line so it gets forwarded to me.

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