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On a Roll

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I'm on roll the last couple of weeks, following up on topics brought up in previous Trader's Corner articles. The purpose is to encourage you to check up on the topics introduced, the charts pondered or the theories proposed. Did those topics or theories make sense? Have they since been disproved?

One of those topics from an April 26, 2008 article concerned the corrective fan principle. The article examined whether that principle would help traders determine whether the downturn that had begun in October had ended and, if not, when it would end. We of course know the answer to that question now, but at the end of April, the SPX had bounced so strongly off the March low that some pundits were claiming that the bottom was in. I wasn't one of those who believed it was, although I wouldn't claim "pundit" status anyway.

That March article had itself been a follow-up to previous articles in November and December, all discussing the corrective fan principle and how it related to the decline off October's highs. For those who haven't read the previous articles, the corrective fan principle is a principle discussed by market guru Martin J. Pring in TECHNICAL ANALYSIS EXPLAINED.

As Pring explains and many traders will have noticed, the first trending move after markets break out of a consolidation pattern often proves to be explosive. Prices climb or decline almost straight up or straight down. Either bears or bulls have been suddenly overwhelmed. They rush to cover or sell, helping to fuel that explosion. The slope of the descending or ascending trendline can be steep.

In fact, it's usually too steep to be sustained. Eventually, that first trendline is broken. Many market watchers assume at that point that the trend has ended. Not so. Usually, after a bit of chopping around, the movement continues, but this time along a less steep trendline.

That second trendline also proves too steep to be sustained. Eventually prices break through that one, too, establishing a third trendline, this one with a much more manageable and less steep slope. Usually, the corrective fan principle claims, it's when that third trendline is broken that the trend has ended. A period of disorganization or a new trend begins.

I've seen the principle work in uptrends and downtrends, on intraday and longer-term charts.

Annotated Two-Minute Chart of the SPY:

Traders often observe a steep decline such as SPY's after the violation of a third rising trendline. Conversely, in the case of a third declining corrective fanline that's broken, they might observe a steep rise. Sometimes, however, the ending of one trend does not result in the immediate beginning of another. It may instead result in a period of disorganization.

Identifying the three trendlines does not always prove as easy as it was on the SPY's intraday chart, especially when the action is underway. Sometimes, RSI establishes its own three trendlines that corroborate the price trendlines, helping to validate them. That was true of some times during 2006 and 2007 when previous articles about the corrective fan principle were written, examining trends that were underway at that time.

The trend that began in October 2007 was to prove more difficult, however. In late April, establishing the three trendlines was proving particularly difficult. The annotations on a chart from that the Trader's Corner article written at that time pinpoint some of the difficulties. Those annotations reference previous articles attempting to establish the trendlines.

Annotated Daily Chart of the SPX as of April 24, 2008:

I concluded the April article by saying that I was not fully convinced that the second, blue trendline was a valid trendline. I was stumped, but related what I knew for sure. "At least two trendlines have been or may be in the process of being established. The green trendline has only two touchpoints, so may not be in the final form. If the green line were drawn through the upper candle shadow on December 11's high, cutting off that shadow, the April 14 high was a third touchpoint for the green trendline, so it's possible that we'll decide that version works best at some point in the future."

The purpose of this follow-up article is to determine whether there was another decline to and bounce from the blue trendline. Such an action would give it more validity than it seemed to have at the time of the previous articles. The conclusion was that, whether the blue trendline was valid or not, whether the green trendline was the second or third of the fanlines, it had not yet been violated. As of April 24, I thought that "the corrective fan principle says that the trend that began last fall has not yet concluded." My best guess was that "the green trendline may well be only the second and not the third of the three corrective fanlines."

So, what's happened? Quite a lot.

Annotated Daily SPX Chart as of July 18:

If I'd written this article a week ago, I still would have concluded that this pattern wasn't a clean one, but this week's near touch of the blue trendline and bounce from it confirmed its validity, at least in my mind. That April article proves that this wasn't a conclusion reached only in retrospect, either, as that article had spoken to the validation of that trendline that such action would provide.

Another difficulty has arisen, perhaps clarifying some confusion about the green trendline. The fact that the SPX popped above that first green trendline but then didn't act in the expected manner--either a steep zoom higher or else a settling into a longer period of consolidation than it did--suggests that the original green trendline was not the final or third of the three fanlines. I've redrawn a higher trendline, but it, like the original green trendline has only two touchpoints so far, so it remains somewhat questionable.

Those reading the article may decide that I'm just redrawing trendlines in retrospect to fit what happened. To some degree, I am, although I had noted all along what would validate that blue trendline and my concern about the "only two touchpoints" establishing the green one. Those who have read previous articles about the corrective fan line's use through past years know that there's not often this much uncertainty. We've heard a lot since last August about the strange conditions, the "not since" conditions with some far-away year or period ending that phrase, and I'm seeing some strangeness here, too, that defies an easy interpretation.

Here's what I would do now. If the SPX should continue its bounce, I would be particularly wary of rollover potential at both green trendlines, so currently at about 1320 and then again near 1400-1410. Keep in mind that both of those are descending, of course, so will be lower as time passes.

If the SPX should break through that top, new green trendline, bears should be aware of the potential for either a new trend to be established or for a long period of disorganization before any new trend--either up or down--is established.

With that top green trendline not broken and with the second one broken only temporarily and the failure of its support leading to another steep decline, all market participants must be aware that rallies, as sharp as they might be, can still be prone to failure. Unfortunately, these charts suggest that the SPX remains susceptible to further retests of that newly validated blue trendline.
 

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