I wrote in my most recent Index Wrap (6/18/11)
that I assessed a 'probable' likelihood that the market was at least at or near a short-term bottom and 'possibly' had reached a low for the downside move. This view assumes that the recent decline was a correction
within a still ongoing bull market and NOT the beginning of a bear market; I consider the long-term trend to be bullish. If there is another big down leg
below recent lows, then I would start to question my assumption.
I have a 'recipe' so to speak for what I consider to be 3 of the most important technical factors in assessing if the major indexes are at or near a tradable top or at or near a tradable bottom. When these 'big 3' occur in conjunction with each other, there tends to be the highest probability that a top or bottom has formed.
Number ONE for both tops and bottoms is PRICE action. As they say about the English Prime Minister, the FIRST among 'equals' is PRICE action.
At tops, unless there's a possible double top, I look for a significant trendline break; i.e., a key UP trendline is pierced. This is the #1 point highlighted on the left of my first chart below; the S&P 500 (SPX) daily.
Along with the SPX example of the pierced trendline are two key indicator events: The (13-day) RSI is at an 'overbought' extreme and #3, my bullish/bearish sentiment indicator is also showing a type of 'overbought' extreme in that traders get what I define as extremely bullish. We're not talking about the most recent SPX action so let's move on to possible/probably bottom formations.
PRICE action is again numero UNO and with the S&P 500 I was seeing some likelihood of a double bottom setting up. It wasn't EXACT as such bottoms are sometimes approximate. There was one final downward spike low at 1249 back in March, but 2 of the 3 lows then were in the 1258 area, where SPX appears to have made a second bottom just recently. A possible double bottom is more clear cut with the Nasdaq Composite, the chart of which will follow.
Bottoms sometimes see more extremes in bearishness as is seen above with my (CPRATIO) 'sentiment' indicator. At tops traders tend to have been bullish for some time and relatively high bullish sentiment readings tend to be common, with fewer spikes into extreme territory. With bearish corrections, especially after a prolonged bull move, traders tend to resist getting bearish until a 'tipping' point; and then you see the somewhat rare instances of CBOE equities put volume exceeded daily equities call volume. With my 'recipe' for a tradable bottom, there is the combination of an RSI low extreme AND a low level of trader bullishness, so there's also a low extreme. (In my CPRATIO I divide calls BY puts precisely so that LOW readings are bullish, the same as an extremely low RSI suggests bullish turnaround potential.)
In my Saturday bullish forecast, when the market still looked bleak to the bulls, it was no stroke of genius to suggest otherwise. I only needed the TRUST I have in key price/chart patterns, combined with 2 key technical indicators that I've studied over the nearly 3 decades that I've been a stock index analyst and trader.
The point of my next chart, that of the Nasdaq Composite, shows how in this market, the potential double bottom was quite exact and where I've long thought key support would be found, at 2600. Moreover, and I made this point in my Saturday Index Wrap commentary, the pattern that's often seen in bearish CORRECTIONS is that the second down leg 'c' is often longer than the first downswing 'a' by a Fibonacci relationship, especially where this second down leg (c) is 1.5 to 1.618 times longer than the first down leg (a). This consideration was another tip off but not of the same import as points 1-3 made above.
As I said price pattern considerations are the number 1 or primary factor, so I look at all indexes and all chart time frames in assessing whether there's a overall pattern that looks compelling in suggesting a top or bottom formation. When I looked at the Dow 30 (INDU) weekly chart seen below, it was apparent that this past week's low rebounded from INDU's dominant up trendline. This pattern, like the potential double bottom low seen with SPX and COMP, gave some further credence to my thought to do some buying on the start of this week.
Was I convinced that the major indexes were at or near a 'final' bottom (to the correction)? No, but I only needed to have conviction that the risk to reward in getting into calls was favorable; i.e., significant 'reward' potential relative to RISK.
MORE ON BULL AND BEAR 'FLAGS':
I wrote a recent Trader's Corner article (5/28/11) on patterns that suggest a continuation of the current trend, that of so-called 'flag' formations. In the stock indexes we rarely see these patterns on daily charts, unlike in individual stock (or commodities) charts, but they do show up more commonly on hourly charts such as seen below with the 60-minute SPX.
In some cases, sometimes more often with bull flag patterns with the indexes, there's a sharp price surge just prior to the minor consolidation (that traces out a 'flag') and this surge or spike can be likened to a 'flagpole' that precedes the flag. Moreover, there is a 'measuring' implication for a 'minimum' next move once prices break out above the top end of the downward sloping flag.
My next chart is simply a close up view of the first bull flag pattern seen above on the SPX hourly chart. The 'flagpole' typically is measured at the start of the upward price surge that precedes the downward sloping (by use of two trendlines through the tops and bottoms) consolidation that is the 'flag' pattern. The height of the flagpole becomes a price target for a next 'breakout' move above the upper trendline as highlighted below.
In this example, the flagpole height is 15 points. The next move in SPX, once prices penetrated the upper end of the flag (the 'breakout' point), was exactly 15 points. This was the end of the move, but the bull flag pointed to at least a further upside move. The SPX hourly bull flag that formed last (right hand side of the chart above) has seen a subsequent move that is more than any projected 'minimum' move, as is fairly common when a bull flag BEGINS a turnaround upside move.
Bull and bear flag patterns are seen more often in DAILY stock charts; as I said only rarely is this the case with daily stock index chart patterns. The flag pattern examples below are highlighted on the daily ExxonMobil (XOM) chart. The top made on the final run up predicted by the bull flag was later equaled by a subsequent rally which formed a double top. This was a juicy short or put play. The subsequent bear flag pattern, which takes on a variation shape (of a 'pennant') predicted further weakness to come in XOM, even though a rally called this into question for a time.
AN EXAMPLE OF AN 'ISLAND' TOP:
I wrote another Trader's Corner piece last month (5/18/11)
on the significance or lack of significance of various types of chart 'gaps'. Sometimes, when there is final top or final bottom for a move, a pattern develops of a gap or series of (downside or upside) overnight price gaps that lead to a so-called 'island' formation.
ISLAND BOTTOMS are what I showed examples of in the aforementioned Trader's Corner article of last month. The island bottom is where downside price gaps carry prices toward a final cluster of lows. There's a sideways move, then an UPSIDE gap or gaps carries prices higher. This leaves a sideways trend at the bottom that, like an island, is an isolated formation. Best to look via the LINK to my 5/18/11 article for chart examples.
A rare ISLAND TOP formed recently in the Nasdaq 100 (NDX) Index and is highlighted below. This formation is exactly the opposite of the island bottom. A considerable drop occurred after the NDX island top and kept me predominately bearish on the market, especially on tech stocks.
I held a bearish view on Nasdaq UNTIL the potential double bottom low developed recently as highlighted on the NDX chart above. Today's (6/21/11) sharp upside move suggests that NDX's correction may be over. What develops next, whether a broad trading range market or a retracement of some percentage of the prior decline (e.g., 38, 50 or 62%), followed by a further decline is unknown. But, again, I don't need to know a 'final' outcome for a move, only that getting into a bullish trade at the assumed double bottom offers favorable to quite favorable risk to reward.
GOOD TRADING SUCCESS!