The S&P 500's 2B Test of Bottom

04/22/03 10:14:30 AM

by David Penn

How could a technician have caught the mid-March rally?

Security: $SPX
Position: N/A

For many (yours truly included), the rally in the S&P 500 that began on March 13th was a surprise. Even those who spoke of a war rally expected that rally to begin sometime after the invasion of Iraq began--instead of almost a week in advance. What might have been especially painful about this rally is that if you missed the first three days--Thursday, Friday and the following Monday--you missed half of the move to date. Of course, if you believe that those three days were the first three days of the new bull market, then missing the 60-point move should not bother you very much. However, if you are of the opinion that the mid-March rally was simply another bear market rally, then those first 60-odd points were no picnic to watch pass by.

In spite of all of the well-informed and well-intentioned advice urging traders to focus on developing trend and to leave market reversals to the high-wire type traders, attempting to catch market reversals is an almost irresistible temptation. This may be especially so in bear markets, when traders and investors alike compete to be the one who actually buys silver at $5 in the early 1970s and watches it soar to $50, or jumps on the Dow at 1000 in the early 1980s and rides that train to quintuple digits years later.

A successful 2B test of bottom set the stage for a near-100 point rally in the S&P 500.

Graphic provided by: Prophet Financial Systems; Prophet.net.

The tip-off for the mid-March 2003 rally is one that I've written about for Traders.com Advantage many times before: Victor Sperandeo's 2B test (see, no, buy his Methods of a Wall Street Master for a complete explanation--in the meanwhile, see my article, "The January Reversal: 2B or Not 2B?" Traders.com Advantage, January 10, 2003). For now, know that the 2B test of bottom occurs when a trending market makes a low, rallies and then makes a lower low. At this point, the trader is watching to see whether or not there is follow-through to the downside after the new lower low. If there is, then there is likely no bottom and the market is probably headed lower. However, if there is no follow-through to the downside--even in the absence of a strong move back up--then the aggressive trader begins to prepare for the possibility of a reversal.

The S&P 500 experienced just such a 2B test of bottom from mid-February to mid-March 2003. After an extended downtrend (the S&P 500 topped in January just above 930), the S&P 500 made an intermediate term low of about 806 on February 13th. The S&P 500 bounced from this low for two days before slipping into a consolidation range for the duration of the month. This consolidation range finally gave way on March 10th as the S&P 500 closed to within a full point and a quarter of the February low. One day later, the S&P 500 broke through to mark its lowest close of the year at 800.73. This was the crucial moment. If the S&P 500 had followed that day with an even lower close on the following day, then the likelihood of further declines was significant and a rout of the bulls more than probable.

However, the S&P 500 did not collapse on the subsequent day. Instead, it formed what Japanese candlestick chartists refer to as a "hammer" which is a bullish candlestick pattern when it appears at the end of an extended downtrend. Moreover, this hammer closed above the low from the previous day, not providing the sort of downside follow-through that would immediately point to continued declines. Sure enough, the S&P 500 exploded upward on the day following the hammer, opening below 810 and closing above 830. While an aggressive trader might have looked to get long above the previous two days high, it was clear that the downside follow-through had not occurred and that a 2B reversal was quite possibly at hand.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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