Will A 1-2-3 Trend Reversal Mark The Top?

02/23/05 11:00:49 AM

by David Penn

How do I top thee, market? Let me count the ways.

Security: $SPX
Position: N/A

Those who believe that the rally that began with the August 2004 low came to an end in December may have gained an ally in the market action since 2005 started. Not only did the Standard & Poor's 500 collapse for the duration of January 2005, but the rally that has taken place since that collapse ended has failed--so far--to set a new high in the S&P.

From the perspective of stochastic divergences, it is hard to get too much more bearish than the daily S&P 500 is right now. The late December/early January peak has a negative divergence--which itself is part of a longer-term, negative stochastic divergence (November versus December/January peaks). And now, the rally that is rolling over in mid-February is similarly accompanied by a negative stochastic divergence.

While I am the first to admit that it is true that negative stochastic divergences don't always result in reversals, there probably aren't too many instances in which multiple negative stochastic divergences don't result in some measure of misery for the bulls.

Figure 1: S&P 500. Will multiple negative stochastic divergences result in a reversal to the downside in the S&P 500--or will a sideways trading range between 1220 and 1160 be the result?

Graphic provided by: Prophet Financial, Inc.

What is especially interesting in the context of the most recent negative stochastic divergence accompanying the February peak-in-progress is the potential for a 1-2-3 trend reversal. The 1-2-3 trend reversal was one of the major setups discussed in Victor Sperandeo's great book, METHODS OF A WALL STREET MASTER. This setup has three parts (hence the "1-2-3"): the first is a trendline break, the second is an attempt to reassert the previous trend with a new high (or low, in the event of a downtrend), and the third is a move beyond the break extreme (a low in the case of a previous uptrend, a high in the case of a previous downtrend).

Looking at the action in the S&P 500, the first condition was met very early in January as a trendline from the October lows (recall the low for the move was in August) was broken to the downside. Bears pushed the S&P 500 down to just under 1170 before the bulls were able to put up a stand. This marked the end of phase 1--and also marked the significant low point for the market to fall through in phase 3.

Phase 2 was the late January to mid-February rally, as the bulls tried to reassert the uptrend. The test of strength here is the ability of the bulls to make a new high (though, as we know from the 2B test, a new high without followthrough to the upside remains a danger for the bullish cause). Although the S&P 500, as of this writing, is still trading above its 50-day exponential moving average (EMA), it does appear as if the market is rolling over and that the attempt to reassert the old uptrend is in serious danger of failing.

Phase 3 will come in the event that the bulls have in fact failed to reestablish the old uptrend. The decisive moment that marks this failure is considered to be a break below the low point established at the end of phase 1. Again, in this present case, it is possible for the S&P 500 to find enough support on the 50-day EMA to avoid completing phase 3 of the 1-2-3 trend reversal. But if the negative divergences have anything to say about it, lower prices in the S&P 500 are more likely in the near term than are higher prices.

Should phase 3 be successfully completed and a 1-2-3 trend reversal occur, then it should not be surprising if the entire rally from October is retraced. I say this because of a swing rule measurement from the December/January peak at 1218 to the mid-January low of 1164 points to a downside of some 54 points, should potential support at 1164 be broken. A downside of 54 points would send the S&P 500 plunging toward 1110, leading to a serious test of the October 2004 lows.

David Penn

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

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Will A 1-2-3 Trend Reversal Mark The Top?

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