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Dow's Dangerous Downside

03/14/06 09:43:21 AM
by Gary Grosschadl

Broadening tops are a bearish formation, and the Dow industrials shows this pattern on its weekly chart.

Security:   $INDU
Position:   Sell

The broadening top formation has a series of higher highs and lower lows and is considered fulfilled when it breaks to the downside, outside of the lower trendline. Because it is such a wide-reaching pattern, a mere touch or test of the lower trendline has substantial implications even without a downside break. Should a downside break occur, the height of the pattern subtracted from the downside breakout point gives you the approximate target.

However, the mitigating condition here is aptly shown by a powerful line of support: the 200-period exponential moving average (EMA) is currently at 10,142. We can easily conclude that as long as the Dow Jones Industrial Average (DJIA) remains above this often-watched harbinger of support, the uptrend is intact. Note how the upper trendline and the 200-day EMA roughly relates to a rising channel (Figure 1). But keep in mind the old saying that "what goes up must come down."

FIGURE 1: DOW JONES INDUSTRIAL AVERAGE, WEEKLY. This is a sobering view for the DJIA should the markets turn south.
Graphic provided by:
As the DJIA is very near the top trendline, a lower test soon is a very real possibility. The magnitude of this test has a wide range of correction. The first line of potential strong support involves a drop of 934 points to the 200-day EMA.

Support here would be bullish for another ride up to the top trendline. A trading strategy for this index could be to take profits near this top trendline and then reload when convincing support is found. Figure 1 suggests if the bears take control, then another 1,000-point drop could evolve, should the lower trendline come into play. Under super-bear conditions, the lower pattern fulfillment target becomes 7500. This deep retracement would test 2003's hammer bottom.

Several indicators are considered on this chart; note the weak trend displayed at the top graph showing the average directional movement index (ADX). This ongoing trend would suggest at best a sideways drift with the potential for an eventual downleg. The lower indicators are also cautionary. Both the moving average convergence/divergence (MACD) and the relative strength index (RSI) show a general negative divergence to the index's higher peaks forming the top trendline. Finally, the stochastic oscillator shows an overbought condition in the 80 area, hinting at an overdue downleg.

The view here is that there is more downside potential here than upside promise. Should the market's big-money players also take this view, then the downside has dangerous implications. Will the 200-day EMA hold? Stay tuned.

Gary Grosschadl

Independent Canadian equities trader and technical analyst based in Peterborough
Ontario, Canada.

E-mail address:

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