The Rally That Was

12/21/01 04:06:03 PM

by David Penn

Intermediate top patterns suggest declines are nearer than further advances.

Security: DIA
Position: N/A

One of the biggest bugaboos in trading is being "right, but early (or late)." While this shibboleth probably causes less consternation than others (such as letting a gain turn into a loss by not trailing the position with a stop), it is no less capable of costing money than any other lapse in discipline. Nevertheless, for better or worse, any current look at the major indices will likely encourage many to consider the temptation of being right, but early. After a powerful, countertrend, bear market rally, the Dow Industrials, Nasdaq 100 and S&P are all showing signs of fatigue.

It always pays to look at intermediate moves in the context of the larger trend. In each of the major three averages, the rally that began in the wake of the September 11th terrorist attack is slowing down--like a speeding car suddenly encountering rush hour traffic--and running right into the congestion of this summer's month long trading range. In the case of the Dow, this trading range/resistance has a bottom of about 102--the area that has thus far eluded the post-September 11th advance.

After a 26% countertrend rally, the Dow Industrials look to be running out of steam and into an intermediate head and shoulders top.

Graphic provided by: MetaStock.

In fact, neither the Dow nor the S&P 500 has re-entered the summer trading range (between 117 and 125 in the SPY). The Nasdaq did so at the beginning of November, and a high was reached at the beginning of December that was comparable to the middle of the summer range (between 39 and 46 in the QQQ). If a new bull market were underway--much less a sustainable rally--then the highs of the summer would be the next ground to be taken. Failure to do so suggests a significant, though not overwhelming short-term correction.

On the intermediate term, a number of head and shoulders-like formations have started to appear--if not in the averages then in the indicators themselves. Both the SPY (which formed a tradable intermediate head and shoulders formation in the spring of 2001) and the DIA (which formed a weaker intermediate head and shoulders formation at the same time) look to be building on the right side--or final advance--of intermediate head and shoulders formations that began in early November. This time around, the H&S top in the DIA looks clearer than the one in the SPY, but the consolidation at the top of the current rally looks by all accounts to be for real.

Breakdown points for the ETFs of the averages are: 97 in the DIA, 111 or so in the SPY and 38 in the QQQ. Target lows for each of these are: 92 in the DIA (the Dow 30 suggests 9000, however), 106 in the SPY, and 34 in the QQQ. It should be added further that the overwhelming long-term trend (more than six to nine months) is still down in all the major averages. For all the might of the recent countertrend rally (26% in the Dow), it is still a countertrend rally and vulnerable to the greater influence of the larger trend.

The "war rally," with an average gain of 36% (including the Nasdaq 100, S&P 500 and Dow Industrials) in about 90 days is also a bit unusual in terms of typical intermediate price swings. Trader Vic Sperandeo has conducted statistical research going back to the 19th century, suggesting that such swings are usually less volatile (20% is more common) and somewhat longer in duration (107 days). There is no need to quibble over the differences, however. The underlying message is that an intermediate price swing that breaches 20% after three months without a major retracement is, in fact, due for a retracement. This is only more so when that intermediate price swing is counter to the primary trend.

David Penn

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

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