Three Down, Three To Go

06/08/11 08:12:42 AM

by Alan R. Northam

I have defined six statistical signals that when completed provide an overall signal of a reversal in trend. Recent price action of the Dow Jones Industrial Average has now completed three of these statistical signals with three signals left to confirm a new intermediate-term downtrend for the DJIA.

Security: .DJI
Position: N/A

On May 24, I wrote an article entitled "DJIA Trend Reversal? Not Yet!" In that article I provided a current statistical analysis that warned of a possible reversal ahead in the intermediate-term trend of the Dow Jones Industrial Average (DJIA). That article also explained the steps that were necessary for a reversal to occur. At the conclusion, I explained that none of the steps had yet to occur and until they did, the DJIA remained in an uptrend.

Since then, the statistical analytical condition of the DJIA has started to change to the point that three of the conditions necessary for a reversal in trend cited in that article have now occurred and are warning of a possible reversal in the trend of the DJIA.

The first sign of a reversal in trend occurs when price breaks below the lower linear regression channel line. The lower panel of Figure 1 shows the daily price bars of the DJIA since the beginning of 2011. The chart also shows the 50-day linear regression trendline and its upper and lower 2 sigma channel lines sloping upward and colored green. Note that five days ago, the DJIA closed below the lower channel line. In addition, four days ago, the complete daily trading session was below the channel line, providing a clear breakdown. A breakdown of the channel line is a warning of a possible trend change but is not an outright signal, as on occasion, price turns back up into the trading channel to continue higher. Condition 1 of a trend reversal has now been met and warns of a possible reversal in the intermediate-term trend of the DJIA.

FIGURE 1: DJIA, DAILY. This chart shows the daily price chart of the Dow Jones Industrial Average in the bottom panel along with the 50-day intermediate-term linear regression trendline and its upper and lower channel lines, the linear regression slope indicator in the top panel, the R-squared indicator in the second panel, and the relative standard error index (RSEI) in the third.

Graphic provided by: MetaStock.

The second statistical condition required for a reversal in trend occurs when the relative standard error index (RSEI) moves above 0.8. The RSEI is a statistical calculation that represents the volatility in price. High volatility normally occurs at turning points in the trend, while low volatility normally occurs during a trend. Note that the relative standard error index in the third panel of Figure 1 has been above its 0.5 level since late February, indicating above average volatility in price. This can be confirmed by looking at price itself and the deep peaks and valleys in price that have occurred in the trend since February. This above-average volatility is also a warning of a trend reversal looming in the near future. Note that in early March the RSEI moved above 0.8, indicating high volatility but no trend reversal occurred. This is an example that all six warning signals need to occur for a valid trend reversal. Note that more recently, the RSEI has once again moved above 0.8, indicating that a high level of price volatility now exists and again is warning of a possible trend reversal ahead.

The third statistical condition required for a reversal in trend occurs when the R-squared indicator moves below its critical level. The R-squared indicator is shown in the second panel down from the top in Figure 1 and is a statistical measure of the strength of the trend. The critical level is a statistical calculation that marks the point at which there is a 95% confidence level a trend will continue. Note that the R-squared indicator has been moving lower since mid-May, indicating a decline in the strength of the Intermediate-term uptrend. Note also that the R-squared indicator has now moved below the critical level, indicating that there is no longer a 95% confidence level an uptrend in the DJIA will continue.

There are six statistical conditions that occur over a period of time that provide a high probability signal of a trend reversal. During this period each condition is met individually and sequentially to provide warning signals of an approaching trend reversal. When all six conditions have been met, the time of warning is over and a highly confident signal is given that a reversal in trend has occurred.

To date, three of these six warning signals have been given with three more to come. Warning signal 4 will occur when the linear regression slope indicator moves below its zero line, officially signaling a reversal in trend from up to down. However, this newly established trend has no strength at this time and can fail. The fifth warning signal occurs when the R-squared indicator moves back above its critical level. This signal will indicate that a 95% confidence level now exists that the newly established downtrend will continue.

Finally, warning signal 6 is not really a warning signal at all but is a confirmation signal. Confirmation of a trend reversal occurs when the relative standard error index moves back below its 0.2 level. This will signal that the newly established downtrend is now well on its way.

In conclusion, the intermediate-term statistical analysis of the DJIA continues to provide warning signals of a possible reversal in the intermediate-term trend for the DJIA. Two more signals are now necessary to signal an official intermediate-term downtrend reversal for the DJIA with a sixth and final signal of confirmation. Intermediate-term downtrends often last from several weeks to several months and often end when price hits the lower 200-day linear regression channel line. A break down below the lower 200-day linear regression channel line will start a series of six warning signals warning of a long-term downward reversal in trend ahead.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

	Garland, Tx
Website:	www.tradersclassroom.com
E-mail address:	inquiry@tradersclassroom.com

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Three Down, Three To Go

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