|The bottom panel of Figure 1 is that of the S&P 600 Small Cap Index (.SPCY). This panel also shows the 50-day linear regression line (middle upsloping green line) along with its upper and lower two sigma channel lines. The linear regression line represents the trend of index and is often referred to as the linear regression trendline. The upper and lower two sigma channel lines represent the range in which price moves 95% of the time and a move outside this range is to be seriously considered as it doesn't occur often. |
In the majority of cases, once price moves outside the two sigma channel lines, it signals a high probability of a change in trend. However, on occasion once price moves outside the two sigma channel lines, it turns and moves back inside the channel lines. The reason for this is that 5% of the time price it is statistically valid for price to move outside this range. Note in Figure 1 that in late May 2011, price did move outside the lower two sigma channel line but then turned and moved back inside the channel. On the first of June, however, price moved outside the lower channel line and continued to move lower. A lesson to be learned is that once we see a two sigma channel break, we need to look for some follow-through before declaring a valid reversal in trend.
|FIGURE 1: .SPCY, DAILY. This chart shows the daily price chart of the S&P 600 Small Cap Index in the bottom panel along with the 50-day intermediate-term linear regression trendline and its upper and lower two sigma 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 top panel of Figure 1 shows the linear regression slope indicator. This indicator shows that on May 6, this indicator moved below its zero line, signaling a reversal in the 50-day linear regression trendline, representing a change in the intermediate-term trend of the S&P 600 Small Cap Index. This change in trend from up to down can also be seen in the bottom panel, as shown by the red downsloping linear regression trendline. Note that price has now moved down to the red dowsloping bottom linear regression channel line. This lower channel line acts as a line of support where the upper channel line acts as resistance. |
With price now at the lower channel line two things can happen: price can either bounce off the channel line and move higher, or price can break down below this channel line and continue lower. To resolve this dilemma, I often move to a smaller time frame and redo my statistical analysis. Without the aid of a smaller time frame, we simply need to wait another day or two for a resolution to this dilemma.
|The next window down from the top is that of the R-squared indicator. The R-squared indicator is a statistical measure of the strength of the trend. Note that this indicator has now moved above its critical level, indicating there is now a 95% confidence level that the newly established intermediate-term downtrend will continue. However, there is also a 5% chance that the downtrend will not continue.|
|The third panel from the top of Figure 1 is that of the relative standard error index (RSEI). The RSEI is a statistical measure of volatility. Note that the RSEI is below 0.5, indicating below average relative volatility. This is an indication that is starting to settle down as the newly established downtrend continues to strengthen.|
|In conclusion, the intermediate-term statistical analysis of the S&P 600 Small Cap Index has now reversed from an uptrend to a downtrend. Intermediate-term trends can last from a few weeks to a few months. As a result, we should expect to see the S&P 600 Small Cap Index continue to move lower in the weeks ahead. However, over the shorter time period, it is possible to see the index bounce off its lower 50-day linear regression channel line before continuing lower.|
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