Tuesday's Bearish Key Reversals May Have Trouble Working

Whenever a specific technical event is repeated widely in many different stocks, it gets my attention, as it often signals a reversal in the prevailing trend. We call it the principle of commonality. Alternatively, you could think of it as the principle of strength in numbers.

Tuesday's Action saw Multiple Key Reversal Patterns

Tuesday's action revealed a huge number of bearish key reversals (see Chart 1). That's a bar, in this case a daily one, that culminates a rally. The price opens with a significant gap, but ends the session near the close of the previous bar. That means that pretty much all of the trades from the long side made during the course of the bar's development are coming home with a loss. The presence of the gap also means that those early buyers were driven by emotion, meaning that they are unlikely to be strong holders.

Chart 1

Individual key reversal patterns gain significance from several aspects. First, the wider the bar, the greater the battle between buyers and sellers. Second, the heavier the volume, the greater the number of traders that are trapped at higher prices and who consequently need to unwind those positions. Finally, the sharper the preceding rally, the more substantial the profit and the greater the potential for taking them. Tuesday's action met the basic characteristics of a key reversal, but did not score very high in the width, activity and steep preceding rally characteristics. Where it did score was in its widespread appearance in the charts of many stocks. For example, all of the sectors experienced key reversal phenomena, with the exception of materials.

Normally, we expect key reversals, like other one and two bar patterns, to have a limited effect, say 5-10 bars (which in this case represents days). That warning stays in effect until prices either experience a decline or, alternately, cancel the warning by moving decisively above the key reversal high within 2-3 days. If that happens, it reflects a very strong market, as it effectively tells us what should work isn't working and, therefore, it's probably a counter-cyclical phenomenon. In other words, a failed key reversal alters its role from being a negative factor to more of a positive one. Given Wednesday's strong advance, we may be about to find out. There are other reasons for being suspecting limited adverse effects from Tuesday's action.

Many Averages Complete a Double Bottom

First, the Dow, like several other averages, has completed a double bottom formation, as shown in Chart 2. Note the lower volume on the second bottom and the pickup in activity as the price began to break to the upside - classic characteristics of such a formation.

Chart 2

Chart 3 indicates that the Index has also completed a downward sloping reverse head-and-shoulders. Note that there is strong support in the 21,000 area, around the level of the second bottom or right shoulder. In the unlikely event that it should give way, we would be looking at a test of that late March low.

Chart 3

Some Reliable Indicators Just Turning Bullish

Second, a number of indicators remain in an oversold condition; they now look as if they are in the process of reversing. Chart 4, for instance, plots the percentage of NYSE issues above their 50-day MA. The vertical lines indicate that previous upside reversals from below the red oversold line have typically been followed by a strong rally. Even in bear markets, the dashed lines show that a trading range or advance of several weeks have typically been the reality.

Chart 4

Chart 5 has just given a buy signal as my Dow Diffusion indicator, which monitors a basket of Dow stocks in a positive trend, has finally reversed and moved above its MA. The arrows represent periods in the past where the indicator has reversed from at or below the dashed green oversold zone.

Chart 5

A mega-overbought occurs when a short-term oscillator coming off a bottom experiences a multi-year high. That level should exceed anything seen during the previous bull or bear market. Such action indicates very strong underlying momentum, as the bull move jumps out of the gate. In this respect, Chart 6 features the 12-day ROC for the S&P Composite, which has just touched a higher reading than it did coming off both the 2003 and 2009 bottoms. That exceedingly strong upside momentum is another reason why Tuesday's key bar reversals may have some trouble pushing prices lower. That said, enthusiasm for this particular mega-overbought needs to be tempered by the fact that it does not come, as it normally would, following a lengthy bear market lasting 1-2 years. In this instance, it's appearing after just seven weeks from the bull market high and not, therefore, representing its usual major reversal in sentiment. For that reason, I think it should be interpreted more as a sign that the March lows will hold for a lengthy period than as an indication that a blockbuster bull market is in the cards.

Chart 6

If we do see a cancellation of the key reversal days, Materials (XLB), Healthcare  (XLV) and REITS (XLRE) appear to have the most encouraging charts.

Good luck and good charting,

Martin J. Pring

The views expressed in this article are those of the author and do not necessarily reflect the position or opinion of Pring Turner Capital Groupof Walnut Creek or its affiliates.