Some Indexes Break Down from Major Price Patterns: Selling Climaxes Offer Hope!

I am a great believer in the principle of false breaks being followed by above-average moves in the opposite direction to the break. It happens because those who bought on it are caught on the wrong side of the market and are forced to re-position themselves, just as correctly positioned traders start stepping up their buying or selling, depending on the direction of the break. In that respect, I wanted to start off by presenting a classic example using recent action by the S&P, as well as later showing you an example currently developing in real time.

The initial example is is presented in Chart 1, where you can see that a perfectly valid S&P upside break from an inverse head-and-shoulders failed to hold. False breaks or whipsaws need to be confirmed. In this instance, you can see a negative 50-day MA crossover, but, more importantly, a violation of the dashed trendline joining the head with the right shoulder and the more conservative solid line. The false break was followed by the 2022 January selloff, which has already proved to be an above-average move.

That's history, of course, so what are the indicators telling us now? First and foremost, Chart 2 indicates that recent action pushed the Dow back to support. In this instance, it was the lower boundary of a broadening wedge. At market peaks, these formations are characterized by two diverging trendlines that develop in the direction of the prevailing trend.  This diverging action underscores the fact that the technical position is gradually becoming more and more unstable and is why, when completed, these formations are often followed by above-average declines. The words "when completed" have been emphasized, because a price pattern that has not experienced a breakout is not a price pattern, merely a potential formation, as is this one. That said, note that volume has expanded incredibly this week and dwarfs anything seen since 2020.

Chart 3 puts this in perspective by featuring the PVO, where six of the last seven selling climax peaks were followed by a rally. That action does not necessarily indicate the low for the move, but certainly suggests a slowing of downside momentum and possible avoidance of the pattern completion if, in fact, it has peaked for this move.

One reason to be cautious here is that my Dow Diffusion indicator, featured in Chart 4, is quite some ways from registering an oversold reading. This indicator calculates the percentage of Dow stocks in a positive trend and usually drops to some kind of oversold reading at an important bottom, as flagged by the green arrows. Note that, in the last few years, no significant rally following a selloff has been launched without oversold help from the Dow Diffusion indicator.

Several other averages are also above critical chart points. Chart 5 points out that the Common Stock A/D Line is right at the base of a possible top. Note that the NYSE A/D Line has already completed a top of its own, following its failure to confirm the most recent S&P high.

An even greater divergence is being presented between the NYSE Percent of Stocks Above Their 200-Day MA and the NYSE Composite (Chart 6). The indicator peaked at the beginning of 2021, about a year ahead of the Composite. As a result, barely 50% of NYSE Issues were trading above their 200-day MAs when the Index touched its all-time high at the beginning of the year. The indicator has just dropped to a new low, right at the time the Index is approaching the base of a potential broadening formation with a flat bottom. The implication is that it is leading the NYA lower.

Chart 7 sets the scene for the whole world, as the MSCI World Stock ETF (ACWI) has already completed a broadening wedge and penetrated its 200-day MA. Speaking of false breakouts, my Global A/D Line, constructed from a universe of individual country ETFs, experienced a whipsaw move to the upside right at the beginning of the year. It is just starting to confirm the upside move as being false, as it now edging though its 2021 support trendline and is right at its 200-day MA. It may already be through, though, as Wednesday's down day is not reflected in the latest plot. Please remember, it's always possible to update any of these charts by simply clicking on them when that new data is available.

Conclusion

Several market averages have fallen to key support at a time when many are also experiencing selling climaxes. Normally, this kind of condition is followed by a rally or basing period, but other indexes, including the World Stock ETF, Wilshire 5000 and Russell Small Cap ETF, have already broken to the downside. While a relief rally may well develop, now is not the time to be playing hero. Better to take risks at higher levels when the dust has settled.

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.