August 8th, 2009

Difference Between Correction/Consolidation and Reversal

Has it been as good for you as it’s been for me? I’m talking about the treatment we’ve been getting from the market since that erroneous head-and-shoulders that everyone seems to have gotten wrong, except for us here (see “Market Future in in Eyes of the Beholder“). Since that alleged pattern failed and the inverted head-and-shoulders solidified itself on July 10, the market has made a clean shot higher with a 14.94% increase to today’s close.

Now, here come the perma-bears, fear mongers or ultra conservative fundamentalists who can’t see why anything appreciates in value until they can describe and explain why after the fact. Just as this market has taken off, they’re all out there warning of air pockets eventually leading to a crash. In order to navigate the turbulence you have to know the difference between a reversal and a consolidation/correction.

That 9-month log, inverted head-and-shoulders (Nov, 2008-July, 2009) is a classic, clear-cut, near perfect example of a bottom reversal pattern that you can’t find many clearer than. Once having been completed, the odds of it now failing are slim to none (unless there’s a new, unexpected economic disaster on the scale of the world-wide financial crises). Let’s paint that glorious picture one more time. I admit, it looks complicated but I haven’t seen many this perfect or this beautiful:

Before going into what it might mean for the future, let’s walk through the high points together:

  • H, S, H mark each of the general areas of the inverted head and shoulders; the solid horizontal red line is the “neckline”.
  • During November-December, we thought we were looking at a “rising wedge” portending another major leg down. It happened in the form of the near 30% collapse to March
  • Some considered the recover between March and May, also in the form of a “rising wedge”, as the precursor of the final collapse to 600 leading the bears to see a head-and-shoulder top which soon failed.
  • The Index had crossed above the 50-day MA in March, the 100-day MA in April and the 200-day MA at the beginning of June. Some view that crossing as a bullish indicator. As the Index straddled the 200-day MA and slide down with it into July, some saw a “head” while others (like moi) saw the formation of the right shoulder of the inverted H+S.
  • The Index broke the neckline in July accompanied by the requisite improving volume trends as represented by a rising OBV (on-balance volume indicator).
  • NOTE: long ago I described here in terms of the array of the four moving averages. Today, they’re all perfectly arrayed for a bull market with one major exception. They’re all below the 300-day MA. If this market remains positive over the next couple of months, each of the faster MA’s will in turn, as the Index itself stays above the three, cross above the slowest, 300-day MA. As that happens, the Bull Market will be confirmed absolutely.

Today, the Index bounced up against what could potentially be the top of what we might later understand to be the traders’ remorse correction or consolidation. The market might straddle the 300-day MA like it straddled the 200-day. It could end back at 950 just about the time that a traffic jam is created as the 4 moving averages converge with the neckline. That could be around Labor Day or mid-September and could be a glorious day because it would technically mark the true beginning of the Next Bull Market.

And what does that mean? I’ve mentioned here before the rule-of-thumb for measuring targets out of head-and-shoulder patterns: at a minimum, the neckline represents the approximate mid-point of the total move. If the distance from tip of the inverted head to the neckline represented a 43% move (952 neckline/666 tip), then the minimum target could be around 1350-1375. It won’t be a straight line since there will probably be major, lengthy consolidations along the way (the Elliot Waver’s I think call them “waves”).

The recovery from the Tech Bubble Crash saw a major correction that lasted most of 2004 between 1050-1150; my interim target for the first one (after this traders’ remorse correction) is the 1150-1200 area. What will this correction look like? It could be a wedge, a pennant, a channel or merely a return to a trendline or moving average … but it won’t be a head-and-shoulders.

As the bears begin playing their dirges at the death of the bull market, look to see what sort of pattern the Index is making before selling all your stocks, buckling up and reaching for air masks. This plane isn’t going down yet; I hope, it won’t land for quite a while.

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  • Anonymous

    Thank you for the discussion but I think you have not actually make clear the difference between correction and reversal as they are two interrelated concepts but possibly not the same thing.