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PATTERN RECOGNITION ANALYSIS

Sometimes when a market is undergoing a "character” transformation due to the size and number of changes that are taking place simultaneously, we end up with lots of extreme and conflicting readings. In that case we select those indices, which have chart patterns that historically have provided us with recognizable and reliable outcome scenarios and we build our short-term expectations and strategy based upon them.

At the moment it is quite clear that between January and now the markets have been engaged either in an orderly sideways consolidation process, from which they will break out to the upside OR to the downside.

The high put/call ratio, the COT numbers showing commercial traders net long, and the new record number for NYSE member net buy/sell strongly suggest an upside breakout.

Conversely, the high volatility ratios, the low volume, the high number of stocks below their 200 MA despite the recent advance, the McClellan Oscillator rallying 700 points, the SP500 only gaining  4.1%, the number of new lows exceeding new highs, and "good news" greeted with sell orders, strongly suggest an imminent breakdown.

So, let's examine how a breakout or a breakdown would unfold based upon the current chart pattern.

The Dow has the cleanest chart for the job, so we'll focus primarily on the Dow this week and we'll use it as our "master guide” for confirmation in order to trade the SP or NASDAQ. The Dow has been in a well-defined and easily recognizable rising channel. It has risen to channel resistance twice, first during November-December of 2002 and second during January - February of 2004. We know that the first contact with channel resistance was followed by a decline to channel support in March of 2003. Since then, the Dow spent nine months rallying back up to channel resistance, which begs the question: Is it going to move higher above channel resistance or is it going to turn down again and revisit channel support?

Notice that the area of consolidation is still within the larger channel and it is defined by line "C" and line "B" (the upper two thick black lines). If it breaks to the upside, it would have to close above 10370. Therefore, if we have a Dow close this week above 10370, it would imply that the consolidation has resulted in an upside resolution, which should take the Dow to point "D" on the blue line (see next chart).

So if the Dow was to close above 10370, we would go LONG, with a stop at 10370 and we would expect the first upside price target to be in the 10850-11000 zone.

On the other hand,  if the Dow fails to close above 10370 and instead it turns back down, the key level to watch is the May lows. If the May lows are taken out on a closing basis, we should see a further decline to 9750, which is along line "B." From there, we ought to see a brief relief rally that will fail around 10000. This would be followed by another decline back down to channel support around 9100-9000, which happens to be at the intersection of  two support lines and also it is a 50% Fibonacci retracement number. So if Dow fails to close  above 10370, we will go SHORT with a stop at 10370.

Ike Iossif

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