This Week's Weakness So Far is Actually a Good Thing

Posted by jbrumley on March 31, 2020 9:04 PM

Last week was initially encouraging, but the more the market meanders this week, the less encouraging that reversal effort becomes.

Don't be too discouraged by the lack of progress of the recovery effort this week though. Not only could rest-breaks be expected, this is exactly where we'd expect to see them... for a couple of different reasons.

The first of those reasons is this week's encounter with the 20-day moving average line (blue) at 2619. The index spent a little time above that level on Tuesday, but not much... certainly not enough to convince buyers still on the sidelines to jump in and take the advance to the next proverbial level. That doesn't mean it's a lost cause though. Such a technical event is usually more of a process than a singular event, and this isn't should be no different. In fact, it's more apt to be the case given the circumstances. The S&P 500 fell about 35% from peak to trough, so the 20% bounce off that low would be easy to dismiss as a dead cat bounce. The fact of the matter is, however, any 20% bounce is a tough act to follow. Don't forget that even en route to a 35% loss, the S&P 500 didn't move in a straight line.

The other reason we could have -- and should have -- expected something of a headwind here is the Fibonacci retracement line waiting for the S&P 500 at 2649, more or less where it peaked on Tuesday.

The crash course on Fibonacci lines: You may recall them from high school math, or science. Sometimes referred to as the gold ratio. They're built around factors 3, 5, 8, and 13, and all derivations and fractions thereof (5/8, 13/8, 8/13, etc.) because those numbers frequently repeat themselves in nature. That is to say, some species flowers always grow exactly 13 petals.  Pine cones grow three segments to the right, and five to the left. Tree branches that split usually result in new branches, one of which splits again, and the other of which doesn't... resulting in a branch count of 5, 8, or 13, or some extended multiple of those same numbers. Shells expand in a way that always makes the linear distance from one segment to the next either 3/8 or 5/8 of the shell's total diameter.

You get the idea.

The application in trading is similar. That is, it's a reasonable assumption that a stock's chart will "retrace" its previous moves at 3/8 or 5/8 the value of the entire span. Or, it may extend beyond a previous move, moving to 13/8 of a prior advance or decline, or even 21/8 of a past move's distance. The idea relies on the fact that since humans are just animals and reach proverbial "uncle" points at predictable points -- and we do -- then a chart's past can certainly help you determined where it may be headed in the foreseeable future.

A completely reliable approach? No. It's an art, and not one to bet blindly on. It's a good framework to start with when there is no other, however, and interestingly enough...

...the 2649 level where the S&P 500 peaked on Tuesday is a near-perfect 3/8 (or 38.2%) retracement of the meltdown that got started in February.

Stopping the rally here, therefore, doesn't have to mean the recovery is already cold and we're destined for lower lows. This was always going to be a battleground, and actually, better to test the bulls now and force them to prove their conviction than not. Unfettered rallies tend to invite rough waves of profit-taking. If the S&P 500 can grind its way higher from here, the odds are better that the advance will continue, slowly gathering new participants on the way up. That's what we'd rather see, as those sorts of moves have some longevity.

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