Potential SPY Reversal

As SPY fell Friday after 2:00pm, it did so in two distinct thrusts that were retraced about .618%, and closed while engaged in a third thrust downward. So, a potential Bullish Three Drives pattern is developing. See page 220 in The Harmonic Trader. Here is the pattern so far on the SPY 1-minute chart (click to enlarge):

So, a drop to $73.24 on Monday is a potential reversal area. The equivalent level on the SPX is 729. Since the market is so weak, a further extension of the final thrust down might occur beyond 127% to 161.8%. Those SPY/SPX levels would be $72.80 and 724.95.

In the comments on Friday, I said that the market could bounce when the Russell 2000/IWM hit its November low. And the R2K is only an eyelash above its closing low on November 20th, and its intra-day low on the 21st, right now. So that is good additional evidence for a bounce after a further dip.

Also in the comments Friday, I mentioned that the IWM has a bullish inverted hammer candlestick on its daily chart. So, that is another piece of evidence.

Do you see what I’m doing here? I’m using three different approaches to build a case: harmonics, traditional support/resistance, and Japanese candlesticks. I will continue studying the problem from different angles and see if I can strengthen case further.

The next angle is sentiment. As I mentioned in the comments on Friday, people on CNBC were euphoric over “The Amazing -199 Point ‘Rally'”. In fact, you can see Maria Bartiromo praising the market while it was falling at 3:45 into this interview with Robert Prechter on CNBC Friday afternoon (sorry, CNBC took down the video).

That went on all day. As we have been discussing in the comments, there was no panic as the SPX took out a major low. In fact, there was quite a lot of bullish cheerfulness as reflected in such indicators as the put/call ratio. So, I’m thinking if a rally develops next week it won’t get far because so many traders have probably already placed their bullish bets.

Now lets do a gap analysis:

First, lets consider that the Gap of Doom was a “continuation gap” continuing the move down from the February 2nd top. Here is what the textbook says about such gaps on page 219:

Its inference is that prices will go as much farther beyond the gap as they already have gone between the beginning of the move and the gap, as measured directly (and vertically) on the chart.

And indeed, if you look at the Fibonacci retracement I have drawn on the chart, you can see that the Gap of Doom is placed neatly in the middle of the wave down from the top on February 9th to to the close on Friday. In fact, the top of the gap is right at the 61.8% fib (blue line and blue arrow) and the bottom is right at the 50% mark (green line and green arrow).

Prices snapped back hard from Friday morning’s gap down (red “G” on the chart), so it is possible that that was an exhaustion gap which may terminate the wave. Also, during the day Friday, I said in the comments that I was shorting as SPY filled the gap at point “X”. Prices usually reverse when gaps are filled, so I was just fading the gap. However, the fact that SPY was able to fill just about all of the gap is actually bullish because it ate away at most of the resistance there. So, if SPY can climb back up to the “X”, it has a good chance of being able to eventually punch through.

This chart shows some potential rally targets:

The market has two downtrend lines: The 2009 downtrend line (upper blue), and the February downtrend line (black). I have also made an exact parallel to the upper blue line to form a potential downtrend channel.

SPY may want to drop a bit more to tag the lower blue line before moving up. If SPY is not able to recapture the black line, it will likely embark upon an even steeper dive. The purple and yellow lines are potential Fibonacci resistance levels, and the blue “X” marks an ideal spot for shorting. There is triple resistance there from the blue downtrend line, the Gap of Doom, and the turquoise line, which would be a 50% retracement of the drop from February 9th. That’s about 805 for the SPX.

As Phil mentioned, there is a full moon on March 11th, so a rally up to the blue “X” around that time would likely bring out the same frothing-at-the-mouth-bullishness that we saw at the full-moon peak on February 9th. Wouldn’t that be a beautiful shorting setup?

Also on the chart, notice the volume at the November low (black circle), and the volume last week (blue circle). As I have been saying in the comments, volume looks too low to put in another major bottom. However, if volume continues to increase (purple line on volume chart), it would be very dangerous to add short positions.