Earlier this morning, I presented a case for some near-term bullish activity during the Live edition of Filthy Rich, Dirt Poor. If you missed it, there’s a replay link at the end of this article.
Here’s a brief recap – we have an end-of-the-month, quarter, and half-year rebalancing that will need to take place from pension funds that have been sitting on record levels of cash. They will need to buy shares in order to keep the funds aligned with their yearly goals.
We had a bit of sector rotation with Energy getting hit over the last two weeks while sectors for Communication and Consumer Discretionary have been big winners. These sectors can be a sign that investors are willing to take on more risk in their portfolios.
Then something happened in the market today and this one chart may be presenting a different side to the story. This chart pattern may be signaling the next leg down is right around the corner and now is the time to get ready.
What’s the chart pattern? Keep reading…
I could spend hours talking about Fibonacci Extensions and the Fibonacci sequence of numbers, but the brief version is that there is a sequence of numbers that creates ratios that are common in everyday life. Believe it or not, the same ratio that photographers use to set up shots is also used by some traders who follow these ratios to help determine profit targets and pullback levels. It’s also referred to as the Golden Ratio. If you’re a numbers geek like me, there are some stock market training courses that talk more in-depth about the Fibonacci sequence. Well, read the rest of this article first.
Fibonacci Extensions use the ratios and are drawn on a chart by using three points, marking price levels of possible importance. These points are often drawn at swing high and swing low points.
The extension lines use the ratios and the points to determine where the next price wave is likely to go after a pullback.
Common Fibonacci levels are 38.2%, 61.8%, 100%, 161.8%, and so on. There are other numbers, but these are the key ones to focus on for now.
Let’s take a look at the chart of the S&P 500 index, using the ticker, SPX.
The market high was made in January of 2022, and right after started a sell-off (left side of the chart) and it followed the downward trend line until about mid-march. We saw a relief rally that took out the previous two swing-high points. I’ve labeled this event as point A on the chart below.
The market continued the next leg down with a series of lower lows and lower highs. This pattern was once again broken toward the end of May. Once it was broken, we then go back and identify the most recent swing low. I’ve labeled that event as B on the chart.
Of course, we didn’t know about the next swing high (point C) until after the market started going down, but once that happened, we could go back and add the final dot to our graph.
All major charting platforms have Fibonacci extensions, and once you’ve identified where you want to place your three points, it’s just a few mouse clicks and you’re done.
And now look at how the 61.8% extension level (which you could have added once you had an idea for point C) acted as resistance and the market bounced right off that line! If you were aggressive in placing your C dot a few days after that high with now followthrough, the 61.8% extension would have acted as your profit target. In this case, it was spot-on. Pretty neat!
Now, if you’re like me when I first learned about this, you might be saying, sure, but hindsight is 20/20 and you didn’t know about point C until the market started coming down, and then maybe it was too late to use the 61.8% extension as a profit target, and so on. That is true, but there’s a lot you can learn about how to anticipate pivot points to use as your Fib Extension points, but that would take way too long to discuss right now.
Next is the Fibonacci Retracement tool, which is similar to Fib Extensions, but it only uses two points and helps predict the levels we might retrace back to from the current trend.
Let’s take a look. Using the Fib Retracement tool, I set my points at point C and the most recent low. The retracement levels are in green and should give us some insight as to where we may go from here. Remember, we’re in an overall downtrend, so we’re retracing back up before we head back down.
What the chart above is showing is that from point C to the most recent low (showing a short-term downtrend), we’re likely to retrace back up to the 61.8% Fib Retracement level, which is at $3970.99. Now, look to the left and see where that line goes. It’s right near the gap down from a few days ago.
The way I read this is if we have any strong conviction to the upside and breakthrough that $3970.99 level, we’re most likely to go up and fill that gap, up to $4020, and could be back on our way to retest point C. That’s the 7% up scenario I discussed this morning.
If we show signs of weakness and we see continued resistance around $3970.99, that’s our bearish case for a new leg down. Not only would it not fill the first gap down, but it wouldn’t break through a key Fib Retracement level and that is a very bearish sign in this case.
Today might have been a profit-taking day from last week, but if we don’t see some buying strength at these levels, be prepared for a drop to retest the most recent low.
If you missed the Filthy Rich, Dirt Poor live edition on Monday, you can watch a replay here.
If you have any questions, comments, or anything we can help with, reach us at any time.
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Guest Writer, Filthy Rich, Dirt Poor
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