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As the S&P 500 tests new highs, is the uptrend at risk?

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Following a series of closing highs last week and the index's first intraday breach of the 1,900 level one is inclined to ask: how much longer can the S&P 500 can sustain its uptrend? If charts are anything to go by the underlying trend is here to stay.

The S&P 500 weekly chart shows a strong trend with each upthrust target defined by the width of the trading bands. The market has broken through the consolidation around 1850 and the trading band calculation provides a target near 2000. Chicken Little is frightened of heights and terrified the S&P 500 will fall. Do the charts support this fear?

Individual stocks can and do collapse suddenly and without warning; it's in the nature of company risk. However, indexes rarely collapse without warning because they aggregate the company risk of all index constituents. Even the growth of Exchange Traded Fund activity has not altered this fundamental relationship.

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For those who do not understand charting it may appear that an index, and by extension a market, can collapse quickly. There are very rapid market collapses, as in 2008, but these are generally preceded by clear chart signals with broad-based index chart patterns.

The Dow and S&P 500's collapses in early 2008 were preceded by early warning chart pattern behavior. Our CNBC column notes and commentary on Squawk Box Asia in late 2007 and early 2008 identified these patterns and set, what were at the time, almost unbelievably low downside targets.

There are four significant patterns that point the way to a major trend change, which are best seen on a weekly trading chart. Currently, the S&P 500 is not showing any pattern development which indicates a major correction or change in the trend.

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The most powerful and reliable of these patterns is the head and shoulder pattern. The left shoulder of the pattern is created by a rally and retreat. This is followed by a second rally that lifts the index to new highs before the market retreats again, creating the head. A third rally and retreat creates the right shoulder. The lower points of each shoulder are joined by a neckline. The distance between the neckline and the top of the head is measured and the value is projected downwards from the neckline to set a downside target.

The head and shoulder pattern, which develops over several months, has a high level of reliability in individual stocks, and is also very reliable when applied to index analysis. The DOW developed a head and shoulder reversal pattern in late 2007.

Next is the rounding top pattern, which reflects a more gradual loss of confidence. The peaks of index activity are best described as a curve and enthusiasm loses momentum. Once the base of the rounding top is identified the distance between the base and the top of the rounding top is measured and used to calculate the downside targets as shown with the FTSE in 2008. This pattern often takes many months to develop.

The development of a down-sloping triangle pattern is less common in index behavior but when it occurs it's a reliable trend reversal signal. This pattern includes a well-defined support level and a well-defined down-sloping trend line. The vertical face of the triangle is measured and this value is projected downwards to set the downside targets.

The blow-off top pattern follows a period of extreme upward momentum. This characterized the NASDAQ in 2000. This pattern is less useful for identifying the time of the market collapse but provides ample warning of the need for caution.

None of these four trend reversal patterns appear on the weekly S&P 500 chart. The absence of these patterns does not rule out a temporary correction but it does suggest there is a low probability of a market collapse and a change in the trend direction.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders – www.guppytraders.com. He is a regular guest on CNBCAsia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe.

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  • Daryl Guppy is an independent technical analyst who appears frequently on CNBC Asia.

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