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If Dow Fails to Break 13,317.... Big Drop Coming: Chartist

A severe decline for the U.S. markets may be about to begin and traders may want to consider several technical warning signals.

So far the Dow Jones Industrial Average has managed to trade higher into the month of August to test the May 2012 high of 12,338. But once again the index has not managed to penetrate the resistance barrier of 13,317 which has been a key level for the index.

Since the October 2011 rally which has so far gained 28.20 percent the Dow is now showing several signs that may be a precursor to a rally about to fizzle out and start a correction. What is interesting is that a similar situation had occurred in October 2007 when Alan Greenspan had provided positive comments on the state of the economy. This was then followed by a major decline which lasted 17 months.

So where does the Dow stand at present?

On a monthly chart we have technical resistance at 13,317 and the index has failed three times so far. Currently this month registers as the fourth attempt. Historically, when we have seen fourth attempt failures, this can lead to major moves in the markets. With the daily chart, technical resistance comes in at 13,060 – 13,190, which has also seen the index fail to hold onto. Both the monthly and daily chart resistance levels are signaling a potential weakness at current price levels.

Next we also have technical divergence on several indicators and on multiple time frames. This is where we see a disagreement between price and indicators where they move in opposite directions. The recent rally in the market to the upside had not been followed through with momentum indicators, which suggests that the rally on low volume was not a conclusive move. Strong moves are in sync with price and positive momentum.

Another signal which has caused concern is the VIX or Volatility Index. Options traders are aware that a low VIX reading whilst the market is moving higher demonstrates complacency in the markets. Basically traders are losing sight of risk at current levels. The last low VIX reading which occurred earlier this year in April led to a decline of 9.7 percent.

Coupled with the VIX reading we also see that the index has traced out a Five-Wave pattern. Markets often move in waves of threes and fives. The current pattern sports a Five-Wave scenario which may lead to a Three-Wave correction to the downside.

We also have seen a “Bearish Engulfing” pattern emerge last week. This is where the index makes an attempt for a high but fails and closes the week lower. During the attempt to rally the market surpasses the previous weeks high and also breaks past the previous week’s low ending the week on a negative note.

Finally on a momentum basis, the Dow has provided a bearish signal suggesting that if on Friday we see the index break below 12,979 and fails to climb above 13,101 then this could be the trigger to start a multi week decline.

Given the five important aspects above, next week may prove crucial along with Ben Bernanke’s speech Friday in providing an opportunity for the bears to come out from hibernation and lead the way forward for a market storm in September.

The bulls will need to take the index above 13,317 in order to negate the above scenario.

Sandy Jadeja is the Chief Technical Analyst for City Index a leading provider for Spread Betting, CFD’s and Foreign Exchange trading. He has been involved with the financial markets for over 24 years and is a trainer in technical analysis. He is a regular guest on CNBC. He can be reached at sandy.jadeja@cityindex.co.uk

CNBC assumes no responsibility for any losses, damages or liability whatsoever suffered or incurred by any person, resulting from or attributable to the use of the information published on this site. User is using this information at his/her sole risk.

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