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Charts show strong bearish DJIA pattern, traders to short rallies

Dow Jones sign
Scott Mlyn | CNBC

The Dow Jones industrial average has developed a strong and powerful reversal pattern, which means previous bullish analysis must be revised.

The dominant pattern on the Dow is a long-term head-and-shoulder pattern that is best seen on a weekly chart. This pattern is overlaid on the longer-term trading band pattern that has defined the rise of the Dow that started in 2011.

The left shoulder of the pattern developed in September 2014. The head of the pattern was not a fast rise and retreat, but developed as a small rounding top between November 2014 and August 2015; this is a long term pattern.

The right shoulder developed between October 2015, with a peak in December 2015. The recent DOW fall below 16,500 points confirmed the completion of the right shoulder of this pattern.

This long-term head-and-shoulder pattern has developed on top of the long, upsloping trading channel that has defined the Dow uptrend that began in 2011.

The 16,500 level is the value of the trend channel line A, which makes it a critical support level. The move below the value of trend line A further confirms the development of the right shoulder. A sustained fall below 16,500 has support from the extended value of channel trend line B. This is currently about 15,200. This is the first target for the Dow.

The second downside target for the Dow is calculated from the head-and-shoulder pattern. There are two key head-and-shoulder pattern target calculations.

The first head-and-shoulder target calculation uses the close at the base of the left and right shoulders. The neckline is drawn between these two points. The distance between the neckline and the top of the head is measured, and this distance is projected downwards. This calculation sets the second downside DOW target near 14,100.

The third downside target for the Dow is also calculated from the head-and-shoulder pattern. The second head and shoulder pattern target calculation uses the extreme low points at the base of each of the left and right shoulders. This plots a lower neckline and the calculation gives a more extreme third downside Dow target near 12,850.

This is a very bearish outlook, given the down closed overnight at 16,516.22.

The head and shoulder pattern developed over 16 months. This is a slow-moving pattern so completion of the pattern with the downside targets may also between seven and 12 months.

This head-and-shoulder pattern suggest strong bearish pressure in the Dow for 2016 so traders will short the rallies.

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