The may have had a thousand-point run on Monday, ending at 16,022.58, but its collapse still has a way to go, with a downside target near 13,900.
The weekly Nikkei chart shows a well developed head-and-shoulder pattern, which is a very reliable, long-term trend reversal pattern.
The pattern consists of four elements. The first is the left shoulder, which is created by a clearly defined retreat and rebound. This developed in November 2014.
The market then continues to rally and develops a peak, or head pattern. This is the second element, which formed in July 2015.
The subsequent retreat and rally developed the right shoulder of the pattern in December 2015, which is the third element.
Although this a long-term pattern,the completion of the downside targets can be very rapid. The low points of each shoulder are joined by a single neckline, making the fourth element of the pattern.
We could use the extreme lows, but with the Nikkei we have used the cluster points on both shoulders to set the position of the neckline.
The first step in using this pattern is to measure the distance between the neckline and the peak of the head, which comes to 3,501 points. This value is then projected downwards from the neckline to give the downside target near 13,900.
This target is a minimum target so often the target is exceeded, as shown with the head and shoulder pattern in the Dow Jones industrial average in 2008.
The pattern is confirmed when the index activity following the right shoulder falls below the extended value of the neckline, as happened in January 2016.
The validity of the downside target is enhanced when the projected level is near a historical support level; with the Nikkei, historical support is near 13,900. This was a strong support level that held between October 2013 andl May 2014. There is a high probability it will act as support again. A fall below this level has support near 12,500.
If the neckline position uses the extreme lows of the head and shoulder pattern, the depth of the pattern is 4,211 points. Project this downwards from the new position of the neckline and the downside target is 12,500.
This suggests that the initial target for the Nikkei is 13,900, with the potential to move to 12500. Either way, its clear that the collapse of the Nikkei is far from over. Sure, there will be rally rebounds but these do not invalidate the downside targets. Traders and investors will carefully watch the Nikkei as it approaches these target levels. A sharp rally rebound is possible, but the most probable outcome is the development of a consolidation pattern.
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.
