Chart: Here is why the Dow’s rally could be limited

Scott Mlyn | CNBC

The Dow breakout above 18,300 is significant, but it is also weak. This is confirmed both with chart analysis and with some fundamental analysis. The Dow chart has two significant chart patterns and they combine to limit the Dow rally in the short-term.

The first feature is the well-established trading band. The lower edge of the trading band is near 15,600. The upper edge is near 18,300. The width of the trading band is measured and then projected upwards. This gives a target near 21,000 for the Dow. This is a long-term target. The Dow is making new highs but there are technical chart features which limit the way the Dow moves to achieve the 21,000 target.

The second feature on the Dow chart is a long-term uptrend line. This uptrend line started in October 2011. To understand the significance of this trend line, we need to understand the way trend lines change polarity or function. Between October 2011 and August 2015, the uptrend line acted as a support level. The Dow would pull back to this level and then rebound and continue the uptrend.

In August 2015, the Dow moved below the uptrend line. Many people believe that when this happens it means a new downtrend starts. This is not correct. It means the nature of the trend has changed and with the Dow, it means the trend line changed polarity and now acts as a resistance line. When the Dow rallied in November 2015, the trend line acted as a resistance level. The trend line is projected into the future and it will continue to act as a resistance level.

When these two features are combined, it provides information about the way the Dow breakout will develop. The long-term trend line will act as a resistance level. The current breakout has an upside target near 19,350 which is near the current value of the trend line. There is a high probability the Dow will retreat and retest the upper edge of the trading band near 18,300 before a rebound rally moves up to test the trend line as a resistance level.

The Dow breakout is bullish, but the value of the trend line limits the up momentum and slows the progress towards the long-term, 21,000 target.

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The weakness of the breakout is confirmed with fundamental analysis. The Dow has added around 1000 index points in 2016. Three stocks, 3M, IBM and United Health have contributed 54 percent of that gain. A total of seven stocks make up 97 percent of the year-to-date rise in the Dow 30. These are Johnson and Johnson, Caterpillar, Exxon and Chevron. The fundamentals of this rally confirms the chart analysis.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders – 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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