Analysis that predicted the Dow's decline shows what may be coming next

  • The Dow Jones index could find temporary consolidation around 23,200 to 23,600.
  • The main support level is seen at 22,500 with a rebound then possible.

We know every good horror movie has a nasty ending, but that doesn't stop us from flinching, or screaming, when it happens.

The Dow retreat is the same. The focus on interest rates in the United States has been a topic of discussion for more than a year. Like a good horror movie the clues have been piling up, but markets like to pretend they have been caught by surprise.

Traders work on the floor of the New York Stock Exchange, (NYSE) in New York, U.S., February 5, 2018.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange, (NYSE) in New York, U.S., February 5, 2018.

One month ago I wrote that the Dow retracement was waiting to happen. We set a short-term upside target near 26,200 which was achieved. Last week, speaking on CNBC's "Street Signs," I noted that the Dow was in bubble territory and primed for a substantial retreat.

Investors who understand chart analysis have been prepared for this retracement. More importantly, they are prepared for the rebound and continuation of the long-term uptrend. Forget the doom and gloom because here lies opportunity.

A retracement is when the market diverges significantly from the current trend and then falls, or retraces, to the underlying trend line. If the divergence between the current high and the underlying trend is very large, then it is a bubble collapse.

The value of the long-term underlying trend line, which started in October 2011, is currently near 22,500. This is a divergence of 4,000 index points and definitely a bubble.

A retracement to this level is uncomfortable for investors, but a rebound from the trend line support level is a buying signal for a continuation of the long-term uptrend. A retracement is a drop of less than 10 percent from the index high. A fall of more than 10 percent is generally seen as a signal for a trend change.

That is a problem for the Dow trading near 26,500. A 10 percent fall takes the Dow to 23,850 and that is above the current long-term trend line support value near 22,500.

However, 23,500 is near to a minor support level. That is a small consolidation band between 23,200 and 23,600. But it is a very weak consolidation support area, so there is a high probability the market will plunge below that level before rebounding.

A fall below 23,500 finds the next strong historical support level near 22,500, which is the value of the long-term uptrend line. This line starts in 2011, so its placement and value is approximate.

Investors will look for the Dow to pause and consolidate in that area before entering again for a continuation of the long-term uptrend.

Traders remain short, but tighten stops as each of those support levels is tested.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders, which can be found at www.guppytraders.com. He is a regular guest on CNBC Asia Squawk Box. He is a speaker at trading conferences in China, Asia, Australia and Europe. He is a special consultant to AxiCorp.

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