I want to highlight the market principle “Momentum Precedes Price” by a past chart example and the possibility that we are seeing a similar set-up in the market. You know all the caveats about market advice; I am posting this for education – not for trading advice. First, let me post a daily chart of the Dow back in May, 2006 (Chart courtesy TradeStation).

1. There is a slight momentum divergence (at the bottom) if you compare the swing highs in late February, late March, and late April with price. The oscillator is making lower highs while price makes higher highs. Price failure is expected to come.
2. The first strong negative impulse occurred mid-May when the Dow fell from its swing high of 11,600 to a swing low of 11,100, erasing 500 points rapidly. Note the new momentum low (reading of -200 on the oscillator) – momentum precedes price, so after a counterswing up, expect a new price low.
3. A counterswing up occurred at the start of June (from 11,100 to 11,300) where the market found resistance at the convergence of the 20 and 50 period moving averages. Your “new swing low” is now imminent. This setup a great, high probability short “large target” trade with a very tight stop.
4. The expected new price low came as expected with a new swing leg lower, taking the market to 10,800.
5. Note the easy to spot momentum divergence (to the BUY side) that occurred mid-June (oscillator makes higher low while price makes lower low).
6. The new “swing low” leg was almost exactly the same distance as the previous swing low leg.

Of course, price rallied a bit, retested the lows, and then rallied strong from this point (until the recent shock decline).

Now, I want to point out a similar, ominous pattern in the current market (also in the S&P and Nasdaq).

Here are some observations on the current situation:

1. We see similar momentum divergences in price swings leading to the recent decline (they’re difficult to read as the “swings” or volatility have contracted).
2. Momentum still precedes price. Our recent decline took the Dow from above 12,750 down to 12,050, erasing 700 points. Please observe the impulse move and the clear and overwhelming new momentum low which took our oscillator to -300.
3. Expect a counter-swing upwards and then expect a new price low following a new momentum low.
4. Swings often occur in equal magnitude, so we can anticipate a possible “equal measure” swing low, which could take the Dow down to 11,800 or lower.

Consult your own research before making investment decisions. I have annotated this chart with the most likely price SWING. The annotations are my own.

Please check out March 8th Market Coments by TraderMike who suggests a similar theme, yet uses volume analysis (volume divergence with price) to hint at a similar prediction. Oda at Options the Easy Way provides a longer term Dow Chart analysis and nice picture of the S&P (SPY) and the similar declining volume on a rally theme as Mike indicates.

Regardless of the swing chart, please understand that the market is going to have a difficult time overcoming the declining 20 and 50 period daily moving averages. If anything, the convergence of those barriers should set up a strong, high probability shorting opportunity and chance to place a close stop just above the convergence zone and play for a large target of upwards of 600 Dow Points (with a stop 50 to 100 points above these averages). Trading is not about being right – it is about finding high probability opportunities and taking them, yet honoring your stop when your ideas are invalidated.

Remember, it is much easier to predict swings in the market, and not overall trends. And in trading, it is wise to know when you are wrong. My analysis will be invalidaded should the market trade above 12,400 and rise above that level. In that case, take your stop, and move on to the next trade. But odds are so strong for a new leg down that I had to post this (usually private) analysis, if for nothing but for a warning not to get aggressive on your long positions in this counter wave (which some TV pundits are calling a “bottom”. Calling? More like yelling at the top of their lungs).

Regardless of your approach or thoughts on the market, please be careful out there as the weeks ahead transpire. There is a lot of uncertainty in the market and please be mindful of that.