Thursday, December 30, 2010

Inflection Point Modeling

One comment that I have recently read a lot is that "Market is very resilient," and a common question that any market savvy person should ask is "Are we approaching a trend reversal?" In any case, both statements are very thought provoking, and I have been thinking about these two notions i.e. market's resilience and trend reversal, for the last few weeks. 

While I was thinking about these statements, I got myself involved in a neat little programming project. During this project I came across a unique method of analyzing the stock market's internal harmonics. This method might be useful in analyzing crucial trend reversals in conjunction with my favorite Market Matrix (which I will discuss over the weekend).

I have analyzed this model over various time-frames and have found it to be a good indicative tool. However, there is always room for improvement and I will try to do so on a regular basis. In any case, since modeling can never substitute real time analysis, observations and implementation, I am publishing the latest chart of this model. It shows SP500 along with various trend reversal signals generated by this model during the last 2 years.

Trend Analysis Model

Each of the two graph employs a different model for calculation and graphical purposes. It is evident from the plot that these models have generated several reversal signals, and almost all of them have corresponded to a short-term top or bottom. Thus, a natural question to ask would be that when is the next reversal date?

The next reversal date (according to the model) is highlighted in the plot. It comes out to be January 6, 2010 (+ or - 3 days). Now the question is, whether it will be a top or a bottom. The answer will depend on whether we drop into this reversal time window and then bottom out, or do we continue to rise into this reversal time window and then top out.

In short, right now these plots are suggesting that a significant trend reversal could occur within one week. This reversal can be significant because the reversal potential is present in both of these models. When viewing this trend-reversal date in conjunction with the current lopsided sentiment picture (extreme optimism) and completed wave structure, there is a very high possibility that we are approaching a high rather than a low and that this high can produce a significant decline.

1 -If the market did not decline or rise at one of these trend reversal points, then it went sideways for some time. It normally happened in strong up or down trends.
2- Always trade in the direction of the trend. Even if there is a trend reversal date, wait for confirmation by other signals because: 
“The market can remain irrational longer than you can remain solvent.” - John Maynard Keynes

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