Chart of the week: Here’s the litmus test for FTSE 100

Is the FTSE 100 breaking down?

It is wisely said that it is not a stockmarket, it is a market of stocks. Some shares will be in bull trends, some in bear trends and the rest in no discernible trend at all. In a sometimes imperfect attempt to monitor the general trend of shares, we have the various stock indexes – and today I will follow up on my 14 August coverage of the FTSE 100.

In general, when the FTSE (UKX) is in bull mode, many leading shares will also be rising and the path of least resistance will be up. That makes the simple strategy of ‘buying the dips’ highly successful. And that has certainly been the correct approach since the Credit Crunch lows of 2009.

But when the FTSE is in bear mode, the opposite will be true and buying the dips will become a toxic tactic. And with Friday’s severe break of major support, are we entering such a phase now?

Let me review where we were in August. Here is the chart I showed then:

I made a case that the overshoot high at the precise 7,600 level on 2 June was very likely the top of the 8½-yr bull run off the 2009 lows. I noted that the market was rallying into a wedge (or ending diagonal) pattern – and these can be very powerful reversal signals, provided the support of the lower wedge line can be penetrated with force.

And on 14 August, I noted the market had broken through a day or so previously and was giving me that ‘sell’ signal. But although the market was in a severe decline off the 8 August high, a possible outcome would a sharp reversal back up – in the same manner as the wave 4 to5 rally in May-June.

In other words, a short trade taken at the 14 August low at 7,301 was fraught with risk of a snap-back rally and the dreaded whipsaw (the bane of all traders). For that reason, I decided to stand aside and watch developments.

This is what I wrote then: “With all of the above clues, I can state with some confidence that the trend is now down and it would take an unlikely move above the C wave high at 7,550 to change my mind. Of course, we could see a small bounce towards the lower line in a typical kiss, but that should be about it. But a kiss miss would suggest big declines immediately ahead.”

I was prepared for a bounce and warned that if the rally carried to place a kiss on the lower wedge line (or even just miss the kiss), it would suggest the decline would resume. So how did this pan out? Here is the updated daily chart:

From the 14 August low, the market did indeed enter a consolidation period and rallied to place a few kisses on the wedge – but the wedge line resistance held firm. This set the stage for a re-test of the lower consolidation zone at the 7,300 area. And, on Thursday, the attempt to break down succeeded and on Friday the market closed well below that shelf of support, which now becomes a ceiling of resistance.

Trading breakouts can be tricky, but here, a short trade on the break was the percentage play since the consolidation zone was lengthy and the thrust out of it was likely to be strong.

So how does this look in the bigger picture? Here is the monthly back to the Millennium:

The FTSE had topped on two other occasions at the 7,000 area (in 1999 and at 6,750 in 2007). But in this rally phase, we have a new all-time high at the 7,600 level. Can we consider this a bullish portent? Are we currently in a dip off the June high which will lead to a renewed push to new highs?

If so, the market must push up past the new-formed resistance at around the 7,300 level. That will be my litmus test. With that as my fail-safe level, I now have a roadmap that will guide my trading – and that is a huge benefit for any trader/investor!

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.