Bullish Island Reversals and New Market Leaders?
Bullish daily island reversal pattern occurs when a gap down on the chart is followed by a gap up the following day. It is denoted by a space (gap up and gap down) that resembles an island. Although these technical reversal patterns are rare, they are interesting and important to an investor and specifically to a trader. Why? Island pattern takes place when there is a pivotal turn in the marketplace reflecting a potential change in the battle between the bulls and the bears. A bullish island reversal develops during a correction/decline as the bears have control of the market. They overwhelm the bulls pushing the price trend lower and lower thereby leading to a gap down. A sudden negative news story or an unexpected adverse event tends to be the key driver of this downturn. The price remains low for a day or more, but then suddenly there is a change in investor sentiments as the bulls take over or regain control. They begin to push the price trend dramatically higher, creating a gap up. Again, sudden news or an event is the key driver to the change in investment sentiments.
The general interpretation for a bullish island reversal is a positive one as it signals the potential for the next rally. However, the strength of the rally depends heavily on the extent of the initial downtrend. The stronger and the deeper the correction or the decline, the stronger the buy signal. In addition, if the two gaps (gap up and gap down) are very large the subsequent rally tends to be stronger and more sustainable. Many also believe that if the island reversal occurs near key technical levels such as a previous major technical breakout, a key retracement, major moving averages (50-day, 200-day, etc.), key trendlines or prior large gap ups it takes on more technical importance. The argument for this is that many technical driven traders, quant driven models, and computerized trading systems tend to buy positions near areas of major technical supports.
We are encouraged by the numerous bullish island reversal patterns confirmed across major US market indexes during 12/4/19 including SPX, INDU, NDX, COMPQ, NYA, MID, and SML. You can blame the gap downs followed by gap ups the next day on the changing sentiments by investors/traders as the result of the news on the trade wars. The last time we witnessed these reversal patterns were on 10/4/19 when NDX and COMQ both recorded bullish island reversals. Noticed the two over-the-counter markets went on to dramatically outperformed their US equity peers over the next two months. NDX (+13.16%) and COMPQ (+13.06%) as compared to SPX (+10.45%), INDU (+9.45%), and NYA (+9.05%).
We suspect the ensuing rally may not be as strong as the 10/3/19-11/27/19 rally as the prior decline leading to the 10/3/19 bottom was deeper and more extensive. However, we believe that there may be a near-term change in leadership roles within US stock markets heading into the end of the year and possibly into early-2020 because several key US stock indexes recorded bullish island reversal patterns very close to their respective key technical support zones (i.e., moving averages and prior breakouts). Not only does this imply relatively attractive risk/reward profiles, at least from a near-term perspective, but it may also signal the broadening of market breadth to include stocks outside the large-cap arena. If this trend continues this can lead to the next sustainable intermediate-term rally. Some of the US indexes that came closest to their respective key technical supports during the 12/3/19 corrections are: NYA, INDU, MID, and SML. Please refer to the enclosed charts for additional information.