Island Reversals in a major average like the S&P 500 are rare and are reliable indicator in signaling that a trend change has just occurred. As such an Island Reversal can identify a bottom after a lengthy or deep decline, or a top after a rising trend has run its course. Since Island Reversals occur at the end of a trend, they represent emotional exhaustion, whether it is despair at a bottom or exuberance at a high.
An Island Reversal is defined by its distinctive price pattern and occurs in market averages and individual
stocks. An Island Reversal top is formed when a market average gaps higher usually on some good economic news. The gap is created when the low of the gap day is above the high of the preceding day, which creates a space. The Island Reversal top is formed when a gap lower follows the gap higher, so that the low on the right side of the formation is above the high of the day of the gap lower day. (Up-trend example) Island Reversals can be 1 day or several days. The gap lower forming the Island Reversal top can be in response to negative news or simply exhaustion after a big move higher.
An Island Reversal bottom develops after an extended decline is accentuated by negative news that causes a gap lower. The low of the prior day is above the high of the day of the gap down. (Down-trend example) The Island Reversal bottom is completed when some good news causes the market average to gap higher leaving a space between the highs of the Island and the lows on either side above the Island.
The key point is that an Island Reversals occurs at the end of a trend and signals that a new trend in the opposite direction has begun. An Island Reversal at a bottom can be used as a buy signal to invest into the stock market and a sell signal after an Island Reversal top. An Island Reversal top is negated if the market average subsequently closes the gap by trading up to the prior lows following a top. An Island
Reversal bottom is negated when the market average falls to overlap the highs that formed the Island Reversal bottom thereby closing the gap.
On June 5 the S&P 500 gapped higher after the Labor Department reported a surprising increase of 2.5 million new jobs compared to estimates of a loss of 8 million jobs. After trading higher for four days, the S&P 500 gapped lower on June 11 after the Federal Reserve indicated the Fed would keep the federal funds rate low through 2022. This lack of confidence in the speed and strength of the rebound forced investors to confront what should have been obvious – there will not be a V-shaped recovery. Instead it will be labored and require constant monetary accommodation and additional fiscal stimulus. Emotional buying on June 5 and emotional selling on June 11 created a gap of more than 1.0% in the S&P 500 which is quite large.
The Island Reversal lower is obvious on the S&P 500 ETF SPY shown below. This Island Reversal lower developed after the S&P 500 had rallied by more than 40% since its bottom on March 23. A number of sentiment measures like the Call / Put Ratio reached levels indicating that investors had become quite bullish, after such a big rally and in anticipation of a solid economic recovery in the second half of 2020. As noted in the June 8 WTR, “The disconnect between the stock market and the economy has never been so wide.” This disconnect can be closed by the economy catching up to the stock market or the stock market falling to reflect economic reality. The Island Reversal top suggests the stock market will fall more in coming weeks.
If the Island Reversal top signals a top, how much further can the S&P 500 fall? If sentiment had become too bullish and optimistic, the decline has to be deep enough to dampen bullish sentiment. Ideally, the S&P 500 will decline enough to bring the Call / Put ratio down to near 1.0. The S&P 500 fell to an intraday low 2767 on May 14, so a test of that support is likely. A drop to 2750 – 2800 may be sufficient to
dampen bullish sentiment and provide a buying opportunity. A close below 2767 would open the door for a decline to 2650.