A Review Of The Modified Donchian Channel System

(I accidentally posted this before it was edited and complete, so check out the finished post.)

The Donchian Channel trading method was popularized by Richard Dennis as part of his Turtle Trading system. It could not be simpler. Just go long an N period high and then sell or sell short an N period low. Clearly the success of the Turtle traders proves the validity of this method. But...it doesn't seem to work too well with stocks and stock indexes. In the book, Way of the Turtle by Curtis Faith, the system tests results are based on commodities, currencies and treasuries, but not stocks or stock indexes. (This is a great book for understanding the philosophy behind trend following systems.) I think there is a good reason for that. While I haven't run any tests myself on the original system, anyone who tries to trade it on stocks will quickly get frustrated with the long strings of losses and small profits with just enough big wins on occasion to make you think it's going to work. The obvious problem using the method with stocks led to the Turtle Soup method, which is essentially the same system in reverse, and has led many to claim that it doesn't work at all.

Of course, this is nothing new. I've heard it all before: moving averages don't work, the macd doesn't work, elliot wave doesn't work, trend following doesn't work, and on and on and on. An analogy might be helpful. Imagine someone who has no experience with golf, who has never seen a professional or successful golfer play, but perhaps has heard about the joys of playing golf from friends and family and wants to learn how to play. This person goes out and buys an expensive set of golf clubs and a couple of books, and then heads off to the driving range. How hard could it be? Just hit the little ball with the club. We all now how it's going to turn out - slices, blocks, hooks, shanks, poor distance and frustration. Even after expensive lessons there is likely to be little improvement. The novice soon concludes that it is impossible to consistently hit a long straight shot with a golf club. Whoever invented the golf club surely didn't know what they were doing. Except we know that isn't true. We have many great examples from professional golf that prove that one can hit great golf shots with a golf club. The problem is there are very few people who know how to teach other people how to use one even if they can use it well themselves. The same holds true with trading.

Using the Donchian Channels for stocks and stocks indexes requires some minor tweaking and a little discretion to make it work. I call this the Modified Donchian Channel System. The changes from the original system are based on a couple of observations. First, stocks don't trend as well as commodities and currencies. Second, stocks have an underlying bullish bias. And third, stocks tend to have more false breakouts. So the first modification is that we require CONFIRMATION on all sell and sell/short signals, and long signals that fail to CLOSE at new 20 day high. The second modification is that we do not go short on all sell signals, but only go SHORT when the stock or index is BELOW THE 200DEMA. Third, we use FAILURE SWINGS to help indentify turning points and avoid false signals. And finally, 20 day lows are often a great time to buy stocks.

Let's look at the Qs during 2008 with two channels on the chart. The channels are 20 days and 10 days with 1 day forward offet. The 20 day channels are for buy and sell signals, and the 10 day channels are to help identify failure swings. They should be used for exits only.

The first short signal occurs on 1/4/08. This is a valid sell signal because the previous 20 day low occurred on 11/12/07, there was no intervening 20 day high (closing basis) and the Qs were below the 200dema. On 1/4/08 the Qs closed below the 11/12/07 low CONFIRMING the short signal.

On 3/18/08 there was a failure swing. On 1/23/08 the Qs made a new 20 day low, and then 6 weeks (a long time) later on 3/10/08 there is a new 20 day closing low. There was another attempt with a new intraday 20 day low on 3/17/08, but on 3/18/08 the Qs closed above the highest close of the previous 12 days. So we exit short, but do not go long. This one is somewhat discretionary.

On 3/24/08, the Qs close at a new 20 day high. This is a long signal. After a downtrend with a long period of sideways consolidation and a failure swing, CONFIRMATION is not required.

The double top on 6/5/08 followed by a new 20 day closing low on 6/11/08 confirms a swing failure, and we exit long. This is not a short signal. On 6/24/08, the Qs make a new 20 day closing low below the 200dema CONFIRMING the sell signal and we go short.

On 8/6/08 the Qs make a new 20 day closing high and we exit short and go long. On 9/4/08 the Qs make a new 20 day closing low. On 9/5/08 there is another new closing low CONFIRMING the sell signal so we exit long and go short since the Qs are below the 200dema.

On 1/2/09 the Qs make a new 20 day closing high, so we exit short and go long.

Below is the same chart of the Qs for 2009.

On 1/24/09, there is a new 20 day closing low. We exit long and go short. I should've waited for another new closing low to CONFIRM the signal, but hey, I'm not perfect. On 2/6/09 there is a 20 day closing high, but it fails to close above the 1/6/09 high so we need to wait for CONFIRMATION, which does not come as the Qs do not close above the 2/6/09 high on 2/9/09 and then head down to the 3/9/09 low, which is not a new bear market low, but a retest of the 11/21/09 low.

On 3/17/09, there is a new 10 day closing high, which would have been the best place to exit short due to a failure swing. I missed it.

On 3/18/09, the Qs make a new 20 day high, but close poorly making it a good idea to wait for CONFIRMATION. CONFIRMATION comes on 3/23/09 and we have been long ever since.

I realize these rules do not permit a completely mechanical approach, at least not easily. However, they can be implemented successfully with a little experience. You only need to use common sense, wait for CONFIRMATION when prudent, and learn to identify swing failures.

The above examples show that one can be successful even with a few mistakes. Let's get real folks. We are going to make mistakes. To pretend that we aren't is to deceive ourselves. I hope this helps.

Waiting

This week's low volume breakout may end up being something, but I doubt it. I am just waiting for the next valid signal.

I promised a chart this week, but it'll have to wait until next week. Holiday preparations have taken my time this week.

Happy holidays!

Transports Closing In On A High

The Dow Transports appear to be closing in on a 5th wave high. The above count is a clean 5 wave impulse that really did not become entirely apparent to me until December 4th. This count does throw a kink in my view that the 10 month cycle low is coming in January as we would expect a correction that lasts at least 1/3 the length in time as the impulse. However, there is at least one solution that would satisfy both constraints, and it is one that I am beginning to think may be true for the other major markets, and that is a triangle. But, that is pure speculation on my part.

Regardless of the new highs today, low volume, momentum divergences, and weak breadth all point to an impending correction. It doesn't have to be a severe correction, but a typical correction would be at least 33% to 38% of the preceding move. The new highs in the Qs also allow for a 5 wave count although it is not as appealing as the count in the Transports. Thus, we could expect a move back down to the June highs, which was the original projection with the zig zag count back in September and October. This is probably deeper that most are anticipating, but we should be on guard for it nonetheless.

I need to make one additional point from this exercise. If the above count is correct, then this bear market rally is not over, as there must be at least one more 5 wave sequence to finish the rally. This contradicts the many primary wave 3 scenarios that have become so ubiquitous lately.

To JK: I will post a Donchian Channel chart this week.

The Party Just Keeps On Going

Trying to figure out what this market is going to do can make you crazy. Today's action in the Qs looks very much like an upward double zigzag that could resolve to the downside, but the extent of the rally means that selling must resume fairly quickly Monday. The problem with that is the Wilshire and the Dow look like they have another upmove to go before completing their respective upward corrections, which means there is a strong likelihood the Qs will make a new rally high on Monday. This doesn't destroy the bearish case as the Qs often are the last to top, but it certainly puts a kink in it.

All that said, unless and until we see multiple indexes closing at new rally highs on higher volume we should assume that a correction will occur. I wouldn't put too much "stock" in next week's action as I suspect few professionals will be trading, but the week after Christmas should be telling.

Have good weekend and enjoy the snow if you can.

Correction Underway - Again

On Monday I said, "If am feeling this emotion, I am sure there are many others. I have felt this before, and usually it means there is a top at hand." Yesterday the Wilshire 5000 Index made a new rally high right at mid-day and has since fallen in a very clear 5 wave impulse move. At this point, we can expect a retracement rally. If it is a simple move, it could end tomorrow or early Monday. If it is a complex move, it could last most of next week. However, I expect that the selling will accelerate the week after Christmas.

Afterhours, RIMM and ORCL both beat earnings expectations, and RIMM is up substantially, but that will probably not be enough to keep this correction from gaining steam. Time is an issue though as I am projecting at least some type of low around January 4. Whether or not that is the low of the correction cannot be determined yet, but I am expecting that we will at least see a retest of the November lows in the Qs and a move to 9700 to 10000 in the Dow before this correction is over.

What I have been pretty clear about is that I do not believe that yesterday's high was the top of primary wave 2 and that this is the start of the dreaded wave 3 armageddon in stocks. A low should be seen in January that will be the last best buying opportunity for some time, in my opinion.

Has Oil Bottomed?

No Breakout Yet

It looked like there might be a breakout attempt early this morning, but it fizzled out. Now we are only 1 to 3 days away from a cycle high, and 4 days away from the winter solstice on December 21. The longer we go with no breakout, the greater the probability of a breakdown.

The above chart shows that both the MACD and the RSI of the Qs have not broken out above their trendlines. This is a must, in my opinion, to validate any breakout.

A Thought Or Two On Discipline

Discipline means more than just following your rules. First and foremost it means not being swayed by one's everchanging emotions to deviate from the chosen course of action. If there is a valid reason to change course, then there is certainly nothing wrong with that, and often it becomes clear that one should change course. However, when the impetus to change is due to a feeling of regret, disappointment or greed, then the change is likely destructive.

The market is a great barometer of the public mood, and it is not likely that we can avoid the emotions that it is communicating to us. Time and again I have found myself imagining the incredible profits that might be realized if a position achieves some extraordinary target. When that happens I know that I have fallen under the spell of the market, and if I, a usually disciplined trader, have fallen under its spell, then perhaps the majority has, and it's probably time to exit the position. It is rare that this emotional cue, when recognized, has failed to save me from a sudden swoon.

Yesterday and today, I have been battling a different demon. All of my reasoning aside, it feels like the market wants to blast off. The temptation is to just dump my short positions and reverse and go long. I can easily calculate potential targets that would make such a move justifiable. However, I also know that the market is communicating something, that the desire for higher prices has become so palpable that it is beckoning me with its siren call to buy, buy, buy. As much as I might want to do that, it makes no sense to do so. Even if it was profitable this time, next time it might not be. I must be willing to lose, unless there is truly a justifiable reason to change course. If I am feeling this emotion, I am sure there are many others. I have felt this before, and usually it means there is a top at hand.

Maybe the market's siren call to buy will be right and I will feel regret, but better regret than to be a puppet.

NYSE A/D Line Breaks Out To New High

The NYSE A/D line broke out to a new rally high today, while the Absolute Breadth Index turned up from its low on Friday. It would not be at all surprising to see new highs in the indexes tomorrow, but the question is whether or not these new highs will hold. At the moment, I will be content to be stopped out of index short positions with stops that are above the recent highs and wait for a retest of the break out levels before going long if the retest holds.

On the daily chart the pattern in the Qs looks like a running triangle, but on the 30 min chart, it is not so clear. If it is a triangle, that would point to a high in the near future as triangles always precede the final wave in a movement.

I still suspect that any new highs this week will be a fake-out until proven otherwise.

2010 Trading Plan

If you haven't already done so, it's time to start working on your 2010 trading plan. I have been working on mine over the last week. I was quite happy with my 2009 plan, but changes in margin requirements for the double leveraged ETFs have forced me to change that approach, which is probably a good thing because although the plan has worked well overall, it has suffered due to too much concentration which has lead to excessive portfolio volatility. My goal in 2010 is to increase return and reduce volatility. I am measuring volatility using month to month returns. The goal here is to get the standard deviation of monthly returns to be less than 4% to 6%. Studies have shown that the expected maximum drawdown can be estimated by multiplying the standard deviation of monthly returns by 5. So the above target would produce a theoretical maximum drawdown of 20% to 30%. If I can do better, then great.

I have found that although some advisors, like Investor's Business Daily, recommend trading only a few positions, that trading more positions using multiple systems reduces volatility. And I like the challenge of managing more positions, so it is a win/win.

I am going to divide my portfolio into 6 groups: Core, Majors I, Majors II, Stocks I, Stocks II and Commodities. The Core group will consist of 6 SPDR sector ETFs. I will trade these using the Swenlin Trend Model found at Decisionpoint. The method is explained under the Learning section. I expect that trading will be infrequent and occasionally go into a neutral stance, which should reduce risk exposure. The Majors I group will consist of 2 major index ETFs. I will trade one using the MACD as demontrated in the System Tracker, and the other using IBD's market calls. Again the trading in this group will be relatively infrequent although there has been alot of action with IBD this year. The Majors II group will consist of 2 major index ETFs. I will trade this group using short term methods including fading the trend when appropriate. The Stocks I group will consist of 4 stocks that I will trade using intermediate and long term methods. The Stocks II group will consist of 4 stocks that I will trade using short term methods. The Commodities group will consist of 3 positions in gold, oil, and one other commodity or commodity index. I will trade gold using the fractal trading method as described in the book Trading Chaos by Bill Williams. I will trade oil using Monthly trade triangles as used by Market Club.

The total maximum number of positions is 21. This may seem like of lot to keep up with, but only 3 of the groups and 8 positions will require short term management. This plan gives me diversity of markets, diversity of methods, and diversity of time frames. We will see how it works out.

Dollar Breakout

The US Dollar Index continued its breakout from last Friday this week. With multiple buy signals including a positive divergence MACD buy signal, trendline breakout, and a clear 5 wave impulse move from the 11/25 low, there is little doubt that higher prices will be seen. However, some sort of pullback lasting 3 to 5 days could occur beginning next week. This could very well be the impetus for a false breakout in the stock indexes, which would be followed by a reversal once the Dollar rally continues. The effect of the Dollar rally on the stock indexes may be muted if the recent action is any indication as the indexes have been flat, not down, during the first leg of the rally. That could change though.

The Squeeze Continues

There is little to add tonight. The tightest squeeze in the indexes that I have seen in years is still in progress. This setup occurs more frequently in individual stocks. The bands usually only stay this flat for 6 days, rarely longer, which puts the end of the setup at Monday and the start of the breakout on Tuesday. This is only a guess, of course.

A similar setup in the SP500 occured in December 2005. The index first fell to the lower 1.50 Keltner band, but reversed and broke out to the upside. The current setup is widely known, whether in the above format or not, as almost everyone recognizes the tight trading range of 30 to 35 SP points over the last 4 weeks. We all know what happened after the most widely recognized head and shoulders top formed in June this year. It faked a breakdown and then reversed to the upside. I think the same type of thing will happen here. The first breakout attempt will be the false one, after which it will likely reverse and show us the real move.

I have updated my turning point and cycle calculations. The next turning point occurs next week on December 16 followed by the 10 month cycle low projection on January 3-4. At this point a sharp move down to the 200dema may be all that we see with such a short window of time.

The Absolute Breadth Index fell to its lowest point since May 2007 today. Another indication that a turning point is at hand.

Absolute Breadth Revisited

The Absolute Breadth Index measures the absolute difference between the number of advancing and declining issues. The original theory was that a high reading would be expected at bottoms and a low reading at tops. At bottoms there are typically a large number of declining issues compared with advancing issues. At tops the number of advancing issues tends to fall first making the absolute difference between advancers and decliners low.

I have labelled the extreme readings in the Absolute Breadth Index above from March 07 to the present. Out of 12 high readings 8 are bottoms and 4 are tops. Out of 7 low readings 5 are tops, 1 was an acceleration point, and the current low reading is to be determined. I could have labelled one more low reading as a top from Feb 07. So, the theory seems to be supported by the market action over the last 3 years. However, one could say more generally that extreme readings are associated with market turning points.

Market volatility continues to contract and low volatility is generally followed by high volatility. Something big is going to happen soon. The only question is what. While the current action could very well be setting up to be another acceleration point, until resistance is overcome with force, there is little reason to believe that will the case. The probability lies with topping action as the SP500, in particular, remains under strong resistance.

It is encouraging to know that we should soon see a resolution to the current tight action. If it doesn't turn out to be a top, then I'll have to do what I did with gold, ie go with it. That turned out great, and this should too.

Dull and Duller

Never short a dull market is an old adage, and perhaps it is fitting for the current environment. That said, I remain 1/2 short against the rally highs after re-entering short positions last Friday. The NYSE Advance/Decline line is not giving us any indication which way this market is going to go, but the MACD of the A/D line is starting to roll over which may point to a downside breakout.

A second clue is that the Dollar index broke out above its downtrend line on Friday and is holding above it. It is only normal to see a retest of that line, which is in progress. More upside in the Dollar is expected and that should correlate to lower stock prices.

Oil is near the limit of its downward correction from the October high, stopping right at its 200dema. It must hold above the September lows to prevent a retracement to the $50 to $55 level. Also, oil is coming in on a 55 day cycle low, a pattern that has been in place since the April low. The overall character of the decline from the October high is corrective, not impulsive, and one possibility is that all of the action from the June high is part of a much larger running triangle. In that case, the current downmove is wave C of the triangle. Even so, oil should not move below the 61.8% RT of wave (B) (7/13 low to 10/23 high) which is 67.53. This level is still above the September low. Therefore, any sustained move below that level must be considered as a larger correction to the 50 to 55 zone.

Another Distribution Day

The distribution days keep piling up, but the downside action has been muted. The longer the market can levitate as we move toward the anticipated 10 month cycle low date in early January, the greater the likelihood this will remain a sideways consolidation that will lead to continuation breakout in the new year.

However, today the NYSE advance/decline broke down below its trendline for the rally from the March low signalling that all is not well. The breakout in utilities, the decline in financials, the rally in the Dollar and selloff in gold all point to a change in sentiment that begs for a correction. Clearly there is a desire to maintain the extraordinary gains from the March low into the end of the year, but success in this regard could lead to a more vicious downdraft after the new year. That event should it occur would be the next great buying opportunity in my opinion.

A 40 trading day cycle has developed since the March low which projects a high mid-week next week. This will probably be a lower high as it was on July 1. Momentum as measured by the MACD moved lower today suggesting that we will see lower prices this week. I suspect that with TXN selling off after hours we will see lower prices this week followed by a rally into the cycle high next week and then a more pronounced selloff.

QQQQ Squeeze Setup

The 20 period 2 SD Bollinger Bands have moved inside of the 20 period 1.5 ATR Keltner Channels setting up a volatility squeeze for the Qs. Typically one would expect the breakout from such a setup to lead to a sizeable move in the direction of the prevailing momentum which is currently negative. The previous squeeze setup was followed by an upside breakout after the momentum turned positive. It remains to be seen which way this one will go, but you probably know by now that I am leaning to the downside.

Two Charts Point To A Top

The chart above of the Dow Jones Whilshire 5000 index is probably the best representation of where the overall market is at the present time. The index closed below the 50% retracement level of the 2007 to 2009 bear market yesterday after moving briefly above it intraday. It is also trading below both the median line and the lower trendline of the rally from the March low. We thus have a confluence of 3 points of resistance that must be overcome for the rally to move higher. At the open yesterday, it appeared that was exactly what was going to happen. The failure to do so on such positive news was a clear failure at resistance and points the way to lower prices. No doubt, another attempt to get through these levels may be seen in the coming week, but until there is a solid close above resistance we should assume the next move of significance will be to the downside or that a longer period of consolidation is coming.

The above chart of the FXY which tracks the Japanese Yen shows a clear breakdown below trendline support on a likely move to below the April 08 low. When I first presented this chart on November 18, the upward correction in the FXY appeared to be complete, which is why I felt confident that a market high was imminent. The Dollar has since moved lower and the YEN higher, but now that the FXY has broken down below the 2008 high, we should expect a retest of the April 2008 low, which should correspond to a correction in the US stock indexes.

The pattern in the FXY appears to be a very large flat correction, which means that the decline should occur in 5 waves. The impulsive decline should occur with some speed as well implying that a bottom is not that far away in time. There is no way to know how severe the decline will be in the stock indexes but until we get a solid breakout from current levels, all the facts point to the 10 month cycle low still ahead.

For those of you who read Carl Swenlin's weekly posts at Decisionpoint.com I want to point out that my work does not agree with Mr. Swenlin's view that the "9" month cycle low occured in November. Mr. Swenlin's market views are some of the most sound and rational that I have seen, but on this point I must disagree. If we do get a breakout, then I'll have to reconsider.

What A Day!

Today's action was about as exciting as it gets with stock indexes closing well off the highs and failing to close above breakout levels, but managing to hold above critical support. The action off of the lows appears to be an upward correction that may have a little more to go on Monday before more selling follows.

It has been my intent since I started this blog to share with you my insights and views on the markets as well as my market positions within reason. I make no claim of trading omniscience. I just call it like I see it within the framework of my trend following and pattern methodologies. If anyone got whipsawed because of my commentary, I apologize, but I must remind readers that the decision to take a position or exit one is your responsibility and yours alone. Please do your own homework and make your own decisions. I hope that my comments will aid you in that process.

In case you are wondering whether I am just blowing a lot of hot air, my total return since I started this blog in January 2008 is approximately 272% using an average of 50% margin. I am disappointed with my results for this year as I have fallen a little short of my goal relative to the market swings that have occurred. Most of this has been caused by attempting to take short positions at potential tops so this is an area I have to work on.

The action for the last few months has been particularly difficult, and I don't think I am alone in that view. However, just as has occurred with the gold market since late August, I expect the stock indexes will begin to trend strongly one way or the other before long. This change of character between strongly trending and choppy markets is just the nature of market behavior. While I have heard many claims of those who are able to alter their strategies to suit the market behavior I have yet to see any evidence of that ability in practice. For the most part traders would do well to stick with one or two approaches.

That said, my intent for the coming year is to better integrate intermediate term strategies with short term strategies to increase return and reduce volatility. As I work on my trading plan for the coming year, I will do my best to share this work with you. Unfortunately, I have a great many things to accomplish by December 31 with my other businesses, and it will be a challenge.

Today I suffered my largest drawdown in the last 3 months, but not because of the index short positions, but because of gold. I had a position in the DGP as well as two mining stock positions. It was evident by 10:30am as gold moved strongly below its 12dema and the dollar was rallying that a substantial selloff was in the making. I exited all of the gold positions with a nice profit but with some drawdown. This is the nature of trading. We can only exit before or after the top (take your pick), but rarely at the top. I don't think I could have traded it any differently so I am satisfied with the result. I don't believe the rally in gold is over, but the runup had gotten to an extreme and a correction is in order.

While oil may retest the November low I still think we will see new highs with a move to around 100. Please see Adam Hewison's Marketclub video on oil which closely matches my own view: Crude Oil.

Tomorrow I will revisit a chart I posted recently on the FXY and look at the potential ramifications of a falling YEN.

May Go Long TWM Again

As I said last night, I would not hesitate to re-enter the index short positions if the action warranted. I am amazed at the lack of follow-through this morning after the blow-away jobs report. I have an order to go long the TWM at 27.25 with a stop at 26.75 as markets appear to be rolling back over. A close below yesterday's low would be a severe blow to the bulls.

Sold QID, TWM, SSG

The TRIN has collapsed to very bullish levels, < 0.60, and the SP500 has broken out to new highs. I have exited all index short positions. I am looking to add to positions that are working OIL, e.g.

Sandbagged

I was afraid of that. That little slip-up by the White House yesterday appears to have done its job as futures are on the rise after a much better than expected jobs report. Is this a sell on the news event? I don't know. I will give the market a few minutes to see what it's going to do, but I will only hold my index short positions if the indexes hold below the rally highs. I will not be reversing and going long the indexes. I will wait for another opportunity.

It has been a while since I have been so wrong footed with an index position. So many factors have pointed to a top that has simply not materialized even though the pattern, price levels, and timing have supported that point of view. In general, I am a trend follower, and it usually pays to wait until the trend has developed, but sometimes one can build a case for taking a position at a top or bottom. See my post on how I traded JPM, Oct 31. But also, take a look at my post of Oct 28 entitled "Is there any doubt?" where I mention how oversold the market was based on the McClellan Oscillator. That little piece of information has proved to be very accurate. If this move fails, I will have not any qualms about going short again.

As I had mentioned in an earlier post, this could turn out to be an acceleration point, and that may be the case now, but it will take a breakout and pullback to prove it. There will be a pullback at some point. We will evaluate the situation when it happens.

Banks Vs Utilities

The top chart shows the BKX bank index rolling over out of a bear flag after breaking down below its rally trendline in October. The second chart shows the XLU utilities index breaking out of a textbook expanding wedge formation and looks solidly higher.

Banks down - utilities up doesn't sound like bull market behavior to me. Note that the BKX was one of the first indexes to break down in 2006 well before the rest of the market while the XLU was one of the last to break down, holding up until December 2007.

Failed Breakout Attempt

The SP500 attempted a breakout this morning which has so far failed. Closing under yesterday's low would warn us that a near term top may be developing, and closing under last week's low at 1083.74 would confirm a top. On the other hand, a reversal of this morning's selloff with a solid close above this morning's high would put the bulls firmly in control.

The ISM nonmanufacturing index came in well under the expected level this morning and also under 50, which indicates contraction. Shortly afterward, the White House put out a press release indicating we may see a rise in the unemployment rate tomorrow morning. This smacks of an attempt to manipulate the markets by either trying to minimize the impact of a worsening unemployment rate or sandbagging the bears who may be wrongly positioned if the rate comes in better than expected tomorrow morning. Either way, this type of behavior is not conducive to a bull market, no matter what our leaders believe. It only adds to uncertainty and skepticism.

Regardless of the market reaction to the unemployment data tomorrow morning, traders would do well to wait for an hour or so to let the market settle down before entering new positions or exiting existing ones.

Churning

Markets have made little progress over the last 3 weeks, but watching the financial channels you might think they are considerably higher than they are. On Friday 11/13 the Qs closed at 44.01. Today they closed at 44.07. While the action has been frustrating, I haven't yet relinquished my half short index positions. The signs of an imminent top are everywhere. The chart above shows the absolute breadth index in Telechart. It has been a reliable indicator of turning points at extreme levels and is rapidly approaching levels that have marked turning points during 2009. Nevertheless, a solid breakout above today's high will force me to exit.

Meanwhile, the DGP, selected gold stocks, OIL, and a few other miscellaneous long positions have more than offset the index short positions in my account. Gold may be approaching some near term resistance at 1246, but I have a revised target at 1297. Oil is still holding well above the critical level of 68.32, and appears to be setting up for its next move higher even if oil inventories are rising.

As Kevin Haggerty is fond of calling them, the generals, the big money players, seem to be doing everything possible to hold this market up until the end of the year, which makes it more likely that any selling will take place after the new year. With Investors Intelligence Bears now down at 17.6%, traders should be on guard for downside risk rather than chasing year end gains.

Lonely Dow

The markets moved higher on lighter volume again today with the Dow making a new rally high all by itself. This fact alone should give traders pause. The chart above shows that the Qs are still below the primay trendline from the March low and in the process of developing a broadening top formation. Markets can breakout either way from such a formation but it is typical to see 3 touches of both the upper and lower trendlines.

I have relabeled the wave count with a new count that eliminates the ending diagonal triangle pattern. Thus, the likelihood that we will see a retest of the July low is significantly diminished, which fits with the fact that there is little time left to complete the 10 month cycle low. The number of new highs continues to fall relative to prior peaks - another sign that the rally is narrowing and another sharp downdraft is likely.

Caution

The pre-market futures are up this morning, but I would urge caution. While the large caps may continue higher into year end, the small caps, financials and semi-conductors, among others, are still lagging badly. Oftentimes, the large caps will play catch up to the downside in this situation. It's fine to swing trade the move, but just be aware of the risk.

I have only added to two long stock positions in the last two weeks. Most of the stocks I have been following have yet to trigger swing trading buy signals, which I find intriguing in and of itself as I watch the Dow levitate near it's highs.

I realize that it is difficult to watch this market grind higher, but this is exactly the type of market that seems to carry the greatest short term risk. Only a sizeable up move in above average volume would alter that view, and we haven't seen it yet.

Correction Is Still In Progress

Today's rally on below average volume coupled with weak breadth was not enough to alter the view that the market is still in a correction, however muted the correction happens to be. Tomorrow being the first day of the month is likely to be an up day, but the overall pattern of the action since the low last Friday is corrective, which means that lower prices will likely be seen in the coming days.

While the action over the last few weeks has been quite bullish and supportive of the view that this cyclical bull market will continue as expected into next summer, a number of factors are also consistent with the interpretation that this is a bear market rally which is undergoing a correction. For example, both the IWM and XLF have broken down below their October lows and are sporting anything but impulsive looking patterns, advance/decline lines are not breaking out even as the Dow has made new rally highs, and the summation index continues to decline. In particular, the IWM remains below its broken trendline from the March low with falling momentum.

Unfortunately, the market behavior since the October highs does not lend itself to an obvious elliot wave interpretation at the moment. However, my hunch is that the IWM is in the middle of a b wave triangle that will resolve to the downside once it is complete. This next leg down should complete the correction. If my hunch is correct, then the subdivisions of the triangle should become readily apparent by the middle to end of next week. Triangles are a trader's best friend as they almost always point to the end of a movement which allows us to anticipate the beginning of the next movement. Let's hope we see a triangle.

Rogue Wave

Tonight the Dow futures are down over 200 points on the news out of Dubai, and while some have been calling for the beginning of the next leg down in the bear market, history does not support such a view. The October 2008 crash followed after months of distribution with markets making lower lows and lower highs. That is not the case now. Sharp declines that come off of rally highs are the market's way of washing out the weak hands so that the rally can continue. The most recent example of this type of behavior is March of 2007, which was followed by higher highs in July and October 2007. It may feel scary, but it most likely is not the start of a new downtrend.

When markets push higher into an intermediate or long term cycle low, a sharp decline often follows which pulls the markets down hard into the low. I believe the expected selloff tomorrow will be doing just that. At the moment I am not entirely certain whether the 10 month cycle low will occur in December or January. Even if the current decline resolves as a 5 wave decline, it probably won't help us much since it could be wave C of a flat correction. The only way we will know for sure is to watch the following rally to see if it is a 3 wave or 5 wave rally.

Either way I will assume that when the dust settles next week or the week after, it will be a buying opportunity for a christmas/year-end rally. The first level of support is the November lows, followed by the 200demas. If the correction needs another leg down to complete it in January, we can always reverse and go short again.

A word of caution - a sharply lower open tomorrow would probably not be a great time to go short except possibly for daytraders. If you are not already short, it would probably be best to sit this one out and wait for the next opportunity.

Warning On Leveraged ETFs

I wasn't going to post today, but I received an email from my broker today that FINRA has increased it's margin requirements on leveraged ETFs effective December 1. Since I have indicated that I am trading these instruments, I felt that I should inform you of this change. The proposed change would effectively destroy the benefits of these ETFs for those trading on margin since the double leveraged ETFs will require twice the margin as the unleveraged ETFs they track. They still offer an advantage for those not trading on margin. I had my broker run a simulation to determine what my buying power would be under the new rules just to make sure that I would not have to exit any positions prematurely.

The double leveraged ETFs had significantly enhanced my portfolio performance since I began using them with index trend following strategies. In my opinion, the indexes do far better with these strategies than individual stocks, so I am greatly disappointed that I will have to retool my trading plan again to deal with these rule changes.

At the moment, I am looking at going to some combination of ETFs and long options, but I am not sure yet. Traders should be prepared for the inevitable ban on short trades once the next leg down in this great bear market is underway. Index futures may be the only way to short the market by that point.

For Once I Agree With Cramer

This afternoon Jim Cramer made the statement that the market action next week will likely dictate the outcome for the rest of the year, and I agree with him. It looks as though the major indexes need one more new low to complete an impulse wave down from the 11/16 & 11/17 highs. If the typically bullish period from the day before Thanksgiving to 12/1 does not exceed those highs, then the correction will remain in force, and we will likely see lower lows in December. If however, those highs are exceeded, then markets may begin to accelerate into the new year and on into the summer.

So far, I see little evidence to convince me that the correction will not pick up speed after next week, if not during it, as my weekly breadth indicator turned negative again this week after being mixed in the prior week. It is rare that the markets will not follow-through for at least a week after a new signal, and this one was also accompanied by a negative divergence.

My hunch is that after a rally attempt next week, we will see a March 07 type swoon that will shake out the bulls to set up the next leg of the rally. We will have to wait and see how the market behaves after that selloff to determine if that will be the extent of the correction or whether there will be one more leg lower.

Both the dollar and gold were up today. It is beginning to look like the trend in gold has decoupled from the dollar. Oil continues to hold up and as long as it remains above 68.32, the trend is up. However, it would be better for the bullish case if it remains above the 73 to 75 level.

Barring any unexpected market action next week, I will be taking a break from posting until November 30. We were able to sell the last of the townhomes that we had on the market since 2008 as well as complete a renovation at a shopping center this week, and I need a break.

Happy Thanksgiving!

Correction Underway

When a apparent 3 wave correction fails, it usually means that it was not a 3 wave correction, but a 1,2,i,ii setup. This appears to be the case today as the chip sector is leading the markets lower. I may be going out on a limb, but I believe this week's highs in the major stock market indexes will mark the high of the first leg of the rally from the March low and we are now in a correction that will lead to the 10 month cycle low in December or January.

The primary evidence for this is the lack of new highs in the small caps, semiconductors and financials coupled with the Qs coming decisively back under its October high this morning. If the current volume run rate continues, the Qs will have the highest volume of the last 3 months on a down day.

I will be looking for a completed 5 wave impulse pattern down on the 30min/60min charts and/or a daily fractal sell pivot, macd sell signal, IBD "Market In Correction" call for confirmation and a chance to add to index short positions for a retest of the November lows and a likely test of the 200demas. Of course, a reversal a breakout to new highs would seriously derail this viewpoint.

I am expecting that gold will test support at the October highs around 1050 to 1100 before moving higher.

Ascending Broadening Wedge Pattern

The Dow Industrials are tracing out a very clear ascending broadening wedge pattern. The upper trendline will be at 10529.55 on Friday 11/20 and at this point, it seems likely that this level will be hit or an attempt will be made at it anyway. The latest rally has been accompanied by sharply declining volume and a multi-week negative divergence in the RSI that suggests that the rally is coming to an end soon.

The likely path of the correction would be down to the lower wedge trendline followed by a bounce into yearend and then another leg down to complete the correction in a head and shoulders top pattern.

This pattern sometimes leads to an overthrow of the upper trendline, but failure to reverse quickly after the overthrow would imply a more bullish outcome. It looks as though options expiration will keep the markets up until Friday.

If a correction does not follow, I will be exiting half index short positions and looking to buy breakouts of leading stocks for a continuation of the rally into yearend.

YEN May Be Portending A Turn

The action in the Japanese Yen appears to be repeating a pattern from January of this year. In December 2008, the Yen made a new high against the dollar, but then a lower high in January as the US markets posted new countertrend rally highs. The subsequent impulsive decline in the Yen coincided with the final leg down in the US markets.

Once again the Yen appears to be making a lower high as the US markets are making new rally highs. Is this pattern giving us a heads up that the rally in US markets is about to end? While there is no guarantee, as long the Yen remains below its October high, it would seem to suggest that is the case. In particular, however, if the Yen makes a new high, then the anticipated correction may not occur. There are other negative divergences still in force as well. The volatility indexes have not made new lows against the recent rally highs.

Unfortunately for the bears, today's action appears to have concluded a 3 wave pullback on the hourly charts, which means new rally highs. As long these divergences remain in place, I will be expecting a correction.

Running Out Of Time

Volume continues to contract as the rally makes new closing highs, which suggests a turn is near at hand. However, if a meaningful decline is to get underway, it should do so soon. Although it does not occur frequently, sometimes a potential 10 month cycle low can become a point of acceleration. We are rapidly approaching the time frame when the 10 month cycle should bottom. My calculations show the 10 month cycle bottoming a little early, around 12/9 to 12/11, while traditional methods could put it as late as 1/9 to 1/12. We also have the typically bullish Thanksgiving holiday period coming up next week. If we do not see a sustained decline into these dates, we may need to consider the possibility of an acceleration move.

Last year the markets bottomed on 11/21/08 and topped on 1/6/09. Will we see a reversal of these turn dates with a top at the end of this week and a bottom on 1/6/10? That is certainly a viable outcome. If, on the other hand, markets begin to consolidate next week rather than decline in earnest, the bearish near term case would be severely compromised.

Dow At Trendline Resistance

The Dow's high today of 10434 hit right on the upper trendline of the rally from the March low. While volume was higher today, it was still below average. Potential negative divergences are developing. An overthrow of the upper trendline is definitely a possibility, but would likely lead to a more severe decline than one that begins from the current level.

I am still expecting a retest of the November low, but due to the fact that we are rapidly approaching the expected 10 month cycle low, it is unlikely that the correction will extend much below that level. Markets have managed to forestall a more severe correction that would have probably ensued had the October decline continued after a modest bounce in November instead of the rally to new highs.

I realize that I stand in the middle between the bears who are out in force calling for an imminent retest of the March lows and the bulls who are calling for the rally to continue into year end, but make no mistake about it, the patterns that I am seeing develop in a number of stocks point to a significant rally once the anticipated correction is over, whether that be November, December or January. I haven't seen this many solid looking setups in individual stocks since June. While some select large caps have been carrying the major markets higher, other stocks have been correcting and building new bases. That alone is enough evidence for me to discount the extreme bearish case.

As always though, we trade what we see and not what we think.

I survived the camping trip with some really sore quads. It is always an experience with my boys' scout troop as the scoutmaster plans some fairly challenging hikes. We started near Rocky Knob on the Blue Ridge Parkway and hiked about 6 miles to the campsite with a precipitous decline of about 2000 feet over 2 miles on a trail which was more suited for a goat than hikers with 40 lb packs. The campsite was very pleasant with a cold and clear running stream. We enjoyed a nice meal of chicken and rice next to the campfire. After a reasonably restful night and eggs for breakfast, we hiked the rest of the loop for another 6 miles back up to where we had started.

The trail, stream crossings and campsite were built by CCC workers during the Great Depression. While I am for less government, it is hard to argue with the benefit that some of the work that was done back then has added to our lives over the decades. The difference today is that I don't see the obvious benefit to the average person from the government's stimulus efforts.

Gone Camping

The critical levels for the immediate bearish case are 10302.37 for the Dow, 1096.99 for the SP500, and 44.09 for the Qs. If these levels are exceeded then the rally is likely to continue or at least move sideways for a few more days.

One reason to suspect that the rally will not continue is the action in the dollar and the euro in particular. The euro looks ready to roll over to retest its November low, which should correspond to a rally in the dollar, which should in turn lead to a decline in US stocks, since the seemingly eternal inverse correlation between the dollar and stocks is still in force. However, at the moment I do not see a major rally in the picture for the dollar. I expect the dollar decline to resume once this little upward correction ends. Traders should not become complacent about the inverse correlation to the dollar. It will end at some point.

While at the moment I feel a little like a teenager standing over in the corner all alone at the dance, there is nothing that says that we have to participate in every market swing. Let's see how things pan out next week assuming I survive the weekend.

Wait And See

The Dow turned back after just surpassing the 50% retracement of the October 2007 to March 2009 decline at 10334. (I had incorrectly stated that level as being 10350 earlier.) We will need to see a continuation of the downtrend with a sustained move below the October high to confirm that the correction has resumed. I say resumed because I suspect that the recent runup from the 11/2 low is wave (B) of a flat correction, and we should see a retest of that low by 12/2 but more likely before Thanksgiving.

It has been observed by seasonal market timers that the period from the Wednesday before Thanksgiving through the first of December is generally quite bullish. If we get a retest of the low by that date, I will be looking for an opportunity to exit short positions to reverse and go long for an expected year end rally. The year end rally may or may not be the beginning of the next leg of the cyclical bull market. It could be just another part of an extended correction. We will just have to wait and see how it unfolds.

VIX Does Not Confirm New High In SP500

Not Yet Convinced

As long as the small caps, financials and other sectors do not participate in this rally, I will remain unconvinced that the latest breakout is for real. While the Qs broke out to new rally highs today, volume was 23% less than at the October 21 high. Volume on the Dow30 and SP500 also contracted as the Dow came within 8 points of the 50% retracement level of 10350. However, the rally may last one to two more days before some sort of pullback or correction.

Bullish And Bearish

With futures this morning pointing to a new high in the SP500, I am forced to consider alternate views on the market action since the October 21 high. However, the big question is whether or not this is a time to begin building new long positions for a another rally leg. In my opinion, it is not. Yesterday the market paused after it's big advance on Monday, so today might confirm Monday's buy signals, but there are some troubling issues with the advance from the November 2 low.

In particular, new highs are lagging even as the Dow is making new highs. The small caps and semiconductors are still lagging significantly. The current rally seems to be a much more narrow affair than the previous rally off the October 2 low as a few stocks have had big gains while others have lagged. The bulk of the advance seems to be in the large caps.

For example, in the Russell 2000 during the first six days of the rallies from 10/2 and 11/2, there were 1706 gainers vs 1404 gainers, respectively, while for the Russell 1000, there were 900 and 878, respectively. For the Russell 2000, 17 stocks gained more than 30% after 10/2, but only 15 have since 11/2, but for the Russell 1000, only 6 stocks gained more than 20% after 10/2, but 12 have since 11/2.

These differences are not huge to be sure, but when you combine that with below average and declining volume, it seems clear that this is not the real beginning of the next leg of this cyclical bull market rally.

In addition, the Dow is closing in on 10,350, its 50% retracement level from the October 2007 high, and the SP500 is still below major trendline resistance from the October 2007 high.

The bottom line is this doesn't feel right to me. There are too many inconsistencies. Although I am forced to conclude that my "meticulous" analysis of the decline from the October 21 high is not an impulse wave as I had labelled it, neither am I satisfied to conclude that the 8 day decline at the end of October was all of the correction. By a process of elimination, however, the current rally must be either wave 1 of a new rally leg or wave (B) of a flat correction. All of the evidence supports the latter. In either case though, we should expect some sort of pullback or decline in the near future, which will allow us to determine which case is correct. If the former, then begin building new long positions, and if the latter, wait for a retest of the November low.

My work with the elliott wave count highlights the difficulties with elliott wave and definitely demonstrates that one should rarely take a full position solely on an elliott wave interpretation. I did not, and I hope that readers of this blog did not either. I have maintained some long positions including gold, oil, and two gold stocks throughout this correction and my account has not been damaged by adding half index short positions on this latest rally (I exited my initial index short positions off of the 10/21 high on 11/2 very near the low). If my suspicions are correct, we will soon see a dramatic swoon toward the November low, which will be the next opportunity to profit from this still ongoing cyclical bull market.

IBD Calls "Market In Confirmed Rally"

For those who read IBD regularly this should be old hat, but I thought it would be instructive to repeat the following from IBD's Market Pulse today:

"But keep in mind that some follow-throughs fail. A confirmed uptrend is not a green light to buy anything that moves ..... Open half positions and follow up if the stock proves itself." (Bold by me).

The same applies to any trend following methodology. Yesterday also saw valid buy signals using the Cabot Tides, Weekly-Daily, and MACD systems. The Donchian and Breadth-Momentum systems remain on a buy. These signals are not a license to put the pedal to the metal. Sometimes the market can run away from you, but I don't get the feeling that is going to happen this time.

IWM At Resistance

While the Dow Industrials and the SP500 got the coverage today, most of the other indexes are lagging and some significantly. The IWM and SMH are more than 5% below their rally highs while the Dow made a new rally high today. The financials and the transports are also lagging. The above chart shows that the IWM is at median line channel resistance and approaching its broken trendline for the March to October rally. The upmove in the IWM has been on declining volume which doesn't confirm the breakout in the Dow. Perhaps these lagging indexes will play catch up, but it seems more likely that the correction will resume over the next few days. However, we may see the Dow stretch for the 50% retracement level of 10,350 before it tires out.

Today's action will likely be called a follow-through day by IBD. However, I would want to see a follow-through of the follow-through. Most indexes are now overbought and due for a pullback. Let's see how that plays out before jumping back on the train.

The value of maintaining some core long positions is being demonstrated again.

Dow Heading For New Rally High

The pattern in the Dow is slightly different than the SP500 and the Qs. It appears that the pattern in the Dow is going to be a flat or expanded flat. The action in the Dow underscores again what I have been saying since March - the risk in this market is to the upside. This doesn't mean the correction is over, but increases the likelihood that it is unfolding as a sideways consolidation or shallow correction. Be prepared to exit index short positions early when the November low is restested.

Wave (c) Pop

This morning's gap up in the stock indexes should complete the rally from the 11/2 low. As always, anything is possible, but this correction would be quite short relative to the preceding wave (C) rally if it was already over. I suspect that given the weakness in the dollar, wave (B) may morph into a more complicated pattern such as a triangle or a flat that will allow the correction to extend into the expected cycle low dates. So, as long as the October 21 high remains intact, I see little reason to exit short positions at this time.

Another possibility that traders should keep in mind is that the current correction could be wave (W) of a more extended correction that lasts into January. Wave (X) would allow for a retest of the 2009 high into year end and wave (Y) would retest the wave (W) low. Such a retest in January, which often shows some weakness in the first two weeks, would not invalidate the 10 month cycle low in December.

The reason I mention this possibility is that position sizing over the next 8 weeks will be critical to minimizing drawdowns. Traders who take oversized positions may be whipsawed if the correction does extend. I continue to be cautious with 1/2 positions. I will let the market give me clear signals to add to those positions as the real trend becomes evident.

Grabbing At Golden Straws

Almost on a daily basis, we are bombarded with calls for a bottom in the dollar and a top in gold. Of course, at some point these calls will be right, but once gold broke out above the February high and the dollar broke down below the August low, the balance of power shifted from the gold bears to the gold bulls. Now, I am seeing calls for a top in gold because it has traced out a 5 wave movement from the August low. I question the validity of that interpretation.

If the form of the move from the October 2008 low was a flat (3-3-5), then the breakout from the triangle should have been down, which is what I originally expected when I went short after the February 2009 high. However, this is not what happened at all as gold broke out to the upside. In order to satisfy the necessary symmetry with wave (A) of the unfolding pattern, gold needs to complete some sort of 3 wave pattern, or combination thereof, in wave (C) from the August low. This means that the advance from the August low would have to be 3, 7, or 11 waves, and therefore, 5 waves is not a completed pattern.

In addition, we would normally expect the time of wave (C) to be approximately equal to the time of wave (A). Wave (A) was 80 trading days, while wave (C) is only 58 trading days to date. I would expect wave (C) to be at least 80 trading days as well, or 1.382 to 1.618 times 80, which is 111 and 129 trading days, respectively. We also have the seasonal pattern for gold which is normally bullish in December and January.

I think it would be premature to exit long positions in gold at this time for intermediate term traders. Until we see a lower high, I will give gold the benefit of the doubt and expect higher prices. When wave Y of (C) is complete, it would be prudent to take at least partial profits. If and when wave Z of (C) is complete, I will exit long. Wave Y projects to at least 1145. While wave (C) would equal wave (A) at 1246.

I have also seen a wave count showing a series of 1s and 2s with gold going to the stratosphere. This is not a reasonable point of view either. While the dollar is likely to go lower down to the 72 area. It will not go down forever, and once it turns in earnest, gold will probably top as well.

I may eat crow on this analysis, but I believe it is correct.

One More Thrust Higher To Complete Wave (B)

Well, as it turns out the impulsive move down from today's high around 10am was wave c of a flat correction, which itself is part of a running triangle. This means that there is at least one more thrust higher to complete the countertrend rally. I will remain short the indexes barring a move up on substantially higher volume. Unlike the fairly clear and distinct impulse waves during the decline from the October 21 high, the rally from the 11/2 low has the character of an upward correction with choppy overlapping waves. Even if the October 21 high is approached or exceeded, it is likely that a retest of the 11/2 low is in the cards.

Also, from another perspective supporting that the correction is still underway, IBD did not call Wednesday's action a follow-through day as the volume was lower than Tuesday on all of the indexes. My charting service showed higher volume for the Nasdaq, so I don't know where the discrepancy is. In any case, it looks like the markets have more work to do before the uptrend resumes.

Countertrend Rally Appears To Be Complete

The rally from the 11/2 low appears to be complete. The markets made a new countertrend rally high this morning around 10am followed by an unmistakable impulse move down in 5 waves clearly visible on a 2 minute chart. Markets are presently in a small degree second wave rally up which should not exceed this morning's high. The risk is that the impulse move down is wave c of a flat correction and more rally is to follow. Of course this rally could extend in a more complex upward correction, but at the moment the upside risk is constrained by the October 21 high.

I have re-entered half short positions in the QID, TWM and SSG. I may add to those positions on a sustained move below the 11/4 low. I may exit these positions on a sustained move above today's high on higher volume.

One wonders after the disappointing employment report this morning how bullish enthusiam could sustain a continuation of the wave (B) rally.

Wave (c) of [c] of (B) Up In Progress

The current rally from the 11/2 low is not impulsive, no matter how exciting today's rally may appear. The retracement targets should be hit or exceeded tomorrow as wave (c) of [c] of (B) (or 2) up completes. I suspect that based on the wave count the market will respond positively to tomorrow's employment report. Once complete, the selling should return in equal measure.

Today's rally qualifies as a follow-through day by IBD's standards, so it will be interesting to see if they call it that way in tomorrow's edition. I would be very cautious in giving that call too much credence. This is one of those times that the principle of the second signal applies. The principle of the second signal is a concept that I developed several years ago which states that "after a countertrend correction has begun, the first buy signal is likely to be false, so wait for the second signal". Occasionally you will miss a rally, but this principle has saved me a great deal of pain.

Once the next wave down is underway, we will be able to gauge whether it is wave (C) or 3. At the moment, it looks like it will be wave (C).

More Rally Near Term

Today the SP500 broke out above the upper channel line of the short term decline and then pulled back to that channel line. The next likely move is wave [c] of 2 or (B) up to the target. If the time of [c] is equal to [a], the whole thing could be over as soon as tomorrow afternoon. On the other hand wave [b] could extend sideways for some time before wave [c] begins. I will be looking to re-enter index short positions at the target zone. whether it is hit before or after the employment report. It is a low risk entry point against the October 21 high. I will add to those positions on a break of today's low (after the target is hit). Of course, there are myriad ways that wave [b] could go at this point including a retest of Monday's low, but at the moment the pattern looks pretty unambiguous.

Supporting the notion that the rally will continue tomorrow is the positive report after hours by CSCO which is up 1.30 or so after hours. The best of all worlds would be a rally tomorrow followed by a gap up after the employment report on Friday. I will sell such a gap near or above the target zone.

While the 30 minute MACD gave a sell signal today, after a positive divergence buy signal, it is generally prudent to wait for the second sell signal to take a position. We may see a negative divergence buy signal at the wave [c] high (or maybe not, it is not required, just beneficial).

Wave 2 Or (B) Up

Markets have broken out above the high of the low day of the correction and above the upper channel line on a higher volume rate than the day before giving strong support to the view that an upward correction of wave 1 or (A) down is now underway. Since wave 1 or (A) down was an impulsive move, the October 21 high should not be exceeded or something different is going on. The most likely target for wave 2 or (B) is the 62% retracement of wave 1 or (A), which puts the SP500 at 1074+/-. However, anything less than the October 21 high is possible. This countertrend move will likely be choppy and could last for several days. Any follow-through day on this move should be regarded with suspicion as it is extremely rare that a correction not complete at least a 3 wave movement.

Gold Breaks Out Again

Gold breaks out to new highs again during a normally weak period. The seasonal charts show that gold typically peaks in late January to mid February. There's really no need to sell before then unless we get a decisive break below the previous all time high of 1029. The recent pullback clearly established that level as a zone of support. The next target is 1170+/-. A blow-off top could see gold extending to 1400 and above and would certainly be a time to take profits.

With other nations raising rates faster than the US is or can, it is unlikely that the dollar is going to reverse its trend any time soon, although many are calling for a dollar rally. Or course, everything could change tomorrow after the Fed announcement, but do we really expect a change of course yet?

Wave [4] May Be Complete

Today's excitement over Buffet's purchase of BNI notwithstanding, it looks as though wave [4] is complete as of 2:10pm and wave [5] down of 1 or (A) is underway. The targets posted this morning should still apply. A breakout above this afternoon's high would be strong evidence that wave 1 or (A) has already bottomed and wave 2 or (B) is already in progress.

Wednesday's are quite frequently turn-around days, so if wave [5] is underway, it may bottom during the day tomorrow. A reversal day tomorrow would be strong evidence that wave 2 or (B) up has begun.

Downside Targets For SP500

This morning's news is that the rate hike in Australia is spooking markets, but does that really make sense? The answer is clearly no. The central bank of Australia said that "economic conditions in Australia have been stronger than expected and measures of confidence have recovered". This sounds like a recipe for Aussie dollar up - US dollar down, which at least for several months has meant US dollar down - US stocks up/Gold up, etc. I would not be too quick to jump on this morning's weakness as a selling opportunity, as it is most likely wave [5] down to retest yesterday's lows.

Downside targets for wave [5] down range from yesterday's low at 1029.38 to the October low at 1019.95 to the 38.2% retracement level from the 2007 high at 1013.74 to the 1000 area. All of these are within the allowable range for wave [5]. At the moment, this morning's gap down in futures does not appear to have the intensity one would associate with a 3rd wave. If we see a 3 wave rally develop followed by break of this morning's low, then it would be time to reconsider that point of view.

Updated Wave Count For The Decline

The SP500 either completed an impulse wave at today's intraday low around 1:30pm or will do so with one more 4th wave and 5th wave. While I show waves [i] and [ii] on the small swing on 10/21, I don't have a high degree of confidence in that labelling. I show the alternate labelling for [i] and [ii] at the 10/22 and 10/23 low and high, respectively. One reason to believe that today's low was all of minor wave 1 or intermediate wave (A) down is the positive divergence buy signal on the 30 minute chart. Even if there is a new low, it will likely just be a retest of today's low.

Given the fact that my position is that we are in a correction of the rally from the March low of uncertain duration and depth rather than a full blown resumption of the bear market, I made a descretionary decision to exit my index short positions today shortly after the intraday low.

I will be looking to re-enter those positions after a sharp retracement to around the SP500 1075 level, which should complete wave 2 or (B). We can then assess the subsequent market action to determine if it is in wave 3 or (C). The impulsive nature of the decline makes it clear that we must be in wave (A) of a zigzag (5-3-5) or wave 1 of an impulse (5-3-5-3-5) movement. The depth and intensity of the next 5 wave down move should help us determine which interpretation is the correct one.

In the event that the market gaps down to a new low, I will evaluate whether it is the end of wave [5] or the beginning of wave 3 based on the action in the first 30 minutes to 1 hour of trading. If it does appear to be wave 3 down in that case, I will re-enter the short positions. However, at the moment that outcome does not appear to be likely.

Near Term Low?

This afternoon's low may market the completion of wave 1 or (A) down. If not, this afternoon's low may be retested before a more significant countertrend rally develops. The countertrend rally may be sharp and could retrace 62% or more of the decline from the October 21 high.

How I Traded JPM

In March of this year, JP Morgan offered a rare opportunity to trade a very low risk/high reward pattern. I had been following the stock since the broader markets rolled over in October 2007. JPM peaked months earlier in May 2007. The wild swings offered traders a lot of opportunities, but I chose to stay on the sidelines as there was no discernable intermediate trend until November 2008, and by that time I was trading the SKF.

After the failed rally attempt in December 2008, the pattern began to come into focus. An ending diagonal triangle was developing which was heading toward a confluence of support. Looking at the big picture, the median line from the 2000 high through the 2002 to 2007 rally was projecting an intersection with support at the 2002 low and the lower trendline of the ending diagonal triangle.

As markets seemed to be heading into the abyss, fear was rampant, but as I commented in this blog, the markets were nearing the completion of a major elliott wave pattern at projected targets at an expected cycle low. With reasonable confidence that a rally of significance was about to commence, I projected the lower trendline to be at 16.50 on March 4. I entered a limit order to buy JPM at 16.50, which was filled on March 5. I did not use a hard stop loss. My exit plan was to sell JPM if it closed below the 2002 low, rallied and then failed. It tested but never closed below the 2002 low, and the rally began March 9.

The target for this trade was the origin of the EDT (ending diagonal triangle) at 50.63. I realized that given the wild swings in the stock it would most likely not make it all the way to the target, so I focused on the target zone of the range of the high day.

JPM peaked in wave (A) of its rally in May well short of the target. The hardest part of this trade was sitting through the wave (B) correction, but it was rather muted compared to some of the other financial stocks. Wave (C) finally got underway in July. It closed in the target zone on September 22, but then promptly closed below it. I waited for a second test of resistance at 45.23. On September 30, it began to fail without making it back above resistance and I exited the position at 44.54 for a gain of 170%. Of course, the stock managed to make a new rally high in October, but it has now rolled over in earnest and a significant correction of the rally is underway.

What made this trade unique is the rare confluence of so many factors including 3 areas of support, a high confidence elliott wave pattern completion, a stock market cycle low and impending rally. In particular, my confidence in this trade was high because I stayed on the sidelines for almost 2 years as I observed and waited for the opportunity to present itself. When the time was right, I pulled the trigger without hesitation.

Sometimes we get so caught up in trying to capture every zig and zag, we miss the real opportunities. This is a perfect example that you don't always have to be in the market or trading every move of a stock to make big profits.

Impulsive Decline

A still imcomplete impulse wave in the SP500 is ongoing. Expect another sharp rally on Monday followed by at least one more new low for the decline. The subdivisions of wave iii are not clear so it could be wave (iii), but the decline definitely has the look and feel of an impulsive move. Once complete sometime next week I would label it as minor wave 1. We would then expect a substantial wave 2 rally to follow lasting several days or more before waves 3, 4 & 5 down to complete wave (A). This scenario is definitely subject to change as there are multiple valid paths that a correction can take, but the reason I am assuming an impulse wave for (A) is that it is the most likely form to trap the primary wave 3 down to Armageddon bears.

Oftentimes the target for a zigzag correction can be estimated by multiplying the length of wave (A) by 1.618. If we use the July lows as a target for the end of the correction, we can project the end of wave (A) by dividing the measure from the October 21 high to the July low by 1.618. This gives a target for wave (A) of 957.94 for the SP500 and 37.94 for the Qs. Both of these are around the June highs interestingly enough. A stop at that point may convince many that the correction is over.

It is also quite possible that the current impulse wave that began October 21 that ends next week is all of wave (A). If we assume that the July highs are the target for the correction, then we can estimate the target for wave (A) as 1011.66 for the SP500 and 39.75 for the Qs. These would probably also be good estimates for the end of wave 1 of (A) for next week as well.

If you're totally confused by the above, don't worry. The point is that the correction has a lot further to run and we can't know what the ultimate target for this correction really is. We can only project possible outcomes and watch as the market action unfolds to see what the most probable path is as we get more information.

I will be looking for a substantial wave 2 rally to add to short positions in the coming week.

Broken Trendlines

The Russell 2000 (IWM) and the Dow Transports have both broken their respective trendlines from the March low. While it is entirely possible that these could be bear traps, it is not the most probable outcome given all of the other factors we have considered in the last week. A retest of the broken trendlines is underway and may last until the middle of next week. Thereafter, expect a resumption of the correction that began October 21.

As long as the Qs remain under 42.79, a small degree 4th wave is probably in progress. Once complete, expect a 5th wave followed by a larger 2nd wave rally. There are many avenues this correction could take. We don't need to get too caught up in the wave count. It will become clearer as the next few days unfold.

The main point is that today we had a sharp countertrend rally off of a deeply oversold condition. That doesn't change the fact that a correction is underway, rather it is consistent with the type of market behavior that would be expected during this correction.

Is There Any Doubt?

Sometimes things happen which call into question the foundations of one's preconceived notions. The market action yesterday and today makes me want to rethink some of my assumptions about the rally and this correction. The chart above shows the ratio-adjusted McClellan Oscillator for the NYSE. It is readily apparent that market breadth as measured by the oscillator is as oversold as it has been since the resumption of the bear market in October 2007, which raises several questions.

Am I wrong about 2010 and is this the kickoff to a violent 3rd wave down as Robert Prechter has been forecasting for several years? Or is the market already so oversold that this will be one of those shakeout kinds of corrections like March of 2007? At the moment I don't know the answer, but I do think it would not be wise to add to short positions at this time, as the most probable outcome is a violent short-term rally beginning as soon as tomorrow or within a few days.

One thing I do feel confident about is that the kind of selloff we have seen the past two days is entirely consistent with market behavior after completing an ending diagonal triangle, and the probability that markets will retrace the entire EDT back to the July lows is very high at this point. We can only watch as the market action unfolds to determine if that will be the extent of the correction or whether the correction continues even lower.

Given that the October high completed a 3 wave rally from the March low, it is entirely possible that we could see a retest of the March low or even lower prices, which could be part of a very large bearish flat correction. In that case, the March lows would be another excellent buying opportunity as the October highs would most certainly be revisited in wave Y up. One clue that could help determine the extent of the decline will be how quickly we reach the July lows. If it occurs well before the expected completion of the 10 month cycle bottom, then lower prices would be probable.

Looking back at the top in the Qs on October 31, 2007, we see that the initial decline lasted 8 days. So far, we are on day 5. This is another reason to expect a near term bottom and a rally into the middle of next week. That rally, should it occur, would be a good time to add to short positions.

If the markets continue in a free fall, then we will have to reconsider whether or not we are in the beginning stages of primary wave 3 down and all that implies.

More Downside To Come

The initial leg of the decline remains incomplete. It may bottom sometime this week, perhaps even tomorrow. The decline in the SP500 looks the most impulsive and I will be using it as a guidepost for the correction. I believe I have resolved the count for the Qs, but I want to wait and see how it looks when the SP500 completes wave A or 1 down.

The Qs closed at 42.34 and below the trendline from the March low (around 42.50 today), which is another strong indication that the trend is now down. Volume was higher on most indexes, so it is hard to imagine that IBD will not call this a "Market In Correction" in tomorrow's edition. Support remains at the 50demas and October lows for most indexes, but the Russell 2000 and Dow Transports are below their 50demas and rapidly approaching their October lows.

Other indications that the correction is gaining momentum is the recent reaction to earnings and guidance by BIDU, SOHU, ILMN and APOL. These stocks have been crushed. Also, AAPL closed below the $200 mark on higher volume today and other market leaders are being sold hard, e.g. FUQI and DTG. This is why I highly recommended selling into the new rally highs in September and October. FUQI is down 33% from its September high. It will take weeks to repair the damage.

An interesting development today was the traditional McClellan Oscillator closing at -280.36. Such low closes have often led to sharp rallies in the past. The rally this time may correspond to wave 2 or B and will likely be a bull trap. As long as the October highs are not exceeded on higher volume, this would be a good opportunity for those who have not opened initial short positions to do so. Again, keep in mind, that I am not expecting an impulsive return to the March lows as many are calling for, but rather a choppy correction to the July lows. Adjust position sizes and stops accordingly.

At this point there is little doubt that the correction is upon us. The only question that remains is how long and how deep. In my opinion the probable answers to those questions are until December 2 to 24, most likely around December 9-11+/-, and down to the July lows. This is certainly not a time to be buying stocks, although many will try.

Double Top With Bear Flag

The Qs completed a 3 wave rally from the 10/22 low just after 10am this morning. A sharp selloff began just before noon today that bounced off support at the 10/22 low and then formed a bear flag. Coming under 42.79 will confirm the double top which projects to 41.76, however, in reality the likely target is the 50dema which is currently at 41.50 followed by the August high at 41.08. The trendline from the March low is currently at 42.40, so if the above targets are hit the trendline will be broken, adding to the growing list of sell signals. We now have renewed MACD sell signals on all of the major stock indexes as well.

While some sentiment measures are increasingly bearish, such a change in sentiment from bullish to bearish is not in and of itself a reason to believe the correction cannot be a deep one. This change in sentiment is normal as the trend changes. Most intermediate term indicators such as the weekly MACD and Stochastics are far from oversold and the 10 month cycle is now in its down phase into the first of December. We should expect that the correction will intensify over the coming weeks with sharp intervening rallies. A break of the rally trendline followed by a retest of the trendline and a move below the swing low of the break will confirm that a move to the July lows is underway.

At the same time, most stocks will not have had time to set up for short trades, rather they will be pulling back for a chance to enter the established uptrends at better prices. AAPL and AMZN come to mind.

Count Invalidated

The bearish count that I presented Friday for the Qs has been invalidated. As long as the 10/21 high is not exceeded, the correction may still be considered to be underway. Unfortunately however, as I have stated on several occasions, we are likely going to see a very choppy and difficult correction. Smaller position sizes and wider stops will be the winning approach.

If we do see new highs today or tomorrow, the next potential turn date is November 3rd by my approach. With a window of +/- 2 days, this puts a possible top at 10/30 to 11/5. But let's not put the cart before the horse, we haven't seen new highs yet.

Another clue that I will be watching to confirm that the correction is truly underway is AAPL falling and sustaining below 200.