Unbelievable Rally

While certain measures seem to indicate that this rally is overbought, the sentiment of large speculators and small traders remains decidedly bearish. I realize that some polls are beginning to turn bullish, but the group that probably influences the small traders the most, newsletter writers, have been extremely slow in jumping on this rally. Many are still calling for a retest of the lows. On CNBC, the guests, for the most part, seem to be hesitant to suggest buying this rally, while they concede that it could go higher. One advisor said that for those that had not already bought this rally, it was too late and investors should wait for a deep pullback before considering going long.

This past week the SP-500 negated the bearish wedge pattern, which I had already demonstrated was a low probability setup anyway. The negation of the bearish wedge means that we are most likely in wave 3 or C of the rally. Third waves and C waves are generally the most powerful waves for stocks, and I expect that will be the case here. The generally neutral to bearish sentiment during this wave 3 or C could lead to explosive upward action.

At the same time, we could see some violent swings mid-month. I think the best course or action here will be to ride out these swings for a mid-June or mid-July top. At the moment it is hard to tell which it will be, but I am beginning to lean toward mid-July. I am now almost fully allocated to the long side, with short positions in APOL and STRA. STRA appears to have completed an ABC upward correction. If APOL breaks the coming test of an uptrend line from the March 08 low, the target will be 32 to 35.

The Big Picture

When it comes to evaluating the big picture, it pays not to become too attached to one viewpoint. In an earlier post, I pointed out that I believe the most likely pattern for the market based on an evaluation of the cycles, sentiment, breadth and elliott waves is that we are in a 3 wave rally, wave X, that is the middle portion of a complex combination correction. Wave W completed March 6 as a flat correction. The current wave X will most likely be longer and deeper than most expect. Oftentimes, X waves or B waves last at least one-third the length of the preceding wave. Since wave W lasted 9 years, that means wave X could last up to 3 years.

At the moment it is hard for me to see how it could last that long given the cycle structure, but I will keep an open mind. I think the most likely scenario will be a top around June 2010. This may seem to contradict my earlier statement calling for a low around that time, but the surge in breadth during this rally has been strong enough to propel the McClellan Summation index above its downsloping trend line from the 2003 high. This action in the Summation Index has been shown by Tom McClellan (as he correctly noted in 2003, by the way) to lead to rallies lasting at least 18 to 24 months. Also, Terry Laundry has now demonstrated that a new valid bull T has formed with an expected duration of 535 days, which is about 18 months. And lastly, I have re-examined my cycles calculations and have come to the conclusion that March 6 was actually the "4 year" cycle low.

This sub-harmonic of the 45 year cycle can vary in length from 3 years to almost 5 years. The last low was October 13, 2005. The low prior to that was October 10, 2002. The next expected low is October 31, 2011. The cycle is expanding in duration from its minima between 2002 and 2005.

If this is correct, it has several implications. First, the 10 month cycle may have phase shifted with a new origin on March 6 just like it did at the October 13, 2005 low. This means the current rally would be at the beginning of the 10 month cycle with an expected duration of 12 to 16 weeks. I will hold judgement on this until we see the action in May. Secondly, it means that we are at the beginning of a longer rally similar to 2003 and 2005 than most expect. Both of these facts fit with the X wave interpretation supported by the surge in breadth.

The 7 year cycle terminus is also in June of 2010. It could be a bottom or a top, but it appears it will be a top based on this new analysis. So the form of this X wave should look somthing like this: rally into June/July, pullback into September/October, rally into December, pullback into January/February, rally into May/June. This is very rough, but should give you an idea of what to expect.

An X wave will be difficult for most to trade. Sentiment should swing wildly, but eventually reach an excessively bullish extreme. Being an upward correction, the bias should be to the long side. Short trades should generally be of the hit and run style shooting for 15% gains.

I will still be trading my systems as usual. What the above analysis does is give me a roadmap for allocation. Realizing that the rally could be longer than expected with an intervening b wave, means I will not be excessively allocated to the short side. It also means that I will not be taking profits prematurely based on the fear of another imminent collapse in the markets.

Finally, all of the above could be 100% wrong. If it is, I will adapt accordingly. If I see a reason to alter my viewpoint, I will inform you as soon as possible. However, your trades should be based on the price action and not any hypothesis about the future form the market takes.

Emergency Plan

Thanks for the supportive comments regarding my wife. I had to take her to the hospital emergency room last Saturday. She had a minor stroke. Currently, she has regained most of her function, but is still weak in her left leg, has reduced peripheral vision in her left eye, and occasionally has trouble finding the right word to say. I expect she will make a full recovery, although it will take several weeks to months.

Although this is a trading blog, I may take the opportunity to rant about doctors and the medical system at some point.

Do you have a trading plan for emergencies? My plan is simple. Do nothing. I have either sized positions so that I do not need a stop, or I have loss stops and trailing stops in place. Any action that I need to take can wait for a few days. Knowing this, I did not experience any anxiety over my account even though I was not able to review my positions on a daily basis until this past Thursday. I know that the markets will always be moving so I am not worried about missing out on profits. This is a business. I have other businesses, and during emergencies, it is OK to let things go until the worst is past, and then check in with your support system to keep things going until you are able to come back. I have found over the years, having had several difficult emergencies and crises, that basically everything is just fine. We tend to have an exaggerated sense of our individual importance, but the world just keeps going whether we are there or not. I just start where I left off, and rarely has it been a big problem.

All the best this coming week.