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.

An Imperfect Wave Count

I was truly surprised that we did not see new intraday highs today for the major indexes given the positive reaction to AMZN and MSFT. The fact that it didn't happen probably tells us more than if it had. The above chart shows the most bearish wave count for the Qs - i, ii, (i), (ii), i, ii.

I have never found more than 3 nested 1s and 2s to be valid so either we see a significant decline after a weak rally Monday morning or something else is going on. Wave (ii) above breaks the rule that a second wave cannot retrace more than 100% of a first wave. However, for the Dow and SP500 wave (ii) did not exceed the wave (i) high, which leads me to believe the above count may be correct. If we look at the above chart as a line chart instead of a bar chart, it does not break elliott's rules even at the 2 minute time frame. I am not saying that it is absolutely correct. I am not sure, but I do know that Steve Hochberg with EWI has successfully used such an approach to clarify intraday charts before.

The point is that selling should ensue fairly quickly Monday or we should probably expect that the rally will continue to new highs as the count devolves to a series of alternating 3 wave movements if the above count is not correct.

Supporting this bearish view is the fact that the SMH, IWM and Dow transports all had a very weak day, and we added another distribution day to the count for all but the SP500. How many distribution days can we rack up before the markets give way?

Regardless, 1121.59 remains the key level for the SP500.

New Rally Highs Imminent

The positive earnings news from AMZN and MSFT are outweighing the negative news from BRCM. The Qs have exceeded the limit for a second wave retracement in the pre-market, but even though this muddies up the subdivisions of the elliott wave count somewhat, it doesn't change the big picture unless and until the SP500 exceeds 1121.59.

In another development gold appears to be heading into a 5th wave in its move off of the August 17 low. It seems that stocks and gold will be topping at about the same time. The question arises as to whether profits should be taken in gold. This depends on each trader's goals, plan and situation. I personally believe that gold will be going higher after a pullback, so I am willing to remain long at this point. The risk in gold is still to the upside and I don't want to be on the sidelines and wake up to a 50 point surge.

I will continue to remain long 1/2 positions in the QID, TWM and SSG as long as markets remain below critical levels.

Breadth Deteriorating

My weekly proprietary breadth indicator fell again. It has fallen 4 weeks in a row for the Nasdaq 100 and the SMH. Even as the Dow was straining to make a new high today, NYSE new highs fell to 134 from over 400 a week ago. The distribution count as measured by IBD continues to grow with the SP500 at 8 distribution days. When the indexes are rising but breadth in various measures is declining we can be reasonably sure that large investors are selling into strength. Sure we would all like to have skin in the game when Amazon pops 14 points after hours, but over the long haul, we will earn some multiple of what individual stocks are doing in the aggregate, so as exciting as catching a big winner like that can be, it is better to be positioned with the direction of the broader market.

One activity that I like to do about once a month is make a quick tally of where the stocks in the Dow are in their elliott wave counts to see if the overall prospects are bullish or bearish while I compare that against the count of the index itself. Oftentimes these will not be in sync, which will let me know that I need to take a fresh look at my index count. At the moment though, things have reached an interesting stage. By my count, at least 8 Dow stocks have completed, or nearly so, a 5 wave count at the intermediate time frame, while another 4 have completed, or nearly, so bearish patterns. For example, WMT and MCD appear to have completed bearish triangles. IBM and MMM look to have completed 5 waves up, although IBM is not entirely clear. IBM, in particular, is a whopping 9.18% of the index and 8 of the 12 are in the top 15 of index weightings.

It has been my experience that when the patterns in the individual stocks are lining up with the pattern in the index, a move of significance is probably at hand. The Dow looks as though it could still make a new high over the next few days, but this is generally not a good sign when it is doing it alone as may be the case.

Mixed Action After Hours

BRCM is down big after hours while AMZN is up big. Overall though I think a falling semiconductor index will pull down the Nasdaq 100 at some point, so the balance still seems to be tipping toward the notion that the correction is already underway. Looking at AMZN's chart, it appears that AMZN is in wave (iii) of iii of 5, so it should hold up until the end of the month. Nevertheless, tomorrow's action should definitely tell us the direction of the near term trend.

A Run On The Bears

Did everyone who went short yesterday change their minds today? You might have thought so given the sharp rally, but one thing to keep in mind before exiting any new short positions just yet is that second waves often are deep retracements. Today's rally may have been a deep smaller degree second wave. If so, there are key levels that should hold near term. For the Qs 43.68, for the SP500 1098.89 and for the Dow 10119.17. The Dow in particularly is notorious for deep retracements.

If this is the case, then we should see selling fairly soon tomorrow morning as a small degree third wave kicks in. If these levels are taken out, and in particular, if the October 19 highs are taken out, then we can expect a move to the higher targets to complete wave c of 5. If the SP500 takes out 1121.59 on volume, I will exit index short positions and wait for a new entry point.

A Rally Top?

The Qs came within 0.10 of the target cited in yesterday's post before 11am this morning on a very low volume run rate. Around 2pm a lower top began to form. Having come so close to the target with a potentially completed pattern and volume running lower than at the 9/23 and 10/14 highs within two days of the next potential turn date, I decided to open a 1/2 position in the QID around 2:30pm. In the last hour of trading things began to deteriorate and the Qs closed below the 9/23 high on increasing volume.

Before the closing bell, Maria Bartiromo was searching for a reason for the selloff. The final conclusion was that a downgrade of Wells Fargo was the reason. The real reason: when a bullish pattern reaches it's completion concurrent with increasing sentiment against a negative cycle period, the market will sell off regardless of fundamentals.

We can't be 100% certain that today was the top of primary wave W, but the probability is pretty high. I will be looking for confirmation over the next few days and an opportunity to increase my positions in the QID and SSG as well as add on with the TWM. Several potential sell signals will do - another MACD sell, IBD calling the market in correction, 5 waves down from today's high with a proper fractal sell pivot, a break of the October low - take your pick.

The minimum objective for this correction is the August low and the 200dema. I expect a rally off of the 200dema back to the 50dema followed by a retest of the first low or a move to the July low. The correction should be complete by early December. At that point we can re-evaluate the potential for the continuation of this cyclical bull market in primary wave Y of cycle wave x into a top sometime in 2010.

I am also short BRCM and MON. There are a few other shorts setting up in individual stocks but not many. Perhaps in a few days things will change.

Closing In On The Target

I believe that the Qs (and the rest of the broader markets) may be in the very last subdivisions of the rally (wave W circled of the rally). It appears that the Qs completed wave a' of c of 5 of (C) this morning on the open. Since that time we have a 3 wave pullback which is probably wave b' of c. A measured move target for c' of c is 43.92 with a target range of 43.69 to 44.53. There is some chance that this morning's high was the end of wave c but another high would be a better fit. Coming under 42.48 would be a strong warning that the rally is over. Of course wave b' could extend or form a triangle, etc, but we should see the final high by Friday.

Overthrow In The Making

With the positive earnings news out of Apple and Texas Instruments this evening, it is beginning to become a foregone conclusion that markets will test the upper limits of the ending diagonal triangle formations. For the Qs the upper limit for the current wave count is 45.43 with the likely target range between 44.07 and 45.05. For the SP500 the upper limit for the current wave count is 1121.59 with the likely target range between 1103.49 and 1121.59.

If the upper limits are exceeded then the next best count would be that we are in wave c of 3 with waves 4 and 5 of (C) yet to come. If we were to see an explosion in volume and breadth over the rest of this week, with ending diagonal limits exceeded, then we might be drawn to the conclusion that the markets are in wave iii of 3 of (3) or (C), a very bullish outcome indeed, though not likely at this point.

I think a wait and see attitude is best at this point with the following exception: an exhaustion gap or large range day that fails to break above the upper limits of the current wave count would be an excellent low risk shorting opportunity. If it occurs, I intend to take it using the QID and the TWM. Stops should be placed just above the upper limits around 45.60 and 1125 (and equivalents for the traded ETFs). I want to give it just a little room in case I've made a calculation error. Of course, everyone should verify these numbers for themselves before taking a trade.

The giddiness that is developing is almost palpable, but take a moment and remember the palpable fear back in March of this year, and then think about what the most appropriate response is to the current market conditions.

Breadth Fading

The ratio adjusted summation index for the NYSE has fallen below its trendline from the March low indicating that breadth momentum is fading. This confirms my own indicator which is showing a negative divergence. This does not mean that the rally cannot continue, but one analyst has labelled this occurence as the "canary in the coal mine", meaning that the rally is losing steam even if it manages to make a new high.

At the moment, we cannot be sure this week's high marks the completion of wave (C) or whether it is just wave a of 5 of (C). Whether it is the high or not the next rally should be sold. Only long term or core positions should be held through the upcoming correction. Short term and intermediate term positions should be sold, in my opinion, on any strength.

For intermediate term traders, a break of the October low or a new sell pivot below the 61.8% retracement of the October up move will confirm the top. For short term traders, a new MACD sell signal, break of the 9/23 low, or new sell pivot may be used to open short positions. We are not quite there yet, but may be by the middle to end of next week.

I am looking for gold and oil to continue higher with occasional pullbacks until later in the year. If conditions change I will do my best to warn you.

One View Of Oil

My view on oil is that it just completed a (B) wave and we are now in wave (C) up. The measured move target is 108.85. A sharp wave 2 pullback or sideways consolidation is due very soon, so some drawdown will have be tolerated, but as long as the 10/5 low of 68.32 remains intact, the trend should be up. Also, be aware that 5th waves and C waves in commodities often extend, so oil could move well above the target. I wonder if this may be the catalyst that gets the correction going in the stock indexes even as the dollar continues its downward slide?

Double Top Setup

While Intel closed higher today, it closed at its lows for the day, which is hardly a ringing endorsement after the earnings report. Intel is now overvalued on the daily and weekly charts and fairly valued on the monthly charts. One would expect some profit taking and consolidation at this point. The SMH has completed a 5 wave move up from its October low, which is also signalling that at the least a breather is coming if not a correction.

Even though the Dow got all of the attention today by hitting the magic 10,000 level, the action in the Qs was the real story. Notice in the chart above how the volume today was 1/3 less than at the 9/23 high as the Qs tried to breakout, but failed to close above the 9/23 high. This looks like a textbook double top. Only a continuation on higher volume will change that. My preferred entry technique is to go short on a sustained move below the lower of the low of the previous high or of the breakout day. In this case, that is 42.38, but yesterday's low is 42.37, so that is a possible short entry point. The first target is the October low at 40.72. The second target is 39.30.

For those following the MACD negative divergence sell signal, today's positive MACD cross need not be a signal to exit short positions. Gerald Appel points out that as long as the MACD itself does not move above its previous high, the position is still valid even if price moves higher. Of course position risk limits still apply, but the idea is that as long as the MACD does not surpass its previous high, the market is just setting up another possible negative divergence.

I have also highlighted the first five days of the last 3 months. For those who are interested, it may be worth developing a trading system around the opening five day range, as the probability of hitting the 61.8% extension above or below the range is quite high. I don't have exact figures, but it is probably in the range of 75% to 83%, well worth the effort of testing it.

Watching The Volume

I will be watching from the sidelines this morning. In fact I won't be watching at all until after my 11:15am appointment, but that's ok. When I get back in I want to see the volume run rate at noon. When (I do think it's when and not if) the Qs make a new rally high today I want to see whether the volume run rate is projecting higher or lower volume than the 9/23 top. For the Qs it would take about 72 mil at noon to equal the 9/23 volume. Then, does the market hold the new high or reverse and turn lower on higher or lower volume?

A new high with a reversal on significantly higher or lower volume and close below the 9/23 high would be a potential short signal, but we must be aware of the fact that this could just be wave a of 5. Also, INTC has clear resistance at 22 at its upper channel line, so this could be it for INTC for a while.

I will consider legging into some short positions. As you know I am already 1/2 short the SMH by the SSG, a bit prematurely, but I will be looking to build some short index positions in anticipation for a correction to the 200demas for the indexes in November. No need to get heavily short this market though, and I am maintaining my core long positions.

INTC Beats But Will It Follow-Through

With Intel up almost 5% after hours, the question that comes to mind is whether it is a breakout or chance to sell? I really don't know the answer to that question, but the elliott wave analysis I presented on Sunday would suggest that it is a chance to sell into strength. This is certainly not an analogous time to 2000, but I do remember vividly when stocks were beating the estimates handily in the spring and summer of 2000 only to be sold hard, so just because a stock beats the street doesn't make it a buy.

When I was talking about the possibility of some dramatic reversals this week, I was specifically referring to individual stocks, and this is the type of setup that I was referring to. Here we are, potentially at or near an intermediate term market top with a large cap stock that has rallied 80% off of its November 08 low that is gapping up into fibonacci resistance (61.8% of 07 to 09 decline). My personal opinion is that if I owned Intel, I would be looking to take at least partial profits here.

Let's see how the market reacts to JPM in the morning too, and of course, there is AMD, IBM and GE among others this week. All I can say is that I am not chasing these guys right now.

Thanks CSCO!

Just sold STAR for a nice 30% gain after buying the breakout from a textbook cup and handle in September. CSCO is buying STAR for $35 per share. Of course, I had a doctor's appointment this morning and didn't see the news until 1pm, by which time the price had fallen to 33.90, but I'm not complaining. They don't all work out so well, but by keeping losses small, we only need a few of these to net solid profits.

Follow-up On Today's Elliott Wave Post

One point came to mind after I made my earlier post. It is possible that markets will just continue higher next week to new rally highs with only a modest 1 or 2 day pullback in between. In that case, traders will need to be on guard for an earlier end to the rally. In fact, if the rally continues to new highs while volume continues to decline, it would be an indication that wave 5 is coming to conclusion.

While looking through a number of stock charts this afternoon, there are a fair number of bullish setups. It has been my experience that the largest number of bullish looking chart setups occurs at or near market tops. (Note: this may be a bear market phenomenon. Most of my trading experience has been during the secular bear market that began in 2000.) Why that is is a mystery to me, but it seems to trap a lot of traders. There is a tendency to want to trade these setups, increasing long exposure, at just the time that markets are ready to turn lower. So again, caution is advised.

An Elliott Wave Resolution?

(click to enlarge)

The above two charts represent my current working elliott wave count for the rally. I have played somewhat fast and loose with the nomenclature in the past few weeks, but I have attempted to reconcile the labelling with Frost and Prechter's scheme from the "Elliott Wave Principle" (EWP) in these charts.

Arriving at a satisfactory count has been frustrating, to say the least. Several less than ideal factors have hindered the interpretation: 1) the April/May up move is not a text book impulse wave, although it appears to be impulsive, 2) the Qs made a higher low in July, while the SP500 did not, 3) the July/August upmove appears to be impulsive, but may not be, and 4) the market action since August has resulted in overlapping waves that subdivide into 3 waves.

Whenever we encounter these types of problems, it often pays to step back and look at the big picture and other information. My preferred count for this bear market is that we are in Supercycle wave (IV) and cycle wave x to be followed by cycle wave y. Cycle wave w completed in March 2009 (red w above). X waves are almost always 3 waves and usually zigzags. Given the size of wave w (9 years), we would expect wave x to be longer than just 6 months. My analysis of stock market cycles, and independent analysis by others, supports the view that the current rally will persist into the summer or fall of 2010. Therefore, we can expect that wave x will be a double zigzag. A double zigzag is composed of two abc zigzags that each have a 5-3-5 wave count. If we consider that the current zigzag is nearing completion, and if we require a 5-3-5 wave count, the only reasonable count that fits both the Qs and the SP500 is as shown above with intermediate wave (C) being an ending diagonal triangle that is yet incomplete.

While it may be possible to arrive at a much more bullish wave count by supposing that the move up from July is a still developing impulse wave that will lead to a huge 3rd wave breakout in the next few weeks, the waning breadth (as I measure by my own weekly breadth indicator) and the current position within the 10 month cycle do not support this view, which leaves us with the ending diagonal triangle (EDT).

From this interpretation, it is clear that the markets will make a new rally high in October after an intervening pullback. For an ending diagonal to be valid, wave 3 cannot be the shortest wave, and in this case that means wave 5 cannot be longer than wave 3. Therefore, as long as the SP500 remains under 1121.59, the wave count will be valid. For the Qs, the upper limit is 45.43.

While these are the upper limits, in all likelihood, these levels will not be seen. Often times, wave 5 for an EDT is 61.8% of wave 3. This gives us targets of 1082.76 and 43.63, respectively for the SP500 and the Qs. Amazingly, 43.63 is the upper target that I calculated weeks ago using trading steps, or boxes. A move above the upper trendline of the EDTs for both markets would put them between these levels. On that basis, we can project the highs for the SP500 to be somewhere between 1080.15 and 1121.59, and for the Qs to be somewhere between 43.17 and 45.43. Given the fact that we will probably see a pullback followed by another rally high, the high will most likely occur sometime toward the end of October and the first of November.

The one fact that follows from the above analysis is that the ensuing correction will be sharp and deep. From EWP pg. 38 we read, "A rising ending diagonal is usually followed by a sharp decline retracing at least back to the level where it began and typically much further." My experience has shown this to be correct on several occasions. Only once do I remember a stock with an EDT falling short of the origin. It has also been my experience that the time of the correction typically lasts about 1/3 the time of the EDT. So we should be prepared for a correction back to the July lows that lasts about 6 weeks. Which also amazingly would put the end of the correction at my projected end dates for the 10 month cycle of December 9-11 to December 24.

We are talking about a correction on the order of 20% or more. So October is the time to be exiting long positions in preparation for the impending down move. A reversal from a new high would be an opportunity to get short, and a break of the rally trendline would be an opportunity to add to short positions.

We can now also make a preliminary projection for the x wave targets based on a measured move. Using the 43.63 and 1082.76 levels above and the July lows, we arrive at target of 52.30 and 1285.29, respectively, a nice 50% gain for wave (Y) of x.

I am sure that the above analysis may not agree with everyone, but until something different develops, this will be my working count for the duration.

The River Of Value

The best way in my view to begin to understand how the market behaves is to visualize it as a river - a river of value. The center of the river is the 50dema - the concensus opinion of value. The banks of the river can be represented by two envelopes of plus and minus 2.5 to 3.o ATRs (10 period). Flood stage can be represented by two envelopes of plus and minus 5 ATRs (10 period). The above chart shows this representation on the daily time frame.

I have placed arrows at points of value extreme. The red down arrows in 2007 were followed by periods of rapid selling. The gray and green arrows appear at periods of selling climax and trend reversal. The yellow arrows mark points of correction or pullbacks. The horizontal cyan trendlines mark points of trend confirmation.

There is a tendency of those in the trend following camp to focus solely on mechanical entries and exits, but I think this leads to an inability to appreciate how the market moves from being extremely undervalued to extremely overvalued. The period of September and October 2008 show how the trend can carry the market along at an extreme for an extended period of time, which is why we wait for confirmation of turns before initiating new positions in the opposite direciton. However, that doesn't mean that we can't recognize the extreme for profit taking. Waiting for confirmation of the turn may require that we give back a great deal of our profits. By taking partial profits at value extremes, we can reduce drawdowns and maximize gains.

We are now coming off the second trip to the upper red envelope. The trend is up, but this has been a good time to be taking profits as the likelihood of a pullback or correction is high. How it plays out, whether as a period of sideways consolidation or a sharp correction down to the trendline and lower extreme is yet to be seen, and since the trend is up, there should probably be some long exposure while preparing for short term shorting opportunities.

Rally Is Suspect

The Qs reversed from resistance at the median line of the advance from the July low on clearly falling volume and with a bearish hook in the MACD. It is beginning to look as if this is an x wave with wave y of a double zz yet to come which should take the Qs down to 40+/-. If this is the case, then wave B of X is underway now. The conclusion of wave y may only be the first leg of a more complex correction that should extend into the late November to early December time frame.

If wave B is not yet underway, a higher rally high may be expected by the end of October, but the pattern in the transports does not support that view. It may be worth considering buying protection at this level, or reducing net long exposure, or initiating partial index short positions or a combination of the above. We are entering the time window of potential turn dates. There are a number of turn dates coming up, so wild swings may in the cards. Only a solid advance (1.7% or more) on rising volume would alter this potential.

Is The Transportation Index Warning?

A potential 5 wave impulse down in the transportation index may be warning us about coming weakness in the broader indexes. The internal subdivisions of the wave 2 flat above are not perfect, but close enough that I think it is a good interpretation. If the current rally is a second wave, we may be only 1 to 2 days away from another move down.

Some Weakness Today - Key Levels

The bulls will be defending key support levels. Breach of these levels may lead to an acceleration of the correction. The MACD sell signal from 9/24-25 is still in force.

For the Qs, we have:

3 week low (also last week's low): 40.72
3 week net line sell signal: 40.46
August high: 40.18
50.0% retracement from 07 high: 40.06
September low: 39.02

For the SP500, we have:

August high: 1039.47
3 week low (also last week's low): 1019.95
3 week net line sell signal: 1018.67
38.2% retracement from 07 high: 1014.14
September low: 991.97

Gold Breaks Out Again

Gold and stocks moved up together today and gold moved to new all time highs. The trend in gold is clearly up, but I do expect the move will be volatile in similar fashion to the move from October 08 to February 09, which means sharp pullbacks will keep the bulls on their toes.

The question before us now is what next with stocks? The one thing that is clear at the moment is that the move up from the October 2nd low in the Qs is not impulsive, and it does not appear to be impulsive for the Dow and SP500 either. If this is correct then lower prices are to be expected, whether soon or a few days from now.

Based on the comments, it appears that we have alot of work to do to reconcile the wave counts. Looking over the stock indexes, I realized that much of the confusion on my part is that I tend to concentrate my efforts on the Qs. Unfortunately, the rally in the other indexes does not match up with the Qs in that the Qs made a higher low in July, while the SP500 and Dow did not, which makes the analysis difficult. They don't have to be completely aligned, however.

I think the point to always keep in mind is that we have many tools that we can use other than elliott wave to help keep us on the right side of the trend. In particular, our main tool is price itself. So far, other than a negative divergence MACD sell signal, there is little that would compel us to short this market at the moment. Therefore, the real question is how long do we want to be right now?

As I have been recommending since late August, I have been lightening up on long positions going into October. (I don't want to be the last one standing when the music stops.) And if everything goes to plan, I will be out of all longs save my core positions by mid to late October.

We may see another new high for the rally this month. Depending on how it behaves then, it may be an opportunity for shorting this market, but the difficulty will be that the impending correction will most likely not be impulsive, and therefore will be difficult to trade. Smaller size and wider stops will help.

I would like to take moment to emphasize a point that perhaps has gotten lost since March. Over and over again back in March, April and May I stated that the risk in this market is to the upside. Since March we have had a historic rally, and now the bears are out in force again. Most of the ones I read are saying that this is it for the rally, and we are going to new lows in Q1 of 2010. I cannot disagree more. Nothing in my work supports this view. In fact I am still looking for higher highs in 2010 regardless of the wave count. The technicals and cycles, quite apart from elliott wave, support a continuation of the rally into the summer, and perhaps fall of 2010. The upcoming correction will be just that - a correction, which is not ideal for shorting. Again I repeat, the risk is to the upside, but I am expecting an opportunity to re-enter at better prices.

Of course, I could be all wet, but that is where price comes in. It will tell us what to do, just like it did with gold. I was wrong on the short side of gold, but now I am long - not wrong. If the market wants to break down to new lows, we'll know soon enough, but we are nowhere near that point yet.

Breadth Sell Signal and McClellan Oscillator

My proprietary weekly breadth indicator gave a negative divergence sell signal as of Thursday 10/1/09. This is only the second time since I started calculating this indicator in July 2006 that it has given a negative divergence sell signal. The last time was just before the July 2007 top. The signal then was about 4 weeks early, but it definitely provided a warning. I think it is warning us again. We may see a new high for the rally, but it will probably be an opportunity to sell.

The traditional McClellan Oscillator in the above chart also gave an interesting signal on Friday. From the September 23 high to the October 2 low, the oscillator has swung from a new high for the rally to a new low for the rally (discounting the initial surge off of the March low). This type of swing can be an indication of the initiation of a new downtrend, as it means the selling pressure is the greatest that it has been since the rally began.

At the moment the rally could be labelled as a 3 wave abc pullback, but that could change next week. Near term, the turn dates are 10/7, 10/9, 10/14, 10/23. I am looking for a bottom on the 10/7 or 10/9 dates and a top either on 10/14 or 10/23. Allow a window of 2 days either way for these dates. Do not trade these dates. Wait for confirmation of a turn.

August Highs Penetrated

What an ugly day. The August highs were penetrated by the major indexes putting the markets on a weaker footing with respect to the expected October rally to complete the first leg of the move from the March lows. We will have to watch it carefully over the next few days to see if the trend is reversing in earnest. The September lows are key as they represent the low of the high month for most indexes. We will also be looking for an impulse wave down that would initiate a trend change.

The semiconductor index has already breached the September low and was down almost 5% today - not a good sign for technology. I am long the SSG from 24.00. If your not yet short the semi's, it's a little late near term, but there will most likely be a rally for a second chance. I will wait to short the Qs and the IWM after we see how this current decline plays out. The indexes are approaching an oversold condition with the McClellan Oscillator at (-189), and the 5 day stochastic under 5 for most indexes. In my opinion, an opening gap down tomorrow, should it occur, would not be a good time to initiate short positions, as a near term bounce is likely. There is support for the SP500 between 1009 and 1018 as well.

Yesterday I sold a number of positions near the open including JPM (+170%), UAUA (+110%) and UWM (+22.2%), UYG (+50%). I will try to go over these trades in the next couple of weeks. I am still long a few positions, and it's not all good, but I will be looking for opportunities to exit most of my remaining longs over the next two weeks.