Friday, May 28, 2010

Three Interpretations

As one reader pointed out, this week's low could be minor wave 1 down and we could now be in wave 2 up, but there are three valid interpretations of the wave structure. I have labelled them in different colors in the order of probability.

In my opinion, the most likely scenario is that we have completed a 3 wave [a], [b], [c] (cyan labels) decline from the 4/26 high. We will now likely embark on a long drawn out 3 wave advance that will be more complex and choppier. Ideally, the bulls would like to see a test of the April high or a new high which would mean we are in a flat correction which will end with a sharp 5 wave decline this fall to complete wave [X] down. This would lead to a renewed uptrend next year and possibly into 2012.

The next most likely scenario is that we have completed 5 waves down from the 4/26 high in wave A or 1 down (magenta labels). There is no way to know for sure, but I am leaning toward A simply because my larger cycle work is pointing to a continuation of the rally next year as stated above. So this would mean we have just finished the first leg of a zigzag, which could become more complex of course. Wave B or 2 up would follow a similar course to the first interpretation except that we will definitely not see a new high although we could see a deep retracement.

I think the least likely view is that we have completed waves 1, 2 and [i] down (yellow labels). This of course is a very bearish view which should lead to a very powerful selloff in June. While I am not dismissing this outcome, I continue to doubt that all of the talking heads on CNBC could be right on this call, and the overall tenor of blogs and advisory services is negative, though a few see the bullish possibilities. This interpretation can be ruled out if we exceed the 5/13 high, and probably even if we come close to it.

One interesting idea that I read this week was the possibility that the extreme nature of the May selloff might have been enough to satisfy the "4 year" cycle low due later this year as it did in 2006. If this is the case, we may find that the selling this fall is more muted than many are expecting.

Unfortunately though, we have several weeks of market action to get through before we can be certain which of the above paths we are on, but knowing that we can narrow it to three possibilites helps us to realize that this is not the time to be aggressively adding intermediate term long positions, but rather to be managing them into the summer high with a view of selling some or all when the time comes.

If we see the worst case scenario developing in June, there will be plenty of time to take on new short positions, but I will be passing on short signals for the next week while the current rally attempt plays out.

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