Friday, July 2, 2010

What's The Worst Case Scenario?

According to Elliott Wave International and Robert Prechter we have just finished minute wave [i] down from the June 21 high, and we are now in minute wave [ii] up. Minor wave 1 down ended on 5/25 and minor wave 2 up ended on June 21. If this interpretation is correct, then a powerful minute wave [iii] down should begin sometime in July. Wave [i] was 972.27 points for the Dow. The typical minimum length for a 3rd wave is 1.618 x wave 1, but oftentimes is 2.618 x 1, so we can estimate the length of wave [iii] down as 1573.13 to 2545.40 points. Assuming a 0.618 retracement of wave [i] down, we can calculate downside targets for the Dow at 8649.62 and 7,677.35 for wave [iii]. Based on this we can see that if Prechter is right intermediate wave (1) down should end around the March 2009 lows and should do so sometime this fall.

At this point the probability that Prechter and EWI are right is rising, but we cannot know for sure until we see a 3 wave rally that fails to clear the June 21 high and a subsequent break of the minute wave [i] low. Even then there are other possible outcomes. A 61.8% retracement of the rally from the March 09 lows is certainly one. This could terminate as a large 3 wave zigzag. If Prechter is right then this will be the most telegraphed selloff in the history of the stock market. Even Standard & Poors is lowering its estimate and calling for a correction this fall. Almost everyone is on the correction bandwagon. Does that make sense? During the decline from 2000 to 2002, there were very few who called for the market to selloff. Most were busy calling bottoms. Few were calling for a selloff in August and September of 2008. Not until the market crashed were there calls for lower lows. Now all we've had is a significant panic selloff and the consensus is that the market is going much lower. I don't know, but I am having a hard time jumping on that train. If the intermediate signals line up in late July or August I will go with it regardless of what I think or feel.

The question then is what to do at the moment. Barring a substantial change in market character we should expect more selling this fall, so the prudent thing to do is to raise cash on rallies. I think it may be premature to go short as we will likely see some sort of rally over the next few weeks. While intermediate systems have gone short, better entries may be possible later this summer. Another failed follow-through day would be a great short entry as well as a MACD sell signal from a lower high.

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