Saturday, August 21, 2010

Alternate Interpretations

All along since the March 2009 low, I have been working under the view that the cyclical bull market we are currently in would be longer and carry higher than most analysts and technicians expected. I still hold this view as I think the current correction is not the resumption of the secular bear market, but rather a separation between the two bullish legs of the cyclical bull.

Unfortunately, the wild swings and extended duration of the correction is the kind of action that is the worst for trend following traders. Some will argue that traders should change styles to adapt to changing market conditions. To some extent this may be possible, but in general it is a bad idea. It presumes that one knows the outcome in advance and when to change back to the preferred style. There is likely to be just as much damage due to missed or late entries due to changing one's approach to the market as there is to just taking the lumps with a few whipsaws.

Nevertheless, I try to temper my position sizing based on the most likely interpretation of the market action. During the current rally, I have been only 50% long index positions since there have been multiple interpretations to explain the market action. While I have concentrated on the most bullish, which is the double zigzag upward correction, other possibilities have been in the back of my mind. At this point, the other possibilities must be taken into consideration.

Originally, I was looking for markets to trace a flat correction with wave B up retracing a large portion of the April to July decline. The action this week does not entirely negate that possibility, but it certainly puts a huge dent in it. The fact is that Monday's low should not have been violated, nor should the lower wave B channel line have been violated. They were and now we should assume that the "strong" case is in jeopardy.

Although I show that it is still possible for the SP500 to get back above 1140 in the chart below, the likelihood now is remote. If wave B does work out to be a double zigzag, wave [x] may be deeper with just a retest of the August 9 high before wave C down begins.

The "weak" case is that the SP500 is tracing out a simple, but deep, zigzag as shown below. In this view, the market should continue its decline next week after a brief bounce with downside acceleration as we go into September. The recent rally from the July 1 low was just wave (c) with an ending diagonal triangle to complete wave B up.

Lastly, I am showing the "middle" case with the Qs as a B wave triangle. This is probable the worst case for traders as at least two more reversals can be expected before wave C down gets underway. If this turns out the be correct, we should look for hesitation with strong negative sentiment at the lower trendline, which would be an opportunity to take profits on shorts with the view of waiting for wave (e) before taking new short entries.

At the moment, I think the long side is basically dead. I will be looking to short this market until I see strong evidence that contradicts the above outcomes. At some point this fall, we should see the completion of the current correction and another multi-month upleg. I would only change my view on this if we see a clear distinct 5 wave impulse lower from the April 2010 highs. At the moment, such an impulse does not appear to be developing, although it is still possible.

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