Friday, August 27, 2010

A Long Hard Summer For Traders

Trading B waves, particularly B wave triangles, is probably the hardest trading environment that one can be in. Although the critical levels mentioned in the earlier post today have not yet been hit, when we consider the end of the month positive bias, the upcoming labor day weekend and the fact that Mondays tend to be positive after a strong Friday close, it seems almost certain that they will be on Monday or Tuesday. This means that the decline from the August 9th high is a 3 wave movement with equal leg length. Thus, there are only two reasonable possibilities left for the expected rally that follows today's reversal: 1) either it exceeds the August 9th high or 2) it doesn't. In the former case, we will end up with a double zigzag upward correction from the July 1 low. In the latter case, we will end up with a triangle as shown above.

In my opinion the weight of the evidence points to a triangle as the final outcome for several reasons: 1) although some sentiment surveys have gotten bearish over the last two weeks, most sentiment measures including the equity only put/call ratio and the VIX remain neutral, 2) a number of cycle calculations point to an impending high from August 26th to September 8th, 3) breadth as measured by the NYSE Summation Index continues to fall, 4) the contracting triangle in the Qs has become fairly clear as a pattern with alternating 3 wave movements, and lastly 5) sentiment tends to become extreme near the end of [e] waves in triangles, which would be the perfect setup for the fall selloff. Neutral sentiment will probably not support a move above the August 9 high. There doesn't seem to be enough time to achieve a rally above the August 9 high. Without an expansion in breadth the rally will be weak. And it should be easy to push sentiment back to a bullish extreme from a neutral condition.

The chart above shows the 50, 200 and 400 demas. Note how well these provide support and resistance. A 61.8% retracement of the recent decline would take the Qs right back to resistance at the 50dema. The 400dema has been major support during the correction so far. A break of that level will certainly lead to greater selling intensity. Although it is not widely followed, I think the 400dema is the best barometer available for separating bull and bear markets. Oftentimes the 200dema will be tested and the 400dema will provide support during bull markets and vice versa for bear markets.

Should the above analysis prove to be correct, it will prove my assertion that the rally from March 2009 to April 2010 was only the first leg of the cyclical bull market, since the decline from April will be undisputably a 3 wave correction. Thus traders can be ready to profit from wave [Y] up to new cyclical bull market highs into late 2011 or early 2012. Note that wave [Y] up would likely be somewhere between 0.618 to 1.618 times wave [W] in length with [Y] = [W] being the most likely. The one fly in the ointment is that we cannot be sure that wave [X] will not extend into an even more complex correction before wave [Y] begins. Even so, a number of larger cyclical factors point to it beginning this fall.

Not all of the stock market indexes are displaying the same pattern, but the fact that this one does is enough to tip the market's hand going forward. When we see bearish sentiment at an extreme with the selloff in wave C down, we will know it is time to get aggressively long.

I must mention in closing that if markets fail to rally next week, then much of the above would be wrong, but I don't think it is. Also, sometimes we may not trade a market well early in the pattern as its form is too uncertain. However, as we approach the end of the pattern and the form becomes clear, we can trade with greater confidence. The rally from the March 09 low is an upward correction in an ongoing secular bear market. This, in and of itself, means that it would most likely be difficult to trade at times as has proven to be the case, but as we approach the possible confirmation of wave [X] down, the clarity that has been achieved should allow to us to trade with confidence in wave [Y] up.

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