Saturday, February 12, 2011

Bottom In The TLT

Turns in the TLT have preceded turns in the stock market by a few days since the rally began in 2009 with a negative correlation.  We now have a setup for a bottom in the TLT with a completed thrust out of a descending bearish triangle, falling volume from the momentum low that occurred in November and rising momentum.  If past is prologue then a top in the stock market should be imminent if not coincident.  To confirm the turn we need to see the TLT close above the 12/15 low of 90.47.  Since we have a completed pattern, or at worst one more new high to complete a pattern, in the stock market, coupled with a possible bottom in the Dollar and the TLT, it is time for top in stocks.

In reviewing the commentary on various blogs, trading websites and the financial news media, the outlook for stocks crosses a spectrum from the extreme bear case to the extreme bull case.  The extreme bear case is well known and is a call for stocks to top now and begin a steep decline to multi-decade lows.  The extreme bull case is that we are cycle wave 5 up to new all time highs and currently we are in the early stages of primary wave 3 up in cycle wave 5.

The problem with both of these extremes is that they disregard a number of facts that contradict them.  With respect to the bull case, it is fairly clear from past history that secular bear markets have lasted at least 12 years if not 16 to 18 years.  If we are cycle wave 5 up, then this last secular bear market from 2000 to 2009 would be the shortest in history.  For the bear case, there are two problems.  First, we have exceeded retracement levels both in price and time that would have been expected for primary wave 2 up.  While 2nd waves can theoretically retrace up to 99% of the previous 1st wave, it really doesn't seem consistent with the fundamental arguments for primary wave 3 down for this to occur.  Secondly, longer term cycles point to the rally continuing well into 2012 or 2013, further reducing the likelihood that this is a 2nd wave.

Readers of this blog know that I have been calling this rally an x wave since 2009 with an expectation that we could retest or exceed the 2007 stock market highs.  Unfortunately, I have underappreciated the potential for this rally to continue without the typical retracements.  I fully expected that we would see a deeper and longer wave [B] or (B) from the April 2010 high.  The continuation of the rally in 2011 has eliminated the likelihood, though it is still possible, that the current rally is wave (B) or B of an expanded flat or running triangle.

I would caution you to be careful and not draw dangerous conclusions.  There are several possible outcomes still on the table.  The most bullish is that we are completing wave (1) of [C] up.  I don't like this option because of the "wedgy" character of the rally, but it is possible.  Thus, we could see a 38% to 62% retracement of the rally from 7/1/10 in wave (2) down with a 50% decline taking the Qs back to the April 2010 high.  We could also see an (X) or [X] wave of undetermined length as wave x morphs into a double zigzag.  There are others, but these two seem the most likely.  The difficulty is that an (X) wave often doesn't have any clear relation in time to the preceding waves.  It is more like a knot that binds the two parts of the larger correction together.  Wave (X) could last 4 weeks or all of 2011.

Regardless which outcome prevails, the time for heroic shorting is long past.  The action in leading stocks suggests that this rally will continue after a correction and money is to be made primarily from the long side.  That is not to say that shorting is out of the question, but it should be done from the view of a hit and run trade, not a trend trade.

Performing well in the current market environment has been and will be difficult for most traders, but we cannot ignore the larger trend.  For those who have missed out on the recent rally there is no reason for regret.  That will happen from time to time.  This cyclical bull market could continue for another 2 years.  This latest rally has only lasted 7 months, so no worries.  Trading is for a lifetime, not just a few months.

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