3 Day Weekend

The general tendency after a Friday selloff prior to a Monday holiday is an up day on Tuesday about 70% of the time. The first day of June is positive about 80% of the time. Together this means the probability of an up day on Tuesday, June 1, is about 94%.

Without respect to elliott wave analysis, overall the current market behavior resembles that of the summer of 2007 which had selloffs in February/March and July/August. This year we have had selloffs in January/February and April/May. Then, the SP500 exceeded the July high before the advent of the most recent bear market. I think we will see something similar this time around but without the same bear market, just yet. If you take a look at a weekly candle chart of the SP500 you will see the similarities in behavior.

In order for the pattern to hold, we need to see an up week for the first week of June followed by a couple of weeks of consolidation and then a multi-week run to retest the April highs. Let's see how the shortened week plays out.

Happy Memorial Day!

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.

Too Early For A Follow-Through

So far only the NDX has held above its 5/6 low and technically by IBDs rules we could consider a 1.7% rally today on higher volume a follow-through day. However, I don't think that would be a fair evaluation of the correction. The NDX is not lower than its 5/6 low only by virtue of the fact that it was harder hit intraday than the other indexes on 5/6. We should count the 5/25 low as the beginning point of a valid rally attempt, in my opinion, which would make today only day 2 of the rally attempt. Valid follow-through days cannot occur before day 4.

Another reason for caution is that many are considering the 5/6 "flash crash" day as a completed impulse from the 4/26 high, but looking at the daily charts the entire initial decline looks more like a 3 than a 5, which means we need at least one more decline and possibly two to complete a double zig zag correction.

One alternate view that deserves mention is that the entire move down from the 4/26 high is a 5 wave impulse. While not likely, the 5/13 high did not overlap the 4/28 low on any of the major indexes, so this is a possibility. If this does turn out to be the case, then we would expect the summer rally to hold under the 4/26 highs and have a 3 wave form. There will really be no way for us to know until well into the summer if this should be the case.

That said, I believe that this entire episode is a panic and not a crash. Markets always fully recover the losses of a panic. Crashes on the other hand take months and years to recover. We will most likely see an attempt at new rally highs this summer followed by a retest of the panic lows this fall into early December. If this panic has been severe enough to wash out the overly optimistic bulls, it may be that we do not have to see a significant decline this fall. Take a look at a chart of CME. It is possibly forming a very long triangle and in wave e now. If CME breaks out to the upside from the triangle this summer, it may be telling us that we are in wave [C] of x up already.

May 25 may mark the end of the correction, but it is premature to jump to that conclusion. We may need more downside testing to prove the bottom is in.

I am saying this for all of the bears out there that believe we are in primary wave 3 down. It is easy enough to say that we should trade without expectations, but we all have expectations and must ultimately take a position. I just don't think that conditions are right for the primary wave 3 wave count yet. In fact, as you may know, I don't even think that is the right count overall. Just be careful that you don't get fully loaded for bear only to find some long horns in your back side.

Working Lower

As I said in my mid-day post yesterday, we are likely headed for another correction low. I expect the SP500 to touch 1008, the 38.2% retracement level of the entire rally, intraday before the correction is over. However, nothing I am seeing at the moment is telling me that we are headed for a crash as so many are predicting. This selloff has been severe in its volatility but the SP500 is down only 12% on a closing basis which is not atypical for corrections. I believe that we will see the low for this correction by early next week if not this week.

I will be looking for a positive divergence with higher lows in the McClellan Oscillator to confirm that a bottom is in.

There are some notable exceptions in individual stocks and any near term rally may provide a good short term shorting opportunity, but vigilance against a violent rally will be required.

Anatomy Of A Trade - IAG

IAG was one of those rare trades that seemed like a layup. After a clear 3 wave decline, IAG formed a base that lasted about 10 weeks with a handle. My expectation was for a test of the previous high. Gold was heading for a retest of its previous high as well, so overall the trade appeared to be a high probability setup. My plan was to buy a breakout above the high of the handle, to exit 2/3 on the first signs of exhaustion and the rest near the previous high. In retrospect I could have probably held on for one more day, but everything is clear in retrospect. Overall, this was a respectable trade and I would definitely take another similar setup if I see it.

One More Retest Of The Today's Low

The intraday pattern is saying that we will see one more low either today or tomorrow to complete the decline from the 5/13 high, but a low is near.

Could The Crowd Be Right This Time?

Last night I showed a chart of the extreme pessimism in the market. This morning Mark Hulbert posted an article on Marketwatch which says that his survey of market timing newsletters, some 300 newsletters, are now 45% short - down from 80% long just 3 weeks ago. This is one of the biggest shifts in sentiment we have ever seen and not one normally associated with tops. It's hard to be a contrarian, but now is the time that contrarians stand up.

The intraday pattern appears to be a triangle. Triangles form before the final wave of a movement. The current down move appears also to be a 5th wave down from the 5/13 high, and although it could be severe, 5th waves are ending waves. We will look for divergences. Should today's low be the end of the move down from the April 26 high, the next likely movement would be a 3 wave upward correction in wave B or X up, which should retrace at least 50%, if not 62%, of the decline. This upward correction will likely take many weeks and be very choppy. A complete retest of the high would be the most bullish outcome, but we are far from that outcome at the moment.

In any case, a retest of the Feb 5 lows is in store for today it seems and possibly lower. Fib support for the Dow is around 9460 and the SP500 is around 1008. We need to find support above those levels or we may indeed be headed for a greater crash and the crowd may indeed by right. I've just never done well going with it, and I don't plan to change my behavior at this stage of the game.