Monday, April 28, 2014

Update to US Equities and US Bonds: The Big Picture Implications Behind the Market's Current Inflection Point

Elliott Wave Theory is based on the concept that markets are not random, but instead follow patterns that are fractal in nature. Markets often seem to move in a structured way, and those patterns replicate themselves across all time frames.  There are times when patterns stand out on the larger time frames, and the market thus broadcasts its intentions for the weeks or months to come; one recent example of this comes from the update of March 31, when I noted that the pattern suggested the market would break out in a head-fake rally, and then whipsaw.  Other times, the larger patterns are a bit more veiled and only the near-term patterns stand out (such as last Wednesday).

Since the market is of a fractal nature, we can anticipate what it's going to do if we can identify the fractal that's forming.  At times we can do that, but ultimately, it's a probability game, and none of us can identify every single fractal in advance.  Which means there's potential danger in overstepping our bounds at the moments when things aren't clear.

Many years ago, when I first started trading, I followed a subscription service that was almost always "quite certain" of what the market would do next.  They rarely offered alternate possibilities to their subscribers, and things were generally discussed in the cut-and-dried tone of "here's what the market's going to do next, and here's why we're perfectly sure of it."  Yet despite their very certain-sounding approach, they were frequently wrong.  By a huge margin.  I've come to believe that some analysts take the "sure-sounding" approach not because they're actually sure, but because it impresses people.

After all, if you're going to pull in new subscribers for your market newsletter, you'd better at least sound like you have a handle on things -- right?  As humans, this is often how we choose people, and this approach works for certain physical things, because most macro physical things are not probabilistic (it isn't until we get down to the quantum level that we encounter probabilities).  Since we exist in a physical world, we become conditioned toward thinking of things as concrete.  For example, a car either "is" or it "isn't."  So we expect concrete statements from people, and we take our car to the mechanic who sounds like he knows what he's doing.  Then later, we gladly pay the $495 he charged us to "rebuild the solenoid linkage distributor," plus the $186 for a "brand new starter belt."  The problem is, the market doesn't work that way (neither does your car, incidentally -- but your mechanic might!). 

Personally, I'd rather try to help people protect and expand their capital than impress them with tough-sounding talk.  Which is one reason why (largely as a result of my early trading experiences) I almost never ignore alternate possibilities in these updates.  Granted, there have been a rare few occasions when the future seemed so clear that I did ignore alternate potentials -- but I think my public track record on those occasions is pretty close to 100%, so my judgment there isn't too terrible.

Anyway, since the market is fractal in nature, we try to anticipate the future based on the expected form of the completed fractal.  And, obviously, when we don't know what fractal the market is trying to form, we have nothing to base anticipation upon.  At those times, I watch the zones that I call "inflection points."  This term is probably best explained with an example:  If the market forms one five-wave decline in the course of a session, I now know that probability suggests another five-wave decline will form and take the market to new lows.

Two five-wave declines makes a corrective ABC fractal, while three five-wave declines makes an impulse wave.  So, the first five-wave decline tells me to expect at least one more -- but what I may or may not know yet is whether to expect two more declines.  Thus once the market has competed two five-wave declines, that represents an inflection point.  If the market only wanted to form a corrective ABC, then it will bottom after that second five-wave move is complete.  Sometimes we know the market is intending an ABC based on the larger fractal, and sometimes we know it's intending to form an impulsive decline.  But when the larger fractal is unclear (or low probability), then inflection points should be treated with additional respect.

Presently, I feel the larger fractal is a bit unclear.  I know lots of folks are "quite certain" they know what it is, and undoubtedly some of those folks will end up being right.  Personally, I intend to take this market one session at a time for the moment.

I don't always know how the market will react to an inflection point, but I'm generally reasonably accurate in identifying those points.  So, all that to say:  Until the bigger picture clarifies more, I'll continue to note the near-term inflection points (those places where turns become higher-probability), but until something jumps out at me, I'll leave it up to the reader as to what to do with that information.  If one is bullish, then one could wait for declines to reach inflection points before going long; and if one is bearish, one can wait for rallies to reach inflection points before going short.

I discussed all this at length because the market has reached its next inflection point.  Below is the chart of the NYSE Composite (NYA) which illustrates this very well:

In prior updates, I've discussed the bond market and how I feel that the long bond is going to rally further over the intermediate term -- and that makes me wonder if there is trouble on the horizon for equities.  Ultimately, though, I do have to respect that the equities market is not inseparably linked from the bond market -- and, even if it were, I could always be wrong about the long bond.  The chart below is the US 30-year Treasury Bond (USB):

SPX has reached an inflection point similar to NYA.  1884 SPX looked like a "no-brainer" short to me, which is why I was near-term bearish last week; however, the risk/reward equation is different at today's prices -- and if one is inclined to take long positions, then this inflection zone is a place to consider that.

In conclusion, if the market was trying to form an ABC decline, then odds are reasonable that it's complete (or nearly so), which would mean a resumption of the rally.  If the decline continues more than a little further, then that would be a clue -- one which may indicate that bears are in control of the intermediate time frames.  The next few sessions should thus be enlightening.  Trade safe.

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Reprinted by permission; Copyright 2014 Minyanville Media, Inc.

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