Friday, August 22, 2014

SPX, INDU, NYA Updates -- Plus the Purpose of Each Wave and Why the Market Isn't Random

As I was looking over the charts last night, I found myself having the same thought over and over:  Wow, is it tempting to get bullishly complacent here...

This smells like a fifth wave.  Fifth waves are the ultimate bastions of complacency.

In the first wave up of a bull market (talking larger wave degrees here -- daily, etc.), the majority are convinced it's not the start of anything -- they figure it's a counter-trend rally to the prior down trend and soon to collapse to new lows.

In the second wave down (which corrects the first wave), the majority believe the collapse has begun.  They continue to believe this even after the third wave up begins -- at first, they figure the third wave is "another" counter-trend rally.

So they short the third wave just when they should be buying.  It keeps powering higher, and their stops provide additional rally fuel.  Somewhere around the middle of the third wave, we hit "the point of recognition" for the masses, and they realize the trend is here to stay for a while.  There's a sudden "herd mentality" rush to jump on board, and that gives further fuel to the third wave.  These are some of the reasons third waves are usually the longest and most powerful waves.

After what seems like forever, the fourth wave correction comes along and confuses the heck out of everyone.  It knocks out the trend followers.  They jump back in.  It knocks them out again.  The permabears are convinced it's the start of a new collapse.  But the majority do not believe it's anything other than a correction -- and they're right.  During fourth waves, counter to "contrarian" philosophy, the majority sentiment is usually correct.  The job of a fourth wave is NOT to strike mortal terror into the masses (like the second wave did), it's to try and screw everyone up and make trading hard again (and fourth waves serve another purpose, which we'll discuss momentarily). 

Eventually, the fourth wave finally ends.  Wait, no, sorry -- just got the memo here, it's not over.  Maybe it's a triangle?  Ah, an expanded flat!  Okay we can move on to the next paragraph now. (Sorry -- just a little fourth wave humor there, for the Elliotticians in our audience.)

Finally the fourth wave ends and... wait, that was only wave A of the expanded flat!  Hang on...

Okay, whew, eventually the fourth wave ends (really!) and the market enters the fifth and final wave up.  By now, bulls are fat and happy.  Nothing can go wrong!  See, we're at new highs again, just like we told you idiot bears!  All dips should be bought going forward, forever and ever, amen.

Complacency reigns.

Bears, on the other hand, are sick of it.  They thought for sure that last fourth wave was the start of the end.  They're done.  No more shorting!  Ever.  It's a proven historical fact that more bears join monasteries during high-degree fifth waves than during any other wave.    

And this is one of the other jobs of fourth waves in a bull market: They condition traders to buy the dips.  By the time the big fifth wave rolls around, traders have become deeply conditioned by all the fourth waves that have unraveled at lower degrees over the recent months (or years) and which have culminated with new highs each and every time.

Think of where we are now -- every time bears think something is getting going on the downside, the market recovers.  Fourth wave at subminuette degree -- new highs!  Fourth wave at minuette degree -- new highs!  Fourth wave at minute degree -- new highs!!!  Etc.  There's been no end to the new highs.

See, all of this is necessary to ultimately create the psychology we encountered back in waves one and two.  Once the trend finally does change, no one will believe it anymore -- not even the handful of remaining bears.  Everyone will think it's another fourth wave "correction" -- right up until that big third wave down hits and wipes everyone out.

And then we rinse and repeat all of the above, but heading down instead of up (for a bear market or major bull correction).

This is a glimpse into what creates the patterns and fractals that make up Elliott Wave Theory.  It's not some crazy esoteric voodoo; it's simply a reflection of human nature.

The market isn't random -- because people aren't random.  They're irrational, yes -- but they're at least partially predictable in their irrationality.  If you walk into a crowded theater with something strapped to your chest that looks like a bomb, then walk up on center stage and threaten to detonate yourself, you will most assuredly get an irrational reaction.  But you will not get a truly random reaction.  In fact, given a few control studies, I'd be willing to bet that we could determine exactly what percentage of the audience would react irrationally and in what way (plus or minus a few percentage points).

(Please note I am NOT suggesting anyone attempt this.)

Individually, strangers are completely unpredictable.  Yet people have a finite range of reactions -- so if you obtain a large enough sample, you can predict -- with high accuracy -- what people in most any group will do in most any situation.  And you can then piece all that together into a pie chart (a finite and closed chart), with only a very small percentage of people falling outside the "normal" reaction ranges.  It might look something like this when you're all done:


People taken individually may seem to behave randomly; but collectively, we behave predictably.  People are funny that way.  As noted, this reality of human nature effectively allows us to predict what an entire group of people will do in almost any situation, minus a very small handful of outliers.  That's why they only need to poll a few thousand people to figure out how an entire country feels about an issue, instead of polling millions (or polling everyone).

And this is why I find it plain silly when people think the market is random, and that Elliott Wave is some impossible theory.  Virtually nothing that involves the herd is truly random.

Anyway, I digress.  The point I started off to make was that the current market's sentiment feels like a fifth wave at higher degree.  That doesn't mean it can't run for a while, though.

Let's start off with NYA, which suggests SPX still has farther to run into new all-time-high territory:

The SPX 2 hour chart is shown below (the referenced fourth wave would be at micro degree -- see next chart).

 The SPX 15-minute chart shows a beautifully-defined channel:

INDU may provide an interesting clue about where we're headed.  Sure looks like a fifth wave here:

Another look at INDU's very-long-term wave count shows that it's possible we're closing in on the end of a massive B-wave rally, but I currently think it's a bit more likely that we'll need to unravel a much larger fourth and fifth wave before the end of the world.  In practice, though, we don't really need to know the answer to that question, and it's irrelevant at this moment.

All we need to do is identify the inflection point where the trend changes from up to down, like we did last month, and know when it's time to stop shorting and/or go long again, like we did this month.  Action is always taken in the present, so trying to determine very long-term wave counts is done primarily for context and to aid in alertness.

To bring up this chart in its full 2200 pixel glory, right mouse-click on the chart and select "open in new window."

In conclusion, we may be nearing a small fourth wave correction at micro degree (SPX 15-minute chart), but it presently appears unlikely that the rally is done for good.  NYA and INDU are both begging for new highs after their recent large ABC declines, so we have to continue to presume the larger trend remains up unless and until the market gives us reason not to.  Trade safe.

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  1. Great post, Jason - from particle physics-style randomness and order to a super-high-def LT chart it'll take me a few hours to properly get my head around.

    The complacency you mention as fourth and fifth waves unravel is hard to quantify, though. We've had varying degrees of complacency and euphoria over the last two years - some of the sentiment figures since Jan 2013 have been off the scale but the mania keeps feeding on itself. At what point, after months of historic extremes, do you judge the participants now can't get any more bullish? I've been underestimating the greed/stupidity/lack of fear for nearly three years, so what is it about this particular bout of complacency that suggests a top?

    Have a great weekend - always appreciate your updates and your photography and banter on Twitter.

  2. Superb post Pretzel. Even more so that usual.

  3. Excellent post thnx.

  4. The Supercycle chart looks great !
    I would only add that we may not get a wave iv and v - imo, there is high probability that we get a 'stunted' wave and end this bull run at about SPX 2,063 !!
    Would welcome your thoughts in this regard.
    ps: I was right couple weeks ago when I posted we were going to resolve the drop bullishly :))

  5. Hi Tom, thanks for the comments. :)

    As to "what" -- well, for one, the wave count fits. Point two is a little harder to quantify... call it instinct or gut. But don't get me wrong, I doubt we're completely there yet. As of the way the charts look at this moment, I think there's probably still some more upside first.

  6. Thanks, Jack -- really appreciate that. :)

  7. Thanks. And yes, I recall your comment -- gotta admit, though, my "short term bearish bias" at that time was dead-on. You may recall I agreed we'd head to new highs over the IT. :)

    As to some sort of truncated move to close out the bull -- entirely possible, and something I've been keeping a close eye on. I have another LT count that's not shown on the chart above, and I'll bring it out in more detail if/when it becomes appropriate. Suffice to say I track a lot more than two counts at any given moment, but if I published my whole chart book in each update, it would just confuse everyone. :)