Monday, November 10, 2014

SPX and INDU: Why There's No Need to Front-Run Tops

"In theory, there's no difference between theory and practice.  But in practice, there is."  -- Yogi Berra

In today's update, we're going to focus on one difference between theory and practice.  As an analyst, my job is to talk about what I see as possible or likely.  As a trader, my job is to protect and grow my capital.  Often those two disciplines find harmony -- but sometimes they are very different things.

I'm going to reprint a few things I've written in the forum recently (with a few minor edits):

My main thought is that we are in uncharted market waters right now... i.e. -- there are no clear levels to act against. You are correct that we could just as easily run up another 100 points.

The last few important tops have announced themselves rather clearly in advance, in my opinion. I suspect the next one will as well. Until then, shorts (for me, anyway) continue to be spec trades and I'm quick to exit for a profit if I can (which has been most of the time, luckily!).

Basically, the way I view it is this: If you're a bear against a market like this, then simply treat every decline like an ABC until proven otherwise. Sure, you might miss the 5th wave down if that decline turns into a 5-wave impulse... but then you can get short again on the larger 2/B wave rally -- and you can then enter that trade with more conviction. Missing a fifth wave decline beats the heck out of taking continual losses all the way up, hoping to front-run that first impulsive decline, which, for all anyone knows, might not begin until 2170 SPX.

I don't know where this market will top right now. There are some inflection points on deck, but right now, we can't give those better than 50/50 odds. And I do know this: Since 2011, whenever I have had any doubt as to the wave count, the bulls have won every time. The tops, on the other hand, have been pretty clear. So, if that same thing holds true now, then "no clear top" means the bull run may well continue until such a time as there is a clear top. 

Along with those thoughts, I'd like to share a chart that underscores the above points:

This is one area where there's a difference between theory and practice.  In theory, we can try to anticipate exactly where an intermediate wave will end.  In practice, there is really no need to. (I assume it goes without saying that I'm focusing on intermediate tops here.  Short-term trades and scalps are approached differently.)

As we can see on the above chart, there's really no practical need to even attempt to front-run intermediate tops.  There's an old trader expression:  "They don't ring a bell at the top."  Of course, that's true (they actually use a buzzer), but in my experience, few tops occur without at least some some hints and signals that there's a decent possibility that a top is forming.  For example, all the decent tops of the entire year have led me to state publicly that I believed a top was forming, well-before the declines kicked into gear.  And a key accompanying point is:  All these tops have given me multiple opportunities to talk about them while they were forming -- so it wasn't like it happened overnight and took anyone by surprise.

So my recommendation (which is NOT trading advice, of course) is:  If you're a bear looking for an intermediate trade, then at least wait until there are some signs of a top.  Once some of the precursors start falling into place, then you can place your bets -- and possibly still lose money, because the precursors of a top do not, or course, guarantee a top.

Think of it this way:  If you want to catch fish, then you first go to a body of water where there are fish... then, if it looks promising once you get there, you cast your line in.  Maybe you'll catch some fish, maybe you won't.  But you don't try casting your line into random places, like into your bathtub, or into a tree, or into an Ethan Allen furniture store.  If you just randomly cast your line every single time you think of fish, you'll only end up with a lot of broken and/or lost equipment.  Yes, I know -- maybe there's a fish in that furniture store.  A huge fish!  Maybe even... oh my goodness... maybe even the new world record for Largest Fish Ever Caught in a Furniture Store!  Anything's possible!

But, still... it probably would be more productive to at least wait until there is a reasonable possibility of catching fish before casting one's line.  And in the case of intermediate tops, we can even take it one step further (I can't stop my brain now, it's still running with this analogy):  We can identify a possible "fish location" ahead of time ("X price level"), and then we can even scout the waters once we get there, because tops take time.  So, once the market starts to give off topping patterns and signals, it's the equivalent of visually confirming that there, indeed, are fish present in the water.  That still doesn't guarantee that we'll catch one, but the odds are a heckuva lot better than they would be casting our lines randomly.

From a practical standpoint, here's what it sounds like when I think there's a good chance there are fish in the water for bears (this is a real-life example, reprinted from September 22, 2014):

In conclusion, everything appears to be in place for bears to have a shot at taking over the market for a while (except for the all-important trend, of course).  Basically, bears have the precursors, and the market has effectively reached most of the intermediate upside target zones.  Near-term, Friday's decline appeared impulsive, so for the near-term at least, I'm expecting lower prices.  As the pattern develops, we'll begin to get a clearer picture as to whether a more significant turn has indeed occurred.

Notice there were multiple signals at that time, such as: completed five-wave rallies, upside target captures, and at least one impulsive decline.  No trend breaks yet, but still a good spot for bears to take a shot.

Anyway, I hope I've conveyed the gist of what I'm trying to convey here.  If you're a counter-trend trader, there's really no need to get too far ahead of the market.

And I hope that was of some value to readers, because I just realized I spent way too much time on it!  So I'm going to have to let the charts and annotations speak for themselves for the remainder of this article.

First, INDU's long-term weekly chart shows bears may be in "last stand" territory:

INDU's daily chart:

INDU's near-term chart:

And SPX's near-term chart, which shows that we've fallen less than a point shy of the preferred target zone of 2035-42, but we do have a trend line break.

In conclusion, we may be wrapping up five-waves of rally, but this market continues to remain less-than-clear in that regard.  SPX did break its red trend line, but closed right on the back-test, so we don't know if that break will stick or not.  I do have to note that the rally from Friday's low does appear impulsive, so a new high wouldn't surprise me at all.  Either way, if there's any sort of significant reversal lurking in the cards soon, then, as discussed, we'll likely receive ample warning.  Trade safe.

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