The Market May Be Undergoing a Fundamental Bearish Shift

As long-time readers know, I have been primarily bullish on equities since November 2012 -- but for the first time since then, I truly have no desire to "buy the dip" for anything longer than a short-term trade.  There are some disturbing early warning signs that the market may be undergoing a fundamental change of character.  

I don't presently know how long this will last, but when I see signals like this from the market, I don't screw around and risk gambling away my financial future.  One of my trading mottos is "when in doubt, get out."  I have often likened trading to poker -- and one of the mathematical concepts required to become a winning poker player is an understanding of "pot odds," which is the ratio of the current pot to the cost of calling a bet.  Simply put: if the pot is $100, and calling costs $10, then the pot odds are 10:1.  Trading is all about odds as well.   

While I'm simplifying this analogy by overlooking concepts such as implied odds, etc., the next mathematical requirement in poker is to calculate the odds your hand has of actually winning the pot.  Then one compares those odds against the pot odds, and folds or calls (or raises) accordingly.  For example, if your hand will win 1 in 5 times, and the pot odds are 10:1, then calling a bet is a winning play over the long term.  But if your hand will only win 1 in 20 times while the pot odds are still 10:1, then the correct play is to fold if someone bets, and wait to try again next round.  (Incidentally, this is also why you want to bet aggressively and don't want to "check" a winning hand; if you don’t bet, you are giving your opponents infinite odds to draw to their long-shots for free against you.) 

In order to become a winning poker player over the long-term, one doesn't gamble, but plays each hand with discipline and according to the odds.  Oftentimes, inexperienced players will stay in the game despite the odds stacked against them -- usually this is because they either don't understand the math, or because they like "being in the action" and lack discipline.  Sometimes, in spite of their poor play, they'll win in the end -- odds are only odds after all, so even bad odds are mathematically required to win occasionally. 

Unfortunately, the thrill and reward of these occasional wins encourages bad players to continue playing incorrectly, and -- worse -- often leads them to conclude that their lack of discipline was actually pure, unadulterated brilliance.  The problem is, over the long haul players who have no discipline will, without exception, eventually end up 100% dead broke -- and that is a mathematical certainty.  I view trading in much the same light, and traders who lack discipline and overplay their weak hands will certainly end up broke as well.

All that to say, while the market always reserves the right to prove me wrong and go on to new highs immediately, I feel the odds are very good that there are ultimately lower lows still ahead.  Note that a near-term reaction rally could begin as early as today's session, but unless the market does something to shift the ball back to the bulls, given what I see today, I would expect the next rally will be sold.  Since the best we can do is attempt to play the odds correctly, here are a few statistics and observations to consider:

1.  The Volatility Index (VIX) rose more than 30% in the last two sessions.  Nearly 90% of the time this has happened previously in the past 20+ years, the market has subsequently gone on to make lower lows before making higher highs. Interestingly, the ferocity of the recent VIX rally also argues for a near-term snap back rally in equities, beginning as early as today's session.

2.  Precious metals have been absolutely slaughtered lately (I'll work up some PM charts over the next few updates), which means the market is at least considering the thought of a deflationary environment.  Further, the extreme volatility in PM's can often be a warning signal that things are about to become more volatile for equities as well.

3.  The momentum lows we saw yesterday are rarely reached in exact tandem with the actual price low, and generally we'd expect to see a bullish divergence before price finds a meaningful bottom.  Additionally, the up-volume to down volume ratio was high enough that we would expect to see further downside and new lows in the reasonably near future.

Let's start off with the S&P 500 (SPX) chart.  I've outlined my best-guess for a market path that presently appears reasonable to my eye, but do please note that predicting an exact path with the market in this position is exceedingly difficult, so don't be surprised if it deviates. 

As I mentioned yesterday, there is currently the potential of five complete waves up from the November lows, which usually means we can expect see a correction begin.

(If you're new to Elliott Wave Theory, I have written a primer article on the subject.)

I spent several hours working with the Philadelphia Bank Index (BKX) last night, since BKX has been a great leading indicator.  The chart below outlines one of the remaining bear options for the long-term: If BKX is forming a massive triangle, it will ultimately go on to new lows beneath the 2009 low -- though it would first grind around sideways/down (relative to the size of the pattern) over the intermediate term.  The chart below outlines the next important long-term levels.

BKX is one of the markets I've been keeping a very close eye on for several months.  A few weeks ago, I made reference to the possibility that a number of markets may be completing extended fifth wave rallies, and BKX was one of the markets I had in mind during that discussion.  I have never been satisfied with the summer-2012 rally as a complete five-wave structure, and the decline into November also did not overlap the potential red wave (i) peak, which keeps the extended fifth wave viable.  Though it's too early to say with certainty, the chart below does outline some signals and price levels.

SPX Finally Connects 2000, 2007, and 2013

A lot can happen in a week.  As some of you know, I have been dealing with a family crisis recently, so I'd like to thank those of you who continue to offer your kind words and support. 

A lot has happened in the market as well -- the S&P 500 (SPX) fell one point shy of my first downside target zone, then reversed strongly and went on to reach a new all-time high.  Interestingly, on Thursday, SPX pinged the trend line which connects the 2000 and 2007 highs, then reversed (as seen, zoomed in, on the chart below).  This is basically the last remaining horizontal resistance level, but it is a "doozy" as they say. 

The market has done its best to make us forget the potential of a long-term triple-top by ramming into it at high speed and looking invincible -- ironically, sometimes this means we should be on higher alert for a reversal.  I genuinely don't have a strong opinion as to what will happen next right here, since the market is basically at resistance but still above support -- but I feel neither side can afford complacency at current price levels.

There are a couple of signals in the chart below which bears may find encouraging:  Note the Bollinger band indicator in the lower panel.  These types of extreme readings are often found in the vicinity of tops.  Daily RSI (top panel) is also continuing to throw off bearish divergences.

   
The 10-minute chart notes some updated trend lines and support/resistance levels. 

In conclusion, the market has finally reached the very long-term trend line which finds its beginning in the same year the country was trying to figure out what the heck a "dimpled chad" was.  I'm not going to make any grand sweeping predictions about this being the end of the line for the rally, because I simply don't know -- but this is a long-term resistance zone, and the potential is there for a complete five-wave rally.  There are also a couple of indicator signals (shown in the first chart) which are often bearish.  This is one of those markets where bears have everything going for them but the actual price action, which has continued to run higher.  Some people refer to that as a bull market. 

Presently, there are no new targets, and this is more of a watch and wait position at the moment -- over the next few updates, the market will likely allow me to calculate some new targets. Additionally, we'll take a closer look at some of the long-term potentials and the signals to watch along the way.  In the meantime, trade safe.

Reprinted by permission, Copyright 2013 Minyanville Media Inc.

Publication Note

Unfortunately, I am dealing with a major family emergency right now, which has temporarily impacted the publication schedule.  I'm hoping this crisis will be resolved by Wednesday, but I'm uncertain if that will actually be the case.

Thanks for your understanding... and thanks again to those of you who show your support openly and generously -- I can't tell you how much that means to me at times like this.  You are surely the best group readers on the planet!  <3 

Good luck out there, and trade safe. 

Why Do Some in the TV Media Still Insist "You Can't Time the Market"?

The ending diagonal we started tracking in late March completed at 1573.66, about one-third of a point shy of the target zone.  On April 3, I wrote:

It is worth noting that yesterday's action did fulfill the minimum expectations for this pattern, complete with an overthrow of the upper trend line -- so while one more new high would look better, it is not required.

I was leaning toward the idea that there could still be one final thrust up still in the cards, but it never came.  It's rare that the market follows a projection that tightly, which is why most traders scale in and out of positions, as opposed to trying to time every move to the exact penny.  Considering that many of the TV talking heads will tell you that "you can't time the market" at all, I think hitting a turn within a third of a point on a 7-point target zone probably argues otherwise -- especially considering that we hit the two prior turns leading into that within a couple of points as well.

Before we get overly excited about the bearish prospects, we do have to recognize the reality that, presently anyway, only the short-term trend is pointed downward.  The intermediate and long-term trends are still pointed upwards -- for the moment.

In the last update, I outlined my expectations for the intermediate-term, so I won't repeat that here.  For the moment, we'll focus on the more near-term and see how things develop.  The first chart is the S&P 500 (SPX) 2-minute chart, and details my preferred interpretation of the wave structure, along with my first two targets.  Keep in mind that if my wave count is correct, we're now entering the small third wave within a larger third wave -- which often means a relentless down-trend for the near-term.  1549 will become key short-term resistance if this plays out. (Incidentally, I ran out of space on this chart...)

The hourly chart notes an intermediate bullish alternate count, which still expects lower prices for the short-term.  It also highlights the first target zone, and notes the second target zone in passing.  If it becomes appropriate, we'll discuss those options in more detail sometime over the next few updates, after the market reveals a bit more of the near-term wave structure.

The Pattern Nears Resolution as SPX Flirts with Its All-Time High

The preferred wave count continues to track extremely well and, as they say, "worked like a charm" again yesterday.  In this update I'll discuss the levels I'm watching for the short-term, and I'll also provide a bit more detail on my preferred intermediate outlook.

I remain bullish on the long-term, not because I feel the fundamentals support it, but because the central banks are still flooding the world with liquidity.  And as long as that continues, it will drive up asset prices.  The Fed seems to be trying with all its might to blow the biggest bubble it possibly can.  Somewhere down the road, I suspect this will all end badly (just as the last two bubbles have) and Bernanke will end up with a huge, unruly wad of US Mint-flavored bubble gum tangled up in his beard.  Then it will be time to break out the scissors.  In the meantime, though, the bubble is what it is -- and there seems to be no reason to try and fight it at the moment.

Let's start with the short-term charts and build from there.  The pattern I've been anticipating and tracking is called an ending diagonal, and so far it's done the "diagonal" part of the pattern perfectly.  Whether it will do the "ending" portion equally as well is likely to be revealed in the next session or two.

It is worth noting that yesterday's action did fulfill the minimum expectations for this pattern, complete with an overthrow of the upper trend line -- so while one more new high would look better, it is not required.  The key upside level to call this pattern into question remains 1582.82.  I have mentioned this next caveat in the past, but not recently:  when patterns such as this appear, if they turn out not to be ending patterns, then they are usually compression patterns which launch the market higher.  It's rare that they're anything in-between, so we should keep that in mind if the market sustains trade above 1583.  That's the caveat out of the way -- but because of the position of this wave within the larger structure, it is more likely that this is indeed an ending pattern.

To the downside, trade below 1558 would suggest wave v of 5 is complete -- or that the pattern was morphing into something entirely unexpected.

The hourly chart discusses the targets if 1582.82 is claimed.  Ironically, the only thing bothering me about the pattern is that it's tracked so incredibly well.  Whenever the market tracks this perfectly, I start suspecting that it's getting ready for a fake-out -- nevertheless, this pattern provides a clear trade setup that's hard to ignore. 

From an intermediate standpoint, the risk/reward is solid.  If the pattern completes cleanly, there's potential for a fair amount of downside.  Don't forget to keep the more bullish alternate count in mind when looking at the chart below, as I have not detailed it here.

Make-or-Break Day for the Near-Term Projections

Yesterday was a make-or-break session for the preferred S&P 500 (SPX) wave count of an ending diagonal, and today offers similar potential.  Heading into Monday's session, wave iii had a short-term invalidation level of 1572.56.  The market not only reversed about two points shy of the stop, but then moved down to perfectly break the trend line which "needed to be broken."  Thus this wave count gains a bit of confidence and continues forward.  The 10-minute chart below is almost unchanged since 3/28, as the market has tracked the projection exceptionally well since.  For short-term trades, this has provided a few excellent low-risk entries, with clear stop levels along the way.

It can be very tempting to get cocky after the market follows a projected path this well -- but these are exactly the times to be cautious as a trader.  I can't tell you how many nights I've scalped a string of eight or more consecutive wins, only to grow too big for my britches and give back half my night's profit on one bad trade.

Just as life does, the market has a way of quickly humbling the proud; so moderation and discipline become the keys to lasting success.  So often, after we achieve success, we become proud and careless -- but in so doing, we forsake the very qualities which brought us success in the first place.  Failure is bound to be the result.  At times we seem unable to recognize that we are rising and falling on our own endlessly repeating inner cycles:  We fail, so we decide to buckle down and work harder; then we work harder, which allows us to achieve success; then, after we achieve success, we become proud and careless again -- so we lose our hard-earned success only to find ourselves right back where we started.  Rinse and repeat.  I've known a lot of traders (and beyond), myself included, who have fallen into this trap at times.   

I believe one key to trading is to learn to act in accordance with the times, and to recognize that sometimes doing nothing is actually the most productive thing we can do.  Trying to plant crops in frozen ground only wastes precious resources -- so avoid the trap of needing to "constantly be part of the action."  We can gain a great deal of understanding by learning to recognize not only the cycles of the market, but also the cycles of our own tendencies.  And many days, the opponent we're trying to overcome isn't outside of us at all.  I've said it before: I believe our biggest opponent in trading, and the hardest one to beat, is ourselves. 

We currently have a pattern that appears reasonably clear -- and we also have some key levels to watch which will tell us where things become less clear.

It's now anticipated that SPX will form another thrust up, to a new high.  Ideally, I would like to see this rally break the upper red channel boundary (but this is not required), then reverse back into it and rapidly retrace toward 1540.  We are again presented with a very clear stop level for near-term trades, since the diagonal as labeled is invalidated above 1582.82.

The hourly chart notes the targets of the more bullish alternate count if 1582.82 is broken.  This level is key because wave v in a contracting diagonal cannot exceed the length of wave iii.  Every now and then, diagonals are transposed slightly from the most obvious count -- in other words, the wave which currently appears to be wave iii could conceivably be an extension of wave i (a diagonal is "allowed" to have a wave which is a double zigzag; a double zigzag is two connected ABC's).  That presently appears markedly less likely, but it is not entirely outside the realm of possibilities.

In conclusion, the ending diagonal pattern has tracked quite well so far, now it remains to be seen if it will conclude with equal ease, or morph into something more bullish.  Trade safe.

Reprinted by permission, Copyright 2013, Minyanville Media, Inc.

Intermediate Indicator on the Cusp of a Sell Signal

In my opinion, for the last couple weeks, this market has been less about clinging doggedly to set-in-stone predictions, and more about figuring out the correct "if/then" equations and then trading accordingly.  I believe it remains that way heading into this week. 

Early in Thursday's session, the S&P 500 (SPX) edged up over the prior high, which invalidated the most immediately bearish short-term wave count (the "if" part of the equation), and moved into the next target zone of 1568-1571 (the "then" portion).  This places the next if/then equation on the table, which I'll discuss momentarily.  The near-term ending diagonal wave count has gained favor, while the intermediate wave count remains unchanged.

The intermediate wave count continues to believe the market is finally approaching a more meaningful correction, though I presently believe this correction will be a buy opportunity, and I remain bullish on the longer time frames.  I still find this market environment unusual, however, so while I think it's important to remain cognizant of the long-term potentials, I don't necessarily think it's wise to get too far ahead of the market -- so we're just going to focus on the near-term and intermediate term right now. 

Before examining the wave counts, I'd first like to offer the chart below as additional supporting evidence for the intermediate wave count, and my corresponding thesis that a larger correction is drawing near.  This indicator has not yet given a complete sell signal -- however, we can see the full sell signals usually come after a correction has begun, so it's worth paying attention when the indicator is close to triggering, as it is now.

Looking at the intermediate-term, the preferred outlook is still that the rally is completing the fifth and final wave for this leg, and that a larger correction will follow.  If you're new to Elliott Wave Theory, the underlying concept is that the market is fractal in nature, and when a five wave structure has completed, a correction is then due.  (I've written a more detailed primer article on the subject, which can be found here.) 

Something I like about the current charts is that the market has declared some key levels for us to watch, and those levels are providing our if/then equations.  When I interpret the market using Elliott Wave, I take a detailed look at the current pattern and try to anticipate the fractal that's forming.  If I can correctly anticipate the fractal, then I can correctly anticipate the market's next move.  It's never cut-and-dried, though, because some fractals look identical in the early stages, which is one reason I often bring other forms of analysis to bear.  However, the advantage I feel Elliott Wave provides during such times is that there are clear rules which allow us to invalidate certain fractals.  While this doesn't always tell us exactly what the fractal is, it still gives us probabilities to work with -- and an invalidation level can most certainly tell us what the fractal is not, which can be very valuable information.

Based on the price action of the last few weeks, I'm inclined to believe the fractal forming in the chart below is a pattern called an "ending diagonal."  In an ending diagonal, the market forms five waves (labeled i-ii-iii-iv-v below) -- and each of those five waves breaks down into three wave structures.  There are two rules for contracting ending diagonals which would allow us to invalidate this pattern and favor the alternate count.  In a contracting diagonal, wave iii must be shorter than wave i, but must be longer than wave v.  This is why 1572.56 can invalidate this pattern -- crossing that price point immediately would make wave iii longer than i.

Ending diagonals make great topping patterns, because they are brutally choppy and keep breaking out just a little bit, only to reverse lower each time, and then reverse again to head back up.  Short-term traders become conditioned to believing the market will come back up each time -- and then, finally, it doesn't come back.

Let's start with the more detailed 10-minute chart, and then examine the hourly for context.

On the hourly chart, we can see the rally appears close to completing the fifth wave of the fractal.  Once this fractal completes, the minimum expectation for a correction would be a trip back into the 1485-1525 zone.  That's a very broad target range, but we'll be able to narrow it considerably if and when the correction actually begins.