Yesterday's Flash Crash Fit the Wave Structure

Over the past week, I've outlined about half a dozen reasons why the odds favor the bears should get another leg down after this rally, and now the market has finally entered the critical "retest" zone for the 1597 high.  Elliott Wave is extremely particular about exact price points, whereas classic technical analysis allows a bit more leeway, and in classic TA, a "retest" is considered as something of a zone which extends somewhat below and above the prior swing high (or low).  I tend to focus more on Elliott Wave analysis within this column, but in practice I blend the two disciplines.  In either case, the market is now at an inflection point.

Yesterday made for an interesting session, as the market experienced a mini flash-crash after AP had their Twitter account briefly taken over by terrorists, who sent out some frightening false news items.  The market experienced several minutes of sheer panicked free-fall, when the terrorists falsely tweeted that Ben Bernanke had just been spotted reading a copy of The Road to Serfdom by Friedrich Hayek.  But it recovered almost immediately, as investors quickly realized this Tweet was so incredibly unbelievable, it had to be a hoax.  I think they also Tweeted something about explosions at the White House, but the market probably shrugged that off as irrelevant.

The hourly chart remains unchanged, and the "best guess" projection I detailed on April 16 has since tracked with far more accuracy than it had any right to.  Note the levels of the Chaikin oscillator in the bottom panel (also note that for some reason, Java refused to draw the red sell signal line in the correct place!  It should be drawn higher on that chart than it is, close to the indicator's current level.)

On the one-minute chart below, there's an amazing little tidbit for those of you who love math and the harmony of the markets -- and it's especially interesting given the events of yesterday's session.  On the chart below, the rally from blue B to blue wave (3) (from 1548.19 to 1560.18) is 11.99 points.  I am interpreting yesterday's rally as an extended fifth, and extended fifth waves often target the 1.618 extension of waves 1-3.  Waves (1) through (3) were 11.99 points.  If we multiply that by 1.618 (the expected extension), it calculates to be 19.40 points.

19.40 + 1560.18 (the peak of blue (3)) = 1579.58 -- which was the exact to-the-penny high of the wave before the flash crash. (Insert Twilight Zone music here...)   I find this all the more fascinating given the "unpredictable" event in the form of terrorist activity and the market's subsequent 16-point plunge.

While I remain in favor of the bear view, the 10-minute chart shows the near-term bull count in rough detail.

SPX Update: Clues from a Proprietary Sell Indicator

Yesterday's article was long on words, so today we're going to focus more on charts.  There's been no material change in the outlook, since so far the market hasn't done anything even vaguely unexpected, but I've refined a few charts and potential targets.

The first chart I'd like to share is one of my proprietary signal indicators.  While I'm not publishing all the constituents which actually make up this indicator, I have noted the prior few years of signals on the S&P 500 (SPX) chart below.  This is one of the signals which is presently keeping me in favor of the bears for another leg down.  Note the present similarities to the examples of 2011 where two sell signals fired off in close succession.

Today, we're going to start off with the one-minute chart and build from there.  One of the challenges in market prediction is the anticipation of how a corrective wave will unfold.  Corrective waves can be quite complex and thus extremely difficult to anticipate perfectly in advance.  Beyond that, the "easiest" market reads are almost always done in real-time, since the market gives off new information by the minute.  It's almost impossible to anticipate every potential turn which will come down the road in a given session (and even more impractical to try and outline them). 

But since a static published column obviously doesn't have the luxury of speaking in real-time, what I try to do is look several steps down the road to give readers some idea of what I'd watch during the session.  Assumptions have to be made in order to do this, and the first assumption I'm making is that this is indeed a corrective rally, as opposed to a new impulse wave which will head to new highs.  Accordingly, I've noted the two most likely possibilities for a corrective wave on the chart below.  If the market sustains trade above 1577, then we'll have to look more seriously at other angles.

 
In the event that my thesis of a corrective rally is wrong, on the 10-minute chart below, in black I have noted the rough turning points I'd watch for an impulsive rally.  Again, presently the only invalidation level for a corrective wave is the prior high -- so all we can do is watch key resistance at 1577 for our first clue that something more bullish may be afoot. 

Why Barron's Prediction of Dow 16,000 Favors the Bears

This weekend's Barron's Magazine cover features the exclamatory prediction of "Dow 16000!" and depicts a bull (replete with a huge Cheshire cat grin) on a pogo stick bouncing over a fat, slow, and apparently confused bear.  Clearly, the message this cover wishes to convey is:  "Have another margarita, bulls! There's nothing at all to worry about!" 

If I were still bullish, I'd worry about that.  (And it goes without saying that one should never drink more than two margaritas before hopping around on a pogo stick.)

This cover is the lead-in for Barron's latest Big Money Poll, and the following quote is found within:

“The stock market isn't the only thing that has set records this spring. Barron's semiannual Big Money poll of professional investors also is setting a record -- for bullishness, that is. In our latest survey, 74% of money managers identify themselves as bullish or very bullish about the prospects for U.S. stocks -- an all-time high for Big Money, going back more than 20 years.”

Barron's has a bit of history with bullish magazine covers, and it isn't terribly encouraging.  There are some logical reasons that publications such as Barron's sometimes make great contrarian indicators, and I'll cover these in a moment. Unlike my column (and many other columns here on Minyanville), publications like Barron's are generally more focused on reporting the past than they are on predicting the future.  This is not to imply any kind of slight against them, or that there's anything wrong with news-based publications -- we have to get our news from somewhere.  To be honest, sometimes I'm envious: Writing about the past allows an infinitely higher degree of certainty -- and involves a lot less head-scratching, fewer sleepless nights, and virtually no potential for "getting one wrong" (or criticism about the same, for that matter).  As Yogi Berra once said, "It's tough to make predictions, especially about the future."

Interestingly, Barron's Big Money Poll in May of 2007 was also quite bullish in tone, and predicted Dow 14,000 -- and that prediction was featured on the cover in a similar way in 2007.  This level wasn't actually too far off, and was reached in October 2007 after a rally of about 6%.  We all know what happened after that.  The bullish cover of 2007 was a whole lot closer to the top than it was to the bottom.

When market publications which usually stick to reporting the past decide instead to predict the future, there is somewhat of an intrinsic "conflict of interest."  Barron's didn't become hugely popular by publishing stuff nobody wants to read -- so by the time they're willing to boldly predict something on the cover, it's at least partially because they feel that cover will make the majority of people want to buy their magazine.  Bears obviously don't want to read an article about "Dow 16,000!"  People who own equities do.  This tells us, in a roundabout way, that "bullish" has gone very mainstream -- and in this way, these types of magazine covers help indicate when sentiment levels are approaching extremes. 

The problem, and I've written about this many times, is that by the time everyone "knows" something about the market, it's usually dead wrong.  When we're talking about bullishness, there are only so many buyers out there -- and it obviously takes a constant influx of new buyers in order for any stock to continue heading higher.  Even if a stock were the Greatest Most Amazing Stock in the World (just as a "totally random example," let's say this amazing stock were, ahem, Apple (AAPL)), once everyone who wants to own Apple already owns it, then at that point, the share price has nowhere to go but down.  

Think of it like an auction where -- unbeknownst to the buyers ahead of time -- there will be 50 of the exact same item auctioned off sequentially, one at a time.  Further imagine that no one at this auction knows in advance that there are only a total of 49 buyers present for this particular item.  In this situation, the first few times the item comes up, the bidding will be hot and heavy since the majority of buyers are still competing with each other.  This drives the bid higher each time, and, more importantly, establishes a psychology of "fair market value" for the item in everyone's minds.  Since the price is continually being bid higher anyway, each subsequent auction then commences with a higher starting bid, and the buyers naturally take no issue with this. 

There will continue to be some degree of competitive bidding, and accordant price increases, right up until the second-last buyer (buyer number 48) secures his item.  Then, with no more buying competition, buyer number 49 will simply pay the high starting bid -- and for a brief moment, this last buyer will actually think he got a "really good deal" because no one bid the item any higher.  But trouble starts (seemingly out of nowhere) when the auctioneer tries to sell item number 50, because suddenly nobody wants it at the opening bid.  He lowers the asking price -- but still, no buyers.  What no one there realizes just yet is that all the potential buyers have already been converted into "owners," so there's simply no one left who's interested in the remaining inventory.  The auctioneer looks around in surprise, and drops the price again, but still no buyers step forward.  And now a new kind of trouble begins, because at that point, all the people who just bought this item feel like idiots.  They're not "happy owners" anymore -- in fact, now they're thinking they probably paid way too much! 

The feeling that we got "ripped off" -- or that we own something nobody else wants (especially an "investment" nobody wants!) -- brings up strong emotions.  These emotions can be exceptionally powerful when it comes to the markets, because emotions in that arena are tied to our sense of financial security, which in turn is tied to our deepest, most primal instincts for survival (none of us can survive for long without any financial resources!). As a result, when the above analogized situation occurs in the stock market, it can actually generate an outright selling panic.  The panic psychology is further compounded by the fact that equities have absolutely no practical use whatsoever in the physical world.  You're essentially buying a really fancy piece of paper, solely because you're hoping you can sell it to someone else for more than you paid for it.  This "greater fool" psychology makes the stock market much more emotion-driven and volatile than the markets for most physical items.  In any case, once a "no more buyers" situation is reached, the asking price will have to continue dropping until such a point as either new buyers find the lowered price attractive, or previous sellers find it attractive once again, at which point a new price floor can be established.      

Do note that I'm not predicting a selling panic tomorrow, I'm merely noting that the sentiment precursors are in place, and a 20-year high in bullishness shouldn't be ignored.  Since I always try to see both sides of the argument, though, I think it's also important to note that these types of sentiment indicators are purely relative, and that makes them difficult to time trades with.  For example, I remember some contrarian investors talking about what a great time it was to buy equities in 2008 when the polls came in showing bears numbered around 60%.  They said it again when bears numbered 65%, and again at 70%, and again at 75%... and so on.  The market didn't end up bottoming until bears numbered over 90% -- so the key takeaway is that numbers which look extreme this week can end up looking mild by comparison in a month or two. 

Moving on to the charts, I continue to feel it's more likely that this is a reaction rally and that bears will take the market back down again after it's over.  The 10 minute chart shown second has a bit more detail about upcoming resistance levels.

It's worth mentioning that last Tuesday's projection (reprinted in the red breakout box below) has played out exceptionally well since.  Hitting three turns in advance on a "best guess" isn't too bad -- especially considering SPX traversed more than 80 points during that time, and the market's now right back to almost exactly where it started (!). That projection correctly anticipated about 85% of the move in terms of points captured, as well as the correct turning points -- so if you traded that roadmap, then you probably did okay. Hope it helped anyway!

We'll see if the original roadmap continues to track or if Friday's slightly altered view comes to pass.  On Friday, while I (correctly) projected the rally into the blue target box, I also slightly favored the idea that would mark the end of the upwards correction.  I noted that I didn't feel I could see "two turns down the road" at the moment, and what would happen after that rally wasn't entirely clear to me.  After studying the charts over the weekend, it does appear there may be some additional upside momentum left, so I've noted the next resistance levels on the chart below.

More Warning Signs for Bulls

On Tuesday, I outlined some of the reasons why I felt the market was undergoing a fundamental change of character, and discussed why I believed the power had shifted to the bears.  Since then, even more warning signs have cropped up for bulls.

The most obvious is the fact that most indices have now broken their intermediate uptrends.  Additionally, the decline in the S&P 500 (SPX) appears to be a five wave impulsive move, which suggests that the trend has shifted, and the next highest degree trend is now pointed down.  Whenever we see a new five wave leg forming in the opposite direction of the prior move, we can generally anticipate this first leg will be followed by at least one more leg of similar length, or longer.  There are other warning signs as well.

The chart below shows the 5, 10, and 20 day exponential moving averages of SPX and the Dow Transportation Average (TRAN).  This is based on a trend-following system which was popularized by Gerald Appel, who rose to stardom by developing the now-ubiquitous MACD indicator.  Okay, maybe "stardom" isn't the right word, since us traders belong to a pretty specialized subculture -- it's probably unlikely that your barber or landscaper has posters of Gerald Appel hanging in the garage, and I doubt he's ever hounded by paparazzi.  

Anyway, the last signal from this indicator was a buy, back in November 2012.  As we can see on the chart, TRAN has already given bearish crosses, and SPX is now extremely close to joining in.  Of course, there are no "magic bullet" indicators, and this one can be prone to whipsaws around tops, which is another reason I use multiple indicators and charting systems.  Nevertheless, this is one more potential red flag in the making for intermediate traders of the bullish persuasion.
  

  
The short-term wave structure in SPX is open to a few different interpretations, but I'm presently inclined to favor a path similar to the one shown below.  We'll have to see what today's session brings, but I suspect we'll see a green close today.

Tuesday's "best guess" projected path has since tracked nearly perfectly, but as mentioned above, I'm not certain if it will continue to do so.  I have left it unchanged on the chart below, but right at this exact moment I don't necessarily feel that I can see two turns down the road for the market.  I do somewhat prefer the path outlined above, which would see a rally for today, then a decline into Monday, then a bounce for Turnaround Tuesday.  Let's get through today's session first, then we'll take another look at the near-term path in Monday's update.

Do note that the red iii/C is not presently intended as a "final target," it's merely a general outline of expected direction at this stage.  Note that the trend line off the November lows has been broken for the first time since then.

SPX and Gold: Song Remains the Same

In the last update we looked at some of the reasons why lower lows are likely to follow Monday's low, while I noted that a snap-back rally could begin immediately.  The market spent yesterday's session in rally mode, and closed near the high of the day, which fit the pattern -- so as yet I have no reason to alter my thesis that lower lows await. 

It's currently unclear to me if yesterday's high will mark all of the (assumed) corrective rally, or if the rally will turn into a two-legged ABC -- in either case, I expect SPX to close in the red today.  There's no material change in the outlook for the S&P 500, so my best-guess projected path remains exactly the same as it was yesterday (though the price action did allow me to delete the rising blue line which was previously drawn in the place where Tuesday's rally has since occurred).

 
While I expect lower lows, we can't ignore the fact that SPX and the Dow Jones Industrials (INDU) both remain in technical uptrends.  A breakdown of the rising green trend line on the chart below is the next step for bears to gain confidence. 

Incidentally, for those who still doubt the value of technical analysis, I would like to note that I charted the blue channel (below) a pretty long time ago -- yet the rally was rejected immediately upon running into the upper boundary of that "imaginary" channel, and the same occurred in reverse when it fell back to the rising green trend line.  The next break of either will be telling.

Finally, given the recent volatility in gold, it's time to update the long-term chart.  Once again, simple trend lines worked their magic, as the recent decline found support at the rising blue trend line.  Given the wave structure, I would be surprised if gold does not ultimately break through that support level.  I've outlined next support and some potential targets -- trade above key resistance is required for me to re-examine that outlook.  Given the numerous failed retests of the all-time high and the subsequent breakdown of the topping pattern, it's hard to view the last couple years as anything other than a significant top.

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.