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Wednesday, March 17, 2010

Putting my last post into perspective: Bears and Idiots

Here is my last post Idiot of the Day: bears. So the title is obviously a play off of zloj’s "Idiot of the day" series. But I want to discuss a few different aspects/intentions of my very simple post.

First, I am bearish. I am still very bearish on the fundamentals of the economy.

But am I an idiot? … The answer is yes

The post was obviously self-deprecating and tongue-in-cheek. But it is also an honest assessment.


Because it is still rally time. The bulls are still in charge. And it was an obvious call to make, and I almost made it at the time, even though I was being stubborn.

The January Top, Why it was smart to be bearish there, Why the “crash" failed, and Where it was smart to be bullish

I made the case for a coming sentiment peak in December here: The Long View. Why is this important? Because markets climb a wall of worry and they fall down a slope of hope. Bullish sentiment readings from a number of different surveys were near all time high readings. From the post above:

But the point of this is to show that stocks climb a Wall of Worry. But we are past that. Everybody is bullish. Investors Intelligence just had the most bullish investor sentiment readings in almost 3 years. Wall Street is slapping each other on the back. Economists are getting accolades. Mutual fund cash levels are near record lows. Everybody is bullish!

So if stocks climb a Wall of Worry, then they fall down a Slope of Hope. Be greedy when others are fearful and fearful when others are greedy.

That doesn't mean that "we reached the magic sentiment level and the drop immediately commences". I am not forecasting a crash tomorrow. But what I am saying is that the environment is ripe for a change. This is not the only necessary ingredient, but it is a key ingredient.

So my point was that sentiment was peaking and we were waiting for the wave structure to complete. You need to have both sentiment and technicals line up together to form a top. That is what my next study in January (just a couple of days before the January peak) set out to do: O Mandelbrot, O Mandelbrot. This post was a study of all of the Wave 1’s down and Wave 2 retracements within Primary 1. It was done to give idea for the shape of the structure for Primary 2, as well as the size and duration. From that post:

Before we go to the last chart and put this into perspective in the larger count, first notice that the structure of each Wave 1 down has a much clearer movement about it. It is an impulse wave and its movement slices through resistance, sometimes almost vertically. This is a motive wave, and its purpose is to carry the overall price movement in the direction of the wave that is one degree higher. And after each impulse wave down, there needs to be a correction. In this case it is a Wave 2. These waves tend to meander. However even when they trend strongly, the internal price action is very overlapping. This is one good way to tell a trending corrective wave from an impulse wave (there are other tells, but this is a key one).

And so what is interesting is that whether the price action took a couple of weeks to a couple of months to play out, the overall structure is very similar.

Next some stats

Wave 2 price retracements: 0.618, 0.500, and 0.500
Wave 2 time ratios: 0.236, 0.500, 0.618

And this limited sample set verifies what we see about Wave 1 - Wave 2 relationships in many other scenarios (on 1 minute charts, 5 minute, etc.). Wave 2's typically (but not always) are deep retracement waves, meaning they retrace the previous Wave 1 by 50% to 62%. The duration of any corrective wave is much more variable. The time component is almost always a Fibonacci relationship too. In these cases we see between 24% and 62%. Sometimes Wave 2's can be as long in duration as Wave 1's, and much more infrequently, even longer (such as 162%).

But *usually* it one of these Fibonacci relationships: 50%, 62%, 79%, or 100%

So now stepping back at looking one degree higher, what do we see about the rally since March?
Currently Wave 2 is 0.500 * Wave 1 in points
Currently Wave 2 is 0.618 * Wave 1 in duration

We can see that Primary 2 has hit many of the targets that we expect to see in relation to Wave 1. Additionally there is a lot about the internal wave structure in P2 that also has some nice Fibonacci relationships: Just a Step Back
So, What does this mean?

It means that conditions are ripe, from an Elliott Wave and Fibonacci Relationship perspective for Primary 2 to be done.

But just because conditions are ripe, does that mean we will begin P3 on Monday? **NO**. Absolutely not. It is a possible scenario, nothing more, nothing less.

So what you see is that I was describing the stage, the technical and sentiment setup that made it a high probability setup (from a risk/reward standpoint) for a top. But before I recap what happened next, I want to point out something else that I wrote in the post above that we will come back to later:

P2 might not be done. It might rally up to the 62% level (1240) and take us out to July (100% of time as P1). That is another scenario where P2 would still be a viable proportion to P1.

Remember this, this is important.

So what happened next? A nice fat very bearish selloff: Looks Like Hibernation Time Is Over / The Real Deal? (Divided Opinions). But was it a crash? Nope. And could we have known at the time that it wasn’t

…. Yep. And I did, but I was being stubborn in my call. …. In short, I was being an idiot.

First indicator: Sentiment. It shifted from extreme bullishness to extreme bearishness *much* too fast. When the next crash begins in earnest (assuming of course we have one, which is *not* a given) it will be in denial. The bulls will be denying the new downtrend just as vehemently as the bears have been denying the uptrend (just as I have done many times). The fact that everybody got bearish should have been a huge red flag.

Why? Like I said above: Markets climb a wall of worry and fall down a slope of hope. Changes don’t happen when they are expected, and they certainly don’t happen when the crowd is “on to it". When cab drivers start offering stock advice again (or hell, even engineers for that matter :) ) then we will have a top. Not before.

Second Indicator: The move was not an impulse. I saw this. I tried to rationalize it. I tried to justify it. But it was not one. I was so *sure* that the trend had changed that I ignored clear and valuable technical evidence to the contrary. Until we see 5 clear waves down in a impulse structure, with acceleration down on the 3rd wave, that is absolutely and unambiguously discernible on a 60 minute chart, there will not be a crash. That is the opening salvo. And even if we do see this, it DOES NOT guarantee a crash. But there is *no way* a crash will commence without this pattern. P3 is an impulse, and the move from January to February was not an impulse. …. And I knew it. Shame on me.

Third Indicator: This is the one I am really kicking myself over. Subconsciously, I knew the correction was over (which I should have know consciously). I knew it the day before the new uptrend started in earnest. I even got out of shorts. But I did not have the balls to go long. See this post from Feb 12: And the Hits Just Keep on Coming. I then tried to justify some BS expanded flat as a wave 2 and went short much too early.

That brings us to Now…. So Where are We Now?

We are in the middle of an Intermediate Wave up. I don’t believe this wave marks the end of P2. I do believe we will get a pullback next (maybe to 1100-1120 on the SPX), but it mostly likely will not be an impulse. Which means that it cannot be the start of P3 down if it is not an impulse.

Wave structures have meaningful Fibonacci relationships in both price and time. And the end of this wave has only trivial relationships with respect to P1. Remember what I said above from my post above: O Mandelbrot, O Mandelbrot

P2 might not be done. It might rally up to the 62% level (1240) and take us out to July (100% of time as P1). That is another scenario where P2 would still be a viable proportion to P1.

This (IMO) is the most likely terminus of the next big move. The 62% retrace level.

Right now the rally is tired. Both volume and breadth are decreasing on the way up. Tired rallies are a good sign that we are entering into the capitulation phase of P2. Bulls are in charge only because the bears are not putting up a fight. This is just a pathetic winding up of the tape. That said, I think we have a few more months of it after a pullback. I think P2 wants to head to the 62% retrace (~1230) in April/May/June/July. And I think it will be an even more tired winding rally than this one.

It won't even be a bear killer, the bears are already dead. This one will be a bull killer. Euphoria will peak. It is like the "Vomit Comet" (the plane NASA uses to acclimate astronauts to weightless conditions) at the height of its parabolic trajectory. At the top, the euphoria of weightlessness is exhilarating ... until your lunch starts sliding around in you. The bulls will have a similar "euphoric-yet-something's-not-quite-right" feeling around then.

Once the wall of worry is climbed and the bears offer no more resistance, only then will we have *the possibility* of crashing. And not before.

Is a Crash Guaranteed?

…. NO!!.

Like I was pointing out here: Examination of the Large Technical Landscape / Possible Paths, the next phase in the secular bear market could be a crash (P2 to P3 transition). Or it might be an extended sideways trading range before a larger rally (Primary B and Primary C of Cycle X) that eventually makes lower lows (Cycle Y) very much like the Japanese NIKKEI has over the last 20 years.
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