Trader’s Narrative

Everyone is excited that the Dow Jones Industrial is above 10,000 - again. While that nice round number may be where most of the attention is, there is another level which we’ve hit that is more significant.

But before I get to that, it is remarkable that every single major index has reached a new high. That includes the Russell 2000 and important sectors like the Philadelphia Bank index (BKX), Semiconductors (SOX) and even the Dow Jones Transportation index managed to reach a new higher close (while not exceeding the intra-day high on September 19th 2009). Also reaching a new yearly high is the Mid-Cap S&P 400 index as well as the Small Cap S&P 600 index. All in all, it would be accurate to say that a rising tide has lifted all boats.

But while everyone is partying like its 1999, excuse me for being a kill joy. The S&P 500 index has once again risen so far above its own 200 day moving average that it gives us reason to believe that all these new highs have stretched an already exhausted trend to the breaking point. Or at least to the resting point.

I presented a historical view of what happens when the S&P 500 is this far above its long term moving average. You can find the details in the previous link but the concise version is that this is not a good time to be long equities.

This rally was launched in early March 2009 when the S&P 500 was almost 37% below its long term moving average. Now it has reached 20% above it. Twice.

The first time in recent history was last month (September 16th) when it hit 20.27%. Not long after we had a very shallow and short lived pull back. And with today’s close it is 20.46% - once again above that magical 20% mark.

By the way, the S&P 500 managed to eke out a +2% advance in the 30 days that followed that first signal in mid September. That’s slightly better than the -1.16% historical average.

Since 1950 to now, we’ve seen very few times that the S&P 500 index has traded 20% above its long term moving average. In fact, the market usually tends to bounce between +20% and -20% like a ping pong ball. To see a large chart showing this, check the link above.

So what we are seeing is rather rare. And the consequence has been historically that the market will have to go sideways or correct. What it can not do is continue to sustain the pace it has so far:

The tendency for equities to remain within a +/-20% band of their long term trend persisted even during the birth of the super-bull market in late 1982. Then, the S&P 500 was barely able to nudge past the 20% mark, reaching a high of 23.28% above its 200 day moving average in early November 1982. While the index itself reached a high of 143 at that point, it was only by February 1983 that it was able to leave that level behind for good. So during one of the most powerful rallies, the S&P 500 basically tread water for 3 months. That is a persuasive precedent demonstrating the power of this simple indicator.

The other insight from this indicator is that at the top we tend to see a clustering of instances at or near +20%. This is indicative of the nature of market tops as they take much longer to form than bottoms. So far we’ve seen 3 instances of +20% during 30 days. We may see a few more. But the message provided by historical patterns is the same. At best we pause to allow the turtle-like 200 day moving average to catch up to the hare-like S&P 500. And at worst (for the longs) we correct sharply lower taking price down to meet the rising long term trend.

Either way, this is not exactly the time to pass around the party hats.

By Neil Beers

So Bob Prechter is bearish again.

That may be no surprise to some, but recall that Prechter was about the only bull on February 23 of this year when he covered the short position he had recommended on July 17, 2007. That was nearly two years later and 800 points lower in the S&P. And the Daily Sentiment Index (DSI) reading for the S&P had gotten down to only 3% bulls!

His February 2009 Elliott Wave Theorist explained, “The market is compressed, and when it finds a bottom and rallies, it will be sharp and scary for anyone who is short.” Elliott Wave analysis, the DSI, and other indicators suggested it was time for a Primary-degree bear market rally. And that is what we got.

Now in his August 2009 Theorist, Bob explains what “the prudent thing to do” in the markets is, based on the same Elliott wave pattern and sentiment indicators — plus the Dow’s 3/8 Fibonacci retracement from the March 9 low.

For more analysis from Robert Prechter, download a free 10-page July issue of Prechter’s Elliott Wave Theorist.

What’s so special about Fibonacci? And why is a certain level of Fibonacci retracement so significant in conjunction with The Wave Principle? Well…

In its broadest sense, the Wave Principle suggests the idea that the same law [the Golden Ratio] that shapes living creatures and galaxies is inherent in the spirit and activities of men en masse. Because the stock market is the most meticulously tabulated reflector of mass psychology in the world, its data produce an excellent recording of man’s social psychological states and trends. This record of the fluctuating self-evaluation of social man’s own productive enterprise makes manifest specific patterns of progress and regress. What the Wave Principle says is that mankind’s progress (of which the stock market is a popularly determined valuation) does not occur in a straight line, does not occur randomly, and does not occur cyclically. Rather, progress takes place in a “three steps forward, two steps back” fashion, a form that nature prefers. More grandly, as the activity of social man is linked to the Fibonacci sequence and the spiral pattern of progression, it is apparently no exception to the general law of ordered growth in the universe. … The briefest way to express this principle is a simple mathematical statement: the 1.618 ratio.

Elliott Wave Principle, Chapter 3

Fibonacci ratios in conjunction with The Wave Principle can help you anticipate trend changes. They allow you to calculate specific price levels of when and where a wave is likely to end. In this case, where the rally from the March 9 low is likely to end. There are several Fibonacci retracements that appear most commonly, so the market could of course move higher before it settles on the next wave down, “but we are no longer compelled to wait.”

Bob Prechter’s August Elliott Wave Theorist published a week and a half early: he did so to give subscribers time to prepare for what’s ahead. The issue provides a list of levels that mark Fibonacci and Elliott-wave related retracements for the rally. He analyzes which one is the most likely end point, and even explains how you can make the most of the waning rally.

You don’t have to be taken by surprise. Get the latest Elliott Wave Theorist and you’ll see where the rally is likely to end. Think about the difference this knowledge can make for you.

For more analysis from Robert Prechter, download a FREE 10-page July issue of The Elliott Wave Theorist. It challenges current recovery hype with hard facts, independent analysis, and insightful charts. You’ll find out why the worst is NOT over and what you can do to safeguard your financial future.

Neil Beers has a bachelors degrees in political science and philosophy, and a masters in classical languages. His broad range of study and focus on ancient and modern thought led him to Elliott Wave International to research and write about the Wave Principle, Socionomics, and human social behavior.

On October 9th, as the market dropped into the abyss and then stepped back to form a wide ranging doji candlestick, I quipped that if this wasn’t a bottom, to go find a cave and buy a gun.

After a brief sojourn below the low of that day, the market recovered and is now trying to claw its way back for good. Many are noticing that the S&P 500 has now broken above its downtrend line (two):

But as you can see in the chart, this isn’t really the first time it has done that during this downturn. In late October, it decisively broke above the downtrend line (one) with a very wide range up day.

Then it gave it all back and more, falling well below its previous swing low. My hunch is that the third time will be the charm (light green three).

If we invert the chart and imagine it has been uptrending, it is easy to notice the familiar pattern of 3 line breaks.

Last summer I pontificated about the future of Apple Inc. (AAPL) wondering if it was time to sell:

All the smart and “hot” money has been trading it and riding it higher. And you can bet they will run for the exit at the first sign that the party is over. Which is why I watch Apple so closely. I’m seeing a confluence of things which gives me reason to believe that the ride may be over.

So how did I do?

Well, Apple thoroughly spanked me. The only tattered consolation I can cling to is after writing that, the rocket ride known as Apple paused for the rest of the month of June. The only thing that knocked it out of the sky was the general market tumble in mid July. It found footing where it had paused earlier and off it went again when the market recovered.

I’m bringing this up for two reasons. One to review a past call and award myself a meager C- and two, to talk about entry into momentum stocks. Most technical traders agree that momentum stocks provide a great opportunity. As the saying goes, “the trend is your best friend”. Or, bodies in motion tend to stay in motion.

This is especially true when the market has corrected and is about to find its footing again. It is a very rare momentum stock indeed that can completely buck the general market tone. Apple certainly didn’t and it was one of the best performers in 2007.

The general market is like the tide or the waves of the ocean. It is a background element common to all boats (stocks). But some boats have better hulls and more hydrodynamic shapes. So they will react differently to the same common element.

Apple carved out a rounded bottom at $120/share, just as the S&P 500 found its footing. For AAPL that level also coincides with previous important points of support. From there it launched into an astounding recovery which left other stocks in the dust. While it has now easily reached the heights it once claimed in late 2007, the S&P 500 is still more than 8% below its highs of October 2007.

Although most would agree that it is smart to ride the momentum of stock like Apple, but can’t agree when exactly they should enter it. I would suggest that the best time is when the market has exhausted itself within a correction and is about to bounce back. This allows you to define your risk and base it on support levels, removing guesswork.

I received this question from a reader (Jim) on March 13th, 2008:

I love your updates, please keep up the good work!

My question is the following: Obviously we are in one of the worst bear markets (stocks) we have seen in a long time and all of the experts tell us novices that you MUST go with the major trend of the market and not fight the urge to go the other way. Yet it seems you have been looking for places to go long all the way down INSTEAD of trying to find places to go short (go with the MAJOR TREND) and I can’t figure out why? I’m sure you don’t care how you make $$ whether it be long or short….During the bull trend you looked for buying opportunities and yet in this bear trend you also looking for buying opportunities….

what would it take for you to write about looking for shorting opportunities? what would the market have to do for you to see every rally as a selling opportunity instead of every decline being a potential buying opportunity?

Thanks Jim. I took a short hiatus for the Easter holidays but I’m back. So let’s see about “keeping up the good work” and answering your questions.

First of all, you are right. Following the trend is a good idea. Especially if you’re just starting out. But let’s take a step back and realize that there are really only three types of trades.

Either method is fine, as long as you have positive expectancy and good money/risk management.

I don’t agree with what you say about this decline though. We can barely call it a true bear market since we just grazed the -19% mark from the top in October to the recent low. In any case, although it certainly feels brutal because of all the bad news flying around, I don’t think we are anywhere near the necessary proportions to call this the worst bear market we have seen in a long time.

So the short answer is that it comes down to style which of the three methods you want to pursue. The long answer is that I’m a masochist (kidding!).

As for what would it take for me to go short in this market climate, that’s a good question also.

I would be trying to short rallies and sell into down trends if the technical and sentiment measures I watch show that even as the market has declined, it has room to decline further.

Here’s what I mean. Let’s say we have a serious move down but the put call ratio doesn’t really budge. Or horror of horrors, it actually moves down slightly! Or let’s pretend that after a waterfall decline, retail investor’s sentiment either doesn’t get gloomy or actually improves! Those kinds of things would make me reassess how I see the market.

But today we are seeing the opposite. We already know that sentiment is absolutely horrible with the complete spectrum of market participants disgusted with the current market. We already know that people are afraid due to the put call spike we saw and we know that the market reached “washed-out” levels of oversold.

On top of that, when we do rally strongly for a few days, we immediately see people question it or dismiss it outright. Take a look at this recent article from BusinessWeek: “Stocks: Beware the Sucker’s Rally” Again, this confirms the abysmal sentiment out there. And in the crazy upside down world of contrarian analysis, it is exactly the sort of thing we’d prefer seeing (as longs).

Hope that answers your question Jim

And if you have a question or comment, please remember to write it on the relevant blog post… unless it has nothing to do specifically with what I have written. In which case, you can contact me.