Friday, February 5, 2010

MTU Weekend Ed - Stocks to rebound, upside potential uncertain (2/5/10 Close)

Bottom line
The rebound anticipated in MTU (1/29/10) turned out to be brief and shallow (+3.09% and a 0.42 retracement in SPX). We are at another point where there should be follow-through on the rebound into Friday’s close. However, there’s much uncertainty surrounding the potential of this rebound. I’ll offer some details on each of the following three scenarios.

[1] The rebound may be shallow, not to exceed Tuesday’s high (1104.73 in SPX).
[2] It may be a moderate or a deep retracement of the selloff since the January high, as long as the market does not make a new high.
[3] There’s even an outside chance that the market may make a new high.

Scenarios [1] and [2] are about equal probability and represent counter-trend retracements in a resumed bear market. Scenario [3] is a small probability event which I highlight here to manage risk against my bearish interpretation of the market action. Friday’s low (1044.50 in SPX) is a critical level with respect to near term bullish potential.

Bear market progress report

With respect to the January top, the DJ Wilshire 5000 Index and the Nasdaq Composite Index have dropped -9.23% and -9.72% respectively. The forceful selloff over the past three days supports the interpretation that the primary trend has turned down.

The case for a shallow rebound (Chart 1-green labels)
The recent selloff has been swift and sizable (-5.45% over three days in SPX), and with broad participation (across stocks, sectors, countries and asset classes). These are often characteristics of a third wave. If so, the selloff over the past three days is wave (i) of [iii]-down. The rebound is thus wave (ii) of [iii], which should be capped by Tuesday’s high of 1104.73 in SPX. Once the rebound is over, the market will enter an even more powerful (iii) of [iii]-down under this interpretation.

The case for a moderate to deep retracement of the decline (Chart 1-red labels, Chart 2-VIX)
The rebound during the first part of the week, which was one of the two scenarios described in MTU (1/29/10), is rather shallow for wave [ii]. It has been +3.09% and a 0.42 retracement in SPX, and +4.3% and a mere 0.29 retracement in the Nasdaq Composite Index. It may be better described as a fourth wave, (iv) of [i].

In addition, the decline to date counts well as a completed five-wave impulse wave in S&P 500 futures and in the Russell-2000 cash index. The decline to date has been well contained within a channel which lends support to the view that it is a single down wave rather than two waves.

Finally, the VIX appears to have completed a five-wave advance from its low (Chart 2) and the dollar index may be completing either [i] of 3 or 1 from its low. The coming second wave retracement in the VIX and the dollar index will correlate well with a larger-degree rebound in stocks.

Under this interpretation, wave [ii]-up has just started and has the potential to reach 1110-1120 and beyond in SPX, as long as it does not make a new high.

A case for a new high (Chart 3 and Chart 4)
It’s possible that the rally since Mar09 is a five-wave impulse and the intermediate degree fifth wave has just started (or will soon start). This is a special (and remote) alternative count to manage risk against my bearish interpretation of the market action, as this interpretation faces three key challenges.

[1] It is not obvious that wave 1 and (especially) wave 3 are five-wave impulse waves.
[2] Wave 4 may be excessively lengthy in duration relative to wave 2. According to one of my counts, wave 4 is measured in months vs wave 2 in weeks.
[3] The shift in sentiment, the technical damage caused by the recent sell-off, the correlated movement in other asset classes and the global nature of the decline may be more supportive of a trend change than a wave 4 correction.

However, the remote possibility of a new high exists in my view. It is also consistent with the observation that

[1] Wave (5)-down of the 07-09 crash appears more like a “three” than a “five.”
[2] Some indices / sub-indices / sectors had bottomed in Nov09 rather than Mar09.
[3] The negative divergence between price and momentum indicators during wave 4.

This count also fits well with the scenario that the cycle wave c since Oct07 is tracing out an ED rather than a regular five. The rally since Mar09 is then C of an expanded flat [2] in some indices and C of an upward flat [2] in others.

Within this context, one should also allow for a potential extension of the current small-degree fifth wave decline (Chart 1-red (v)). If so, the level of the 200-day moving average around 1015-1025 is a decent target.

In terms of a new high, the 0.618 retracement of the crash, at 1228.74 represent a reasonable target.

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