Friday, January 28, 2011

MTU Weekend Ed. - Dip or Top (1/28/11 Close)

The Big Picture

The recent high in the Russell 2000 Index (RUT) is only 48.59 index points (or 6.01%) away from a new all-time high (Chart 1).

A new all-time high potentially posts challenges to the wave theory in its current form, as well as to strategic bulls and bears (or permabulls and permabears).

As Chart 1 shows, the 2002-2007 rally and the 2007-2009 sell-off both count well as impulse waves in RUT. A new recovery all-time high introduces the dilemma of a pair of back-to-back impulse waves that end up being effectively a "corrective" structure.

The implications from a new all-time high in the RUT are two-fold.

First, if the proposed impulse waves are indeed back-to-back impulse waves, refinement to the wave theory is necessary to accommodate the potential for a full retracement of an initial impulse wave (such as a complex B-wave or X-wave that retraces more than 100% of an initial impulse wave, and an expanded zigzag even?).

Even if one of these proposed impulse waves is actually a corrective wave (see below) and thereby avoiding the dilemma, wave theory still needs to address a similar occurrence in RUT during the later 1990s. Then, a final impulse wave (1996-1998) had carried the RUT to its 1998 high and another impulse wave had driven the RUT to its 1998 low before the RUT rushed to its Y2K peak.

Second, one of these impulse waves is actually a corrective wave. For example, the 2002-2007 rally may be an odd-looking triple three involving rare structures and truncations at both ends (see blue count in Chart 1). There may be more sensible ways to count the 2002-2007 as a corrective wave. But the point is a corrective wave count for the 2002-2007 rally is at least no more straightforward as an impulse wave count.

Note that new recovery highs in Nasdaq indexes do not pose the same challenges as their Y2K peaks accommodate this type of corrective rebound (Chart 2).

Interestingly, the wave structure in RUT during the dot-com bubble era could be a potential precedent and could offer guidance.

As discussed above, the rally to and the sell-off from the 1998 high is somewhat structurally similar to the rally to and the sell-off from the 2007 high in RUT. If so, we could have a potential guide for the next 10 years noting that the current time scale is about 3x. If so, we could have a volatile, sideways market that traverses a very wide range for years.

Specifically, the two circles in Chart 1 highlight the potential or the risk for history to repeat/rhyme itself at a larger degree thanks to the fractal nature of waves. The two pink asterisks attempt to locate where we are within the potential market cycle - i.e., at the end of an initial deep-retracing zigzag with wave C of the zigzag much shorter than its wave A.

If history repeats itself, a meaningful pullback after the current advance ends (see below) could be followed by a sharp advance likely mirroring the late-1999 to early-2000 melt-up. The advance is bullish in price terms while being corrective in terms of the larger wave structure (i.e. no subsequent follow-through, only reversal).

It should be noted that no such similarity can be observed in the broader market (e.g. SP500 which is shown in the lower panel in Chart 1). However, given that the trajectories of SP500 and RUT are nearly identical since the 2002 low (Chart 3), it's prudent not to discount continued correlation between the two indexes for the foreseeable future. More importantly, the similarities in wave structures are the most relevant.

Dip or Top
Today's high is a convenient place to complete the advance since the July 2010 low in many aspects. However, it is also probable that today's impulse wave decline is still part of wave [iv] of wave 5 in INDU and SPX since the July low. See the competing counts on INDU, SPX and NDX below.