MTU Weekend Ed - Realized volatility rose, no change in risk/reward (2/26/10 Close)

The market is nearly flat for the week, with SPX down -0.42%. But the past week was volatile, with overnight and intraday spikes in both directions. Compared to last Friday’s close, SPX reached a +0.28% high on Monday and a -2.09% low on Thursday. There has been no change in the poor reward-risk profile for long exposure over the past two weeks. See Despite the rally, little change in risk/reward -2/19/10, and Upside potential no longer compensate for downside risk-2/12/10.




Wave [ii]-up from the 2/5/10 low might have ended a week ago. But without a decisive decline with follow through (or a new high), it is possible that wave [ii]-up is still subdividing higher. Technically speaking, the second wave can retrace nearly all of the first wave's movement.

The above statement by itself is a weak justification for staying bearish. However, it is applicable at the current phase of the market, based on the larger wave structure, fundamentals and technicals.


Chart 1 presents the wave structure of the market since its January peak, with one bullish count to new highs and several bearish counts of wave [ii]-up. To summarize,
(1) (Green Labels) The bullish count assumes the rise since the 2/5/10 low is the start of an advance to new highs, possibly by way of wave 5 or the third three from March 2009.
(2) The bearish counts assume wave [ii]-up of 1-down is a double three that is already complete (red), OR a triple three that is still in progress (red), OR an expanded flat that is still in progress (pink). The yellow label highlights the possibility that the rebound is a (B) wave, rather than wave [ii]. These counts rule out any new highs and imply lower lows once they are complete.

If wave [ii]-up was complete on Feb 22 or Feb 23, Chart 2 presents ways to count the price action since then. The wave [iii] sell-off can start at any moment by these counts. A rise above 1112.75 in the March SP500 Emini will invalidate these immediately bearish counts.

The volatility index, VIX, made a lower low this Friday. Chart 3 offers the primary count of the VIX, with Friday’s low or the coming low as (B) of an (A)-(B)-(C) structure. It’s possible that what’s labeled as (A) is actually a (1), but wave 4 of (1) is almost invisible. The way wave (C) (or (3)) develops will offer clarification.

MTU-The Big Picture (U.S. Stocks), updated June 2011

In terms of the big picture, I have been thinking about the following three key questions for some time. I’ll attempt to outline my thoughts below.

It has been and will be a work in progress for the foreseeable future. As I continue to reflect on these items and as additional developments in key areas surface, I will give revisions and updates in this post.

So please come back to this post for updates from time to time.

June 2011 entry
6/25/2011

Overview
The Feb 2010 entry highlighted the most probable long term bullish or bearish wave counts for U.S. stocks. Based on market developments over the past 16 months, the current entry
(1) adds a more bullish wave count (inspired by tglacour) as at least a competing scenario to the bullish count highlighted in the Feb 2010 entry,
(2) makes adjustment to the bearish count.

Summary of the Feb 2010 entry (see below)
The Feb 2010 entry highlighted the most probable long term bullish or bearish wave counts for U.S. stocks (see this chart).

Based on the bullish count, primary wave [5]-up of cycle wave V-up of supercycle wave (V) of grand supercycle wave [III] has been in progress since the 2009 low.

Based on the bearish count, grand supercycle wave [III] ended at the 2000 high and a grand supercycle wave [IV] correction is in progress. At that moment, it appears that primary wave [2]-up of cycle wave c-down of supercycle wave (a) of grand supercycle wave [IV] has been in progress since the 2009 low.

What has happened over the past 16 months?
[1] 6 of the 11 broad market indexes have since exceeded their respective 2007 highs, including the equal-weighted SP500 index (Chart 1).

[2] Among major SP500 sectors, consumer staples, health care, consumer discretionary and retail sectors have also exceeded their respective 2007 highs, with energy, material and industrial sectors not far behind (see Were it not for financials … (1/21/11)).

[3] In Europe, $DAX and $FTSE100 have already retraced 87.92% and 80.31% of their respective 2007-2009 decline.



An addition to the top bullish count
Chart 2 presents an addition to the top bullish count, inspired by tglacour’s comments in the comments section. While the primary count in Chart 2 differs from what I gather is tglacour’s count (see the alternative count), the main message is the same.

Based on this count, cycle wave V-up of supercycle wave (V) of grand supercycle wave [III] has been in progress since the 2009 low. As a result, the 2009 low is one wave degree higher relative to the previous top bullish count.

The key merits of this count are
(1) it channels better at multiple wave degrees,
(2) the 2009 low rests right on the boundary of the base channel.


Adjustment to the top bearish count
Given new market developments (i.e. new all time highs and deep retrace highlighted in Chart 1), we must downgrade (but not eliminate) the likelihood of the rally since the 2009 low being primary wave [2]-up of cycle wave c-down.

Instead, a cycle wave b-up (or x-up) or supercycle wave (b)-up (or (x)-up) appears far more likely within the bearish interpretation. Please also see discussions in A Potential x Wave (2/4/11) Chart 3 presents the adjusted count.


February 2010 entry
2/21/2010

Q: Is the U.S. stock market in the vicinity of a grand super cycle (GSC) top or just a super cycle (SC) top?
Thoughts:

Bottom line - The U.S. stock market is more likely near a GSC top than just an SC top.

Timing - The GSC top may have already occurred (i.e. 2000 or 2007) or may surface within the next 5 to 10 years. For the 2007 peak to be the GSC top, it is necessary to assume a truncated wave [5] (of primary degree) in smaller cap indices. Thus, it is the least likely scenario (of the three).

Alt – There has been discussions among Elliott wavers about the possibility that the 1929 peak was a GSC top and thus the next GSC top should be 100-200 years away. This description is inferior to the primary count for two main reasons. First, Mr. Prechter (at EWI) has offered a count which (better) accommodates price actions in the early 1700s (at a GSC degree). Second, a 3-year retrace of a 200+ year advance is just too brief.

Q: Which is THE most probable long term bullish or bearish wave count?
Thoughts: See chart. I have highlighted targets for the bullish as well as the bearish wave counts on the chart.


Q: Which one of the bullish and bearish scenarios is MORE probable?
Thoughts:

This remains an open question as of 2/19/10 close.

Observations supporting the bearish count
[1] The broader macro and sentiment picture support a major correction (of a GSC degree).
[2] A major correction maps well into the pattern of economic cycles over the past four hundred years, from the perspective of Kondratieff cycles.
[3] Speculative bubbles typically precede the major correction within every Kondratieff cycle.
[4] SC wave (V) channels well, with the top at 2000. See the solid red channel lines.
[5] Decent Fibonacci relationship among waves. With the nominal peak in 2007, V=I-III within SC wave (V). With the orthodox peak in 2000, V=1.50 I-IV within SC wave (V).

Observations supporting the bullish count
[1] Macroeconomic numbers and corporate profitability have been stabilizing and improving since 2009Q1.
[2] Fiscal and monetary policies worldwide remain very accommodative. The resulting moral hazard is conducive to speculative behavior.
[3] Stock prices have been trending up since 2009Q1, and the retracement of the prior decline has been deep, especially in small cap indices.
[4] The level where the broader stock market had bottomed in 2009Q1 is indicative of a fourth wave ([4] of V(V) in this case). See the dashed green channel lines.

MTU Weekend Ed - Despite the rally, little change in risk/reward (2/19/10 Close)

While SPX has advanced more than 3% over the past week, on a weekly timeframe, there has been no change in the poor reward-risk profile for long exposure, and no change in the wave structure, as discussed in the previous Weekend Update (Upside potential no longer compensate for downside risk, 2/12/10).

The only material changes are that
[1] The rally over the past week allows us to eliminate the advance since the Feb 5th low being wave (ii)-up of [iii]-down of 1-down. This is the first of the top three scenarios outlined two weeks ago (Stocks to rebound, upside potential uncertain, 2/5/10).

The remaining two scenarios are still at play. The red and green labels in Chart 1 highlight the bearish and bullish counts, respectively.

The bearish scenario is my primary count. It describes the current rally as [ii]-up of 1-down, a short term upward retracement of a larger selloff. Once wave [ii] is complete, [iii]-down of 1-down will deliver a forceful selloff.

The bullish scenario is my alternative count. It proposes that the rally since last March has not ended and the current rally is [i]-up of 5-up.

[2] The advance since the Feb 12th low and since the Feb 18th-19th overnight low is nearing its end, if not already complete. Under the bearish count, this peak should be the end of [ii]-up.

There was substantial uncertainty last weekend regarding whether the market was near the beginning or the end of the rebound from the Feb12th low. Hence the poor reward-risk profile then. Now that there is clarity that the market is near the end of the rebound from the Feb 12th low, if the bearish count is on track, the same poor reward-risk profile applies (at one degree larger in EWP terms).

Chart 2 offers a squiggle count of the advance since the Feb 18th-19th overnight low. The count with green labels allows for another push higher, whereas the count with the red labels indicates that the top of the rebound is already in place at Friday’s high.

MTU Weekend Ed - Upside potential no longer compensate for downside risk

[P.S.] There will be no updates through Thursday, Feb 18, 2010]
Bottom line
While the anticipated follow through of the “Feb 5th rebound” came last week, subsequent price actions suggest that 1) prices are coming up against substantial resistance, 2) and that the remaining upside potential no longer compensates for the downside risk. This statement does not mean to rule out further upside potential, but does emphasize the poor reward-risk profile for long exposure at current levels. The downside risk is a third wave decline. Third waves are almost always powerful.

Detail
The previous Weekend Update (2/5/10) called for stocks to rebound, but with uncertain upside potential as the market had likely started a second wave of an ambiguous degree. Stocks did rebound in a sluggish fashion. From the Feb 5th low to Thursday's high, SPX rose 3.40% with the bulk of the rise having been achieved on the first day.

The ambiguity in the wave degree, (ii) of [iii] of 1-down OR [ii] of 1-down, is yet to be resolved. However, it may not be as important as previously thought. Regardless of the remaining upside potential, which most likely is limited, the market is at a point where the remaining upside potential no longer compensates for the downside risk. The downside risk is a third wave decline. Third waves are almost always powerful.

Key observations that highlight the downside risk.
[1] The sluggish rebound has traced out a series of "three"s - 7 of those by my count (Chart 1). This corresponds well with a double three (ABC-X-ABC) in EWP terms. Once the 7th wave completes, the selloff should resume.
[2] If it is (ii) of [iii] of 1-down, the rebound has sent large cap indexes to, and small cap indexes beyond the point of recognition / the Prechter point. In other words, the market has experienced sufficient retracement of (i) of [iii].

[3] Prices are now approaching significant overhead resistance. For example, the 1103-1105 area in SPX (cash) is where several fourth waves of various degrees reside (Chart 2).
[4] The VIX, market implied volatility, is completing an ABC pullback from its Feb 5th high. Within a larger picture, the current pullback is either wave (2) which is a retrace of its Jan 11th - Feb 5th advance and is bearish for stocks when complete OR wave [ii] of an extended wave 5 of (1) and is immediately bearish for stocks. See Chart 3.

The argument for more upside potential has been that the market is in a larger degree wave [ii] advance, rather than a smaller degree wave (ii) rebound. This view is supported by the deep retracement (to date) of the Feb 3-5 sell-off in the Nasdaq Composite, the Nasdaq 100 and the Russell 2000 indexes. However, the reward-risk profile is equally poor for long exposure in these indices, even if they are in a wave [ii] advance.

Take the Russell 2000, for example. The rebound since the Feb 5th low appears to be complete or nearly complete. Its wave structure is either a zigzag with a running flat connecting wave OR a double zigzag with a triangle connecting wave. Furthermore, prices are coming up against strong resistance where multiple fourth waves of various degrees reside (Chart 4).

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.