Saturday, February 13, 2010

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).
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