MTU Weekend Ed - Brace for Impact, Brace for Volatility (6/11/10 Close)

Bottom Line - The rebound over the past four trading sessions (+4.805% in SPX) from the year-to-date lows in most indices has been corrective in nature. The potential for a (near) immediate sell-off to lower lows in stocks, while not consensus, remains high. A continued deep retracement higher, while probable, remains a more remote possibility. In EW terms, a sell-off in the form of wave [v] of 1-down or wave [iii] of 3-down is more likely than a continued wave 2-up rally, especially when the flash crash is put into perspective.

I - The flash crash and the wave structure
With additional market actions / wave structure put in place since the flash crash, we should be able to the put the May 6th flash crash into better perspective to inform on market timing.

Market prints during the May 6 flash crash (about 2:20PM to 3PM EST) are more artificial than not, given the sizable subsequent rebound into the close and the ridiculous prints in some individual stocks and the subsequent reversal.

Note that the index lows reached during the flash crash (e.g. 1065.79 in SPX) are NOT artificial by themselves, from the perspective of the renewed bear market and the fact that these lows were violated only 6 trading sessions later on June 4th, but the timing of these particular prints is artificial.

On balance, removing the market prints during the flash crash (2:20PM-3PM, May 6) should offer helpful perspective on the wave structure. Indeed, it reveals some interesting scenarios – see below.

II- Bearish and primary counts – the June 3rd high (1105.67 in SPX) holds (Chart 1)

[Blue Labels - primary count] The initial sell-off since the April high (which is 1-down) is still in progress. Wave [iii] of 1-down ended at the May 25th low and wave [iv] is tracing out a triangle with Friday’s high as (c) of [iv]. Once (d) and (e) of [iv] are complete next week, we should see a wave [v] sell-off to new lows to conclude 1-down.

While part of wave [iv] overlaps wave [i], this is allowed when wave [iv] is a triangle as long (e) of [iv] does not.

Note that wave [iii] is only moderately longer than wave [i] at 1.19 times. This increases the possibility that wave [v] is an extended wave. So watch out below.

Note that this count accommodates the recent divergence among major indices - SP500 and Wilshire 5000 managed to stay above the May 25th lows by mere points this past Tuesday while the rest of the pack did made lower lows. Under this count, this past Tuesday’s lows are wave (b) of the triangle wave [iv].

[Red Labels] This is a very bearish wild-card scenario which interprets the May 25th low (1040.78 in SPX) as 1-down and the June 3rd High (1105.67 in SPX) as 2-up. Last Tuesday’s low (1042.17 in SPX) was [i] of 3-down and the rebound over the rest of the week was [ii] of 3-down.

This scenario warns that 2-up, a shallow retracement (0.362 in SPX), has come and gone. A wave [iii] of 3-down “crash” is directly ahead.

III - “Bullish” and alternative counts – the June 3rd high (1105.67 in SPX) to be exceeded (Chart 2)
The following “bullish” counts allow for additional (potentially volatile) upward retracement before the market sells off to fresh lows. These scenarios will allow longs to exit / distribute / hedge and the bears to re-load their shorts. Is it too good to be true?

[Red Labels] This count also interprets the May 25th low (1040.78 in SPX) as 1-down but describes 2-up as a flat whose wave [c] is still in progress. Under this interpretation, we have a regular flat in SP500 and Wilshire 5000 but an expanded flat in the rest of the indices.
A variation of this count marks last Tuesday’s low (1042.17 in SPX, truncation) as 1-down in the form of a leading diagonal. This interpretation allows for a much deeper wave 2-up retracement.

[Green Labels] Should the decline from the April high be a temporary pullback rather than the initial sell-off in a resumed bear market, this pullback likely takes on an A-B-C-X-A-B-C structure based on price actions to date.

In other words, the May 25th low (1040.78 in SPX) marks the end of the first A-B-C correction. Wave X, in the form of a flat – a regular flat in SP500 and Wilshire 5000 but an expanded flat in the rest of the indices – is in progress.

IV - Near term bearish potential among “all” top scenarios/counts (Chart 3)

The rebound over the past few days from the recent lows has been corrective in nature and sports a potential ending diagonal in the June SPX mini contract.

Such a structure as well as wave personality fits those of the end of a small degree second wave.

Also note the bearish divergence that has been developing between price and RSI.

Even in a bullish set up (green labels) where last Tuesday’s low is the end of 1-down with 2-up now in its initial stages, this is best counted as a leading diagonal nearing its end.

Thus, a near term (potentially deep) pullback is in order.

Appendix