*** Overall Picture
(Necessary, not sufficient, condition satisfied.) In Monthly Outlook Update (8/1/14), we noted from an EWP perspective that "Since a 5-wave decline is necessary for a larger decline, a fifth wave sell-off next week to retest Friday’s low is required." Lower lows in stocks this past week satisfy this necessary condition.
Market participants now face the uncertainty whether the 4.35% sell-off in SP500 is the ending move of a pullback OR the onset of a larger pullback / reversal.
(Expectations of a larger decline requires confirmation.) We also noted last week that a full retrace of the anticipated rebound offers confirmation of a larger decline. Again, a failure to confirm suggests a short term bottom.
*** German DAX
Price actions in the U.S. Russell2000 index (RUT) and the German DAX Composite also help illustrate these bullish and bearish scenarios. An analysis on the German DAX is timely since we have been focused on European financial markets, geopolitical risks and the sharp drop (-11.42%) in DAX. We make the following observations.
Interestingly, price actions in RUT has been tracking those in DAX quite well since the 2009 bottom. See Chart 1. Coincidence?
From a bullish perspective (since the bearish count from the high is straightforward), recent selloff in DAX could be the ending move of a wave D-down or wave 4-down correction since its January high. To illustrate, one counts DAX from its 2009 low to its January 2014 high as a zigzag and a downward expanded flat since then (Chart 1). Chart 2 offers a closer look at the proposed expanded flat, overlaid with price actions of RUT. The bullish interpretation suggests a near term buying opportunity for wave E/5-up.
*** Near Term Rebound/Upswing
For the moment, a rebound is likely in progress since Friday's pre-market lows in futures. There is heavy near term resistance around 1945 in SP500. Near term support is around 1892 which roughly corresponds to the Thursday-Friday overnight low in ES futures .
Three rebound scenarios are most likely, in our view.
Interestingly and perhaps conveniently, the market has gifted us with 3 unfilled gaps on its way down, observable on an intraday basis. See Chart 3. We can use these gaps to set a target as well as to time each of the 3 rebound scenarios.
Here are some details.
[Green - pullback, bullish - 3 gap fills likely] The pullback ended at Friday's low in the form of a month-long expanded flat in SP500. Since new highs are expected, all three gaps are likely to be filled.
[Blue - extended pullback, semi-bearish - 1 gap fill likely] An expanded flat pullback, wave (W), ended at the beginning of August. Friday's rebound is part of wave (X), in the form of either an upward expanded flat or a sideways triangle. The first gap around 1935 is likely to be filled, but the second gap around 1965 is likely out of reach. A wave (Y) drop should follow once the rebound exhausts.
[Red - potential reversal, bearish - 2 gap fills likely] The sell-off from the high is the wave 1 or A down, the rebound is wave 2 or B up. Wave 2 or B is likely to fill the first two gaps around 1935 and 1965, but should fail to fill the third gap around 1985. A waterfall decline is a possibility if wave 3-down or a strong wave C-down is next.