It's all psychology

R. N. Elliot was the creator of the Elliot Wave Theory. He began his career as an accountant. He was forced to retire that exciting career after obtaining an illness in the early 1920's. He then dedicated his remaining 20 years to studying the stock markets.

What he discovered is that price movements are caused by natural laws based on basic human emotions. It is known in sociology that humans as individuals are capable of making many complex and unpredictable decisions. Yet when humans act as a group, their decisions become much more primative. Some call this group think. Anyway after dissecting 75 years of stock market history Elliot discovered that there existed some of these same primative recurring patterns in stock trading.

The fundamentals of his Elliot Wave Theory are based on how humans react to fear and greed as a group. These primative emotions have been played out for years in certain cycles. Some investors have used his theories to profit for decades.

If it is so easy why doesn't everyone quit there jobs and trade stocks accroding to EWT? Because EWT can ALWAYS show us why things happened, but it is difficult to predict exactly how things will play out.

The strength IMO of EWT is to give an investor a general idea of which direction is most probable for prices to trend and to give some price targets.

For example I had based my forecast of SPX prices in the 600's when the market was in the 900's in Dec and Jan based on EWT. I forecasted a bounce to 750-850 when the market's were sub-700 in early march based on EWT. As prices began to rise I was able to adjust my upper targets to well over 900 based on EWT.

What I need to improve on is trading successfully based on my price targets. It takes time and practice. One must use the EWT to look at all of the possible price movements and then set probabilities to each based on price structure and momentum indicators.

So where are we right now? According to the EWT The move from 666 to 930 was either a complete wave or the first leg of three off of 666. In EWT periods that we are in now are called "corrective" waves. These waves are the period where profits are taken off of a major move. The move from 1450 to 666 on the SPX is being consolidated, that is profits are being taken and new bull posiitions are being established. These periods can take a long time and can take many patterns. It are these periods that discourage many from using the EWT.

We should be able to determine if the move from 666 to 930 was the entire move or the first of three by how prices act in the next couple of weeks. If the move was complete then we will begin the scariest move down of the entire bear market. If not then we will get a small (100-150 point) correction and then another move back up. If prices in the coming weeks act choppy and we trade in ranges then we are preparing for another ramp up. If prices trend down steadily with little overlap then P3 has begun.

Since 930 on May 8 we've traded in a range with much choppy overlap. This is evidence for the probability of higher prices this summer.

Almost there

Sorry I haven't posted yet this week, but I've been extremely busy. I'll get right to it. My thoughts on Friday were wrong. It was apparent when we gapped up at the open. So the other options I had laid out on the table were now the ones to consider. I held my short positions from Friday and waited for a pullback to sell them. The pullback, as has been the case since March 6, never came. So now I will wait and add to them near SPX 930.

My current count (finally) fits great with what has unfolded in the last few weeks. The correction is nearing completion. We should move up from where we are now (910) to possibly test the highs from the other week. Once we peak near or over SPX 930 we will have one leg remaining, the C part down. I am targeting 850 for this right now.

The actions by the market over the past week is exactly why I always scale into and out of positions. No matter how confidant one is in their views, the market always seems to have its own ideas. By getting the general moves correct and scaling into and out of positions one can play without getting taken out. Staying in the game is the most important goal in trading.

Since I went about 50% short on Friday I have plenty of cash left to add to my position when I feel it has peaked. At this point I plan on going 100% short for parts/most of this C down.

Monday could be ugly.

We are poised for a big fall on Monday. I sent out messages this week regarding my change of opinion from favoring one more push to a new high to the top was in last week. The action today added more evidence supporting this. I am now about 75% sure we're headed down sub-850 before revisiting the 900's again.

If my wave count is correct then we are perched right at the beginning of wave 3 fo this C wave down off of 930. This wave should be the longest and fastest wave of this move from 930 to 8??. I am about 65% short. If we get a flat open or small gap up I will add more shorts. If we get a large gap up then I am wrong and will reanalyze.

I have targets for this C wave of 847 and 817. We should be able to tell which will be more accurate when/if this wave 3 develops. I will, as always, keep you guys in touch.

Just to put it out there, there is a 25% chance that we are in a complex correction, which is a fancy way of saying we may test 900 again and continue this choppiness for another week. Let's hope it doesn't happen!

Three possibilites, one most probable.

From an EW perspective there are three clear possibilities right now and one is a major probability.

The most probable scenario has us putting in one more high (or at least testing the high from May 8. The EW count fits great. I have been playing this count successfully in short day trades for about a week. In this scenario we are entering wave 3 up of the last leg. Confirmation of this will be a large gap up open tomorrow or a flat to slightly down open and then a large, quick move up many points tomorrow. FWIW FAS is already up $0.27 in AH so far. This would support the wave 3 tomorrow scenario.

The other two possibilities are that we topped on May 7 AH and will (1) move down in either a shallow correction or a (2) new bear market low. If that is the case we should be in wave 3 of the first move down off of that top. Confirmation would be a quick, and powerful move DOWN tomorrow. If the SPX moves above 920 tomorrow this count would be dead.

I am playing scenario 1, but only 30%. I am confidant this is correct, but it could end at anytime so I am being cautious.

Once this last move up ends we fall significantly but the million dollar question becomes "Has the correction off of 666 completed or has just the first leg of three ended?" We will not know until the prices reveal themselves in the coming months. However I belive that we have not yet seen the top of this move off of 666.

IMO this move will end when EVERYONE thinks the bear market is history. Babyboomers will resume their plans for early retirement and begin riding their Harley's again. Obama will be hailed as the savior (again) for saving us from economic turmoil. I just don't see this yet. Don't get me wrong, I realize that the media has been drumming this beat since about SPX 700, but that is to be expected with a Democrat in the Whitehouse.

Furthermore I believe that to get a P3 drop that is forecast by EW we need another catalyst. Terrible earnings are mostly built in to the current prices. Yes I know we've climbed alot since early March, but we are still down tremendously from the 2007 high. We need an economic catastrophe like the one I laid out in my post last week.

Therefore my longer term forecast is for a pullback beginning as early as Friday back to about 800-825 and then another multi-month rally well into 4 digits. I could see us rally to 1150 before topping. THEN we begin P3 sometime in late 2009 or very early 2010 with a truly horrifying target later in 2010.

Use extreme caution in the coming days.

We are very close to an IT top. All of the writing is on the wall. From heavy distribution days to quickly closing opening gaps up to momentum indicators crossing over and finally an end target on the EW count. Use extreme caution in setting long positions today and into next week.

Since March 6 we've been throwing rocks on top of a house. The rockpile is so large now that we can hear creaking in the walls. It's only a matter of time.

From an EW perspective we have about another 10-30 points up from where we will open. The end is difficult to gauge in cirumstances such as we are in now. Since we are so top heavy we could roll over at anytime, but the chances for a blow off top exist also.

I plan on scaling out of my longs from yesterday as early as today if we get to the 930-935 area. We are set to open near 920 and I got in my shorts in the 900-905 area. What I am looking for in particular is a quick blast upward. This will be the wave 3 of this final move up. I think today's open will be the meat of wave 1. We will then correct sideways or downward before entering wave 3. A possible scaenario is that after today's gap up we drift down or sideways and ramp up near the highs at the close. Then we get a sizeable gap up Monday for the bulk of wave 3.

After this the wave could end at anytime. If I get signals of a blowoff top I will move all in in seconds. If not I will gladly pass up the last few points up to prepare for the next leg down.

I expect the next leg down to be shallow. A usual retrace in past recessions were deep, 50-100%. I don't expect this, although I will keep an open mind for it. It just seems that there is too much "hope and change" in the air for a deep and prolonged correction. I also believe that like a building volcano, by not relieving the upward pressure that has been building completely we set the stage for the terrifying P3 wave that the EW guys are predicting. I will blog about that at a later date since it is many months away.

So I am looking for a retrace in the 38.2% range. The move from 666 to 950? would retrace back to 842. A 50% retrace takes us back to 808. So this is my range 800-850. I look forward to enjoying the ride down and scaring the hell out of the newly rich bulls, at least temporarily.

Near term and Intermediate term views have changed

I have written before (I think it was still in the email days) about what I strive to become as a trader. I strive to trade in the same manner I play poker. In poker I have no preconceived notion as to who is going to win a hand before the cards are dealt. I wait until cards are shown, bets are placed and players react to the process. I then use this information to guess at who has the best hand and if I can beat them or bluff them out.

This is how I want to evolve as a trader. Approach each day and week with no preconceived notions on how the market will move. I want to react to price and volume changes as they reveal themselves. I believe I am making strides, but have a ways to go.

A case in point is the current market situation. The facts showed me for weeks that the rally was stalling. Price appreciation slowed. Most indicators were showing exhaustion to the upside for several weeks. And thus I was short the market. Then on Monday prices rose, alot. I flipped my near term and IT views on the market at that moment.

Why? It became obvious that the prior 3 weeks were in fact NOT a topping process, but a basing process. Was this obvious before Monday's rally? I don't think so.

What became clear was that this move up was not over. We have another leg up to complete this move and Monday was just the beginning of it. It is my view now that near term we will hit prices near or over 950 SPX. I am playing this long. From here the most likely IT move is a retrace of 38% of the move off the bottom. If we top near 950 this would put us in the 850 area. This makes sense. We put in a very solid base in this area. It will take major bearishness to break it. We most likely will not get this bearishness for months.

After this shallow retrace we will being another leg up that takes us up over 1050. This could end this bear rally or we could get yet another leg down and another final leg up over 1100. If this bull ends with one more major leg up ti should go into the fall before ending. If we get a third major leg up (two more after the current leg) it should last into the end of the year and we'd begin the next bear market in Jan 2010 roughly.

The Healing Continues

The credit market index that I have created just had its 8th straight week of positive results (positive = getting incrementally better and negative incrementally worse). That is against a backdrop in the previous 12 weeks where the index was only positive 2/12 weeks. Additionally the weighted average score this week was a .61, the highest result since I began tracking this back in the beginning of December (0 = no change, 1 = incrementally better and 3 = incrementally much better). The average weekly total in the past 20 weeks has been -.06. Net/net the green shoots that Obama loves to talk about continue to show up in my credit market index. This supports not going back to the previous lows we hit, but I still think we are overbought. However momentum works both ways and until we get items that knock this index as well as broader market datapoins the market will remain robust. 2010 outlooks will be really thought about over the next quarter and that could be one of the bigger catalysts to push sentiment back down, but we’ll see.

Thoughts on my long term view

As you guys know I am short term (a couple of weeks) bearish, intermediate term (through summer) bullish and long term (several years) uber bearish. I believe that the deleveraging we are in has only been experienced once in this country's history. That was the Great Depression. Am I saying we are in another Great Depression? Perhaps, but perhaps not. I am saying that this bear market is not over and that in the end we could get second place.

The numbers suggest that at best an economic turnaround will take place in late '09 or early '10. That may be, it is too early for anyone to know. The equity market sure is acting like it is. In fact the equity market did the exact same thing in 1930. The INDU peaked in 1929 at a whopping 381.17. It dropped later in '29 to 198.69 for a loss of 48%. In 2007 the equity market peaked at about 1450. By early 2009 it had fallen 54% to 666.

In 1930 the stock market managed to rally 50% back up to 294.07. I believe, and have posted here, that we should encounter a similar rally. If we follow 1930's pattern we should hit 1050 to take back 50% of the losses.

In 1930 it became apparent to all that the bear was not slayed. Prices fell, and fell, and fell. Finally the low was put in in 1932 at 41.22. A whopping 86% fall from 1930's 294! If we were to suffer a similar fate, an 85% drop from 1050 (assuming we get there) would take us down to 147 on the SPX. Yikes!

This can be seen in a terrifying chart here:

http://stockcharts.com/charts/historical/djia19201940.html

Now fundamentally, from what I know which I acknowledge isn't as much as many others, the Fed was NOT accomadative in the 30's. They actually RAISED interest rates making the situation worse. Our current Fed could not be more different. Will this make a difference? Perhaps.

Lets look at some other comparisons from the GD to today. In the 1930's in order to maintain a balanced budget, President Roosevelt raised taxes on business and the wealthy. He also created many government spending programs to get people working. Sound familiar?

On a positive note the household savings rate was very high prior to the GD and as I said before the country had very little debt and a balanced budget. In contrast our savings rate had been negative for several years prior to 2009 and our budget? Not balanced. Our debt? Monstrous. In fact our national debt has exploded as seen here.

http://www.screencast.com/users/J-So/folders/Default/media/1586f4b3-db1b-4a1a-a8bd-63634469a5c6

Under the Obama administration it is expected that ANOTHER $10 trillion will be added to the debt in the next 10 years according to the CBO. (By the way this post is not a bash on Obama, it is not meant to be political at all.) On top of this it is rumored that we will institute national healthcare. And we have the social security and medicare deficits looming on the horizon.

To sum it up, the US faces a debt of a size that has never been dreamed of in the world's history. I believe that this debt load will become a problem much sooner than most would ever think. I believe that the writing is on the wall that foreigners are already beginning the march OUT of US debt. I also believe this will cause the next major downturn in our economy and the next leg of the bear market.

As the appetite for our debt decreases interest rates rise. Rising rates are what made the Great Depression worse. This time the rates will be caused not directly by a non-accomodative Fed, but indirectly through an accomodative Fed and through astronomically high debt levels.

Can you imagine what would happen to our fragile economy if 30 yr rates went back up to 7-8%? What about 8-10%?

Despite Bernanke's announcement of QE several weeks ago rates are already back OVER where they wer prior. Seen here:

http://stockcharts.com/h-sc/ui

It has been reported that China wants to diversify out of dollars. They are currently buying commodities and diversifying into other currencies. IMHO this is the beginning. It will continue as investors flee long term US debt for shorter term debt and commodities.

So this is my fundamental case for the next bear leg which may begin as early as this fall. Technically the case is already in the charts. Just look at what happened post 1929. We are tracing that same pattern.