Saturday, August 29, 2009

Technical Update 33.09

The probabilities have materially shifted in favour of a lasting market top. Of the 2-3 dozen market indicators I follow, all but a few are consistent with this hypothesis. If you would have asked me in April what I thought would coincide with a bear market rally top, I likely would have answered the following:

- extreme bullish readings from sentiment indicators (DSI, AAII, Investors Intelligence, bullish percent index)
- bullish proclamations from prominent analysts, investors, economists, central bankers and politicians
- media embracement of "a new bull market" via magazine covers and daily cheerleading
- persistently weak economic fundamentals inclusive of deteriorating credit conditions and banking failures
- negative divergences in the currency, commodity and bond markets
- negative divergences in momentum indicators (ie. RSI, MACD, Stochastics, etc)
- declining volume throughout the rally
- decreasing volatility
- countable Elliott Wave corrective patterns
- DeMark sell signals
- Dow Theory non confirmation

Among the above, nearly all conditions have been met. It would be wise to keep an eye on the few that have not yet been met.

- The Dow Theory, by many interpretations, has recorded a buy signal. Some interpret it differently, however.
- DeMark sell signals will record if we have a close below the close 4 bars earlier with followthrough on the next open (any close next week below S&P 1025 should do the trick).
- Elliott wave count could be suggestive of higher prices (I'll cover this more below)
- Although volatility is declining, options traders are overwhelmingly betting on higher volatility (declining prices) in September and October.

For volatility, it is important to note that when looking at the VIX, one is looking at option premiums for 1 month in advance. The VXV, however, measures volatility 3 months forward. The VXV is trading at quite the premium to the VIX. Additionally, historical (realized) volatility has been quite tame. And there has yet to be any "capitulation" in the premiums being charged. In fact, the spread between implied and realized volatility is at multi year highs. This may be something to keep your eye on for the following week, which happens to be the week before a long weekend (monday the 7th) and typically of very low volume.

It is worth pointing out, however, that back in October and November, when volatility was at very extreme readings, the VXV (3 month) was trading at a discount to the VIX (1 month). This proved to be correct as volatility was indeed more muted over the following months. There is no reason (other than contrarianism) that the same cannot prove to be true today with higher volatility being priced in. See chart below:

What is ambiguous about the Elliott Wave pattern (skip this if you don't understand Elliott) is the labeling of the final wave C of (Y). Since the March low, either a "zigzag" or "double zigzag" appeared to be playing out. The highs around 940 in early June marked the first zigzag, however there were not enough other factors (like those mentioned above) for this to mark a high, and a double appeared to be the most likely scenario. So from the 869 low to about 1018, we had an A wave, followed by a B wave retracement to 979 and a subsequent 5 wave rally to Friday's opening high of 1039.47. What is still up in the air is whether the recent 5 wave rally is simply wave (1) of a bigger rally past 1100 or not. I do not think this is the case, but it remains a possibility. Should a strong rally blow past 1050, this would likely become the higher probability scenario. If prices were to rise moderately early next week, we may be witnessing an "ending diagonal" that would terminate itself around 1050.

The chart below is courtesy of Daneric's Elliot Wave Blog.

As I mentioned earlier, the dollar and many commodities have failed to confirm the move higher in equities. Treasury yields, additionally, are well off their lows. If stocks are ready to push higher, these divergences need to disappear.

Lastly, I want to revisit something I was following a few months ago.

One should always be wary of an irrational market to persist longer than initially believed possible. And it should also be mentioned that corrective waves have a tendency to last a minimum of 1/3 the duration of the preceding secular trend. Marking the beginning of the trend as Oct of 2007, the first wave lower was 17 months in duration, meaning that this corrective rally should last at least into the end of the summer. Sharp pullbacks, however, can easily interrupt this path. And that is my primary expectation - that we see a sharp pullback of 10-20% in the near term, followed by a late summer challenge of, and perhaps exceeding of, the recent highs (S&P 956).

We did get our pullback (it was rather dull, though) into July of about 10%. And we did exceed the June highs of 956 (by quite a bit). We have also passed the 1/3 retracement in terms of time. This rally has lasted 25 weeks compared to the decline that lasted 61 (40.9%). Measured in constant dollar terms and using May '08 as the high, our 42 week decline will be contrasted with a near perfect Fibonacci 61.8% retracement next week. Something to think about... or not.

That's all for now.

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Roger J said...


To your list, I think you should add "absurdities at absurdly high levels". That absurdity is the pronouncement of Bernanke as the savior of the world & his re-appointment as Fed chairman. Mish called it an "Orwellian Madness". LOL.

If you follow the Japanese election, the opposition party apparently just won by a landslide (300+ our of 480 seats available)-- first win in over 1/2 century. Talking about shifts in social moods, here's one very nice representation of it. Not that DPJ is better, apparently they're also foolish... with handout programs, yet other plans to "revive the economy". I have the feeling that DPJ is an even more insane Keynesians than the LDP, just by glancing at their so far vague programmes.

Do you see extremely profound changes coming, Matt? Perhaps a yen crash and/or the changing guard of the ultimate safehaven/deflation currency from the yen to the dollar?

If you agree w/ Daneric's EW count that the dollar is currently in P2 and about to enter/already in very early P3, I guess you have to look at that scenario. If the yen is no longer a safehaven currency, then the world is left with only the dollar... which would allow for the violent, extended thrust that normally characterizes P3.

By far not a certainty. Just a possible scenario, and we just have to watch how the markets unfold.

Comments, Matt?

Roger J said...

So Matt,

What do you see on today's action per 10.21 a.m. EST?

Originally we (or at least many EWers -- I'm a new member :)) expected an ED to play out for the final 5th of C of ... of P2 to play out. However, with the break down of SPX under 1016, doesn't it look likely that last Friday was the top?

I think the count should look similar to this (courtesy of Dan):

After all, if we are looking for the perfect sign, perhaps we may never get one. P1 bottom didn't give the perfect signal either. No huge jump in VIX signifying massive bull capitulation. The last impulse looked more like a "3" (only later on, it could be declared as a "5").

Matt Stiles said...


I didn't get the conviction I was looking for on Friday's close, but had it this morning and sizably increased my short positions. It looks like the ED is out and the only remaining bullish possibility is that this is part of wave 2. It's hard to tell so early whether or not the move from Friday morning is in 3's or 5's. We'll likely know by the close.

But I'm not an experienced Ewaver. Still learning.

Regarding Japan, I'm still struggling to figure out what role they will play over the coming decade. The election of a new party could bring some dramatically new ideas in terms of monetary policy. If the present policies continue to fail, they may try something dramatic - perhaps resulting in a capital flight away from Japan.

I wouldn't want to be long or short yen here. Japanese equities may be an interesting play before North American equities.

Japan has not really resolved the problems from their bubble in the 80s. Their demographic situation is still very problematic - the younger portion have essentially no voice.

My view is that Japan will continue to be a deflationary force on the world economy and a potentially destabilizing force. The one thought I can't seem to shake is that North Korea will attempt to "test" the meddle of the new party by some provocative action, the Japanese will overreact and retaliate, and imaginations can run wild from there.

Take all that with a grain of salt...

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