Sunday, February 1, 2009

Weekend Special: The other side

Quite a few of you had asked me for more justification on the bearish scenario I had described. I do admit I lacked the proper technical justifications with clear examples and descriptions as to why we are going down and how far it will be.

- My long term bearish outlook

Before we go into our current market conditions lets review what elliot wave theory means when applied to a major bear market. If you do not know what elliot wave theory is look it up on google first to get a better idea. Here is a basic explanation:

Wave 1: while wave 1 is occuring no one expects it to be the first cycle of a major down turn, news and information is still very positive, price targets are still favoring bulls, as prices drop volume does not increase enough to set of alarming indicators.

Wave 2: Corrective of wave 1, with a 61.8% fib retracement, investors may seem bullish again as we are retesting the upper ranges on the retracement.

Wave 3: very bearish sentiment, prices drop quickly with little and short lived retracements, usually strongest wave exceeding wave 1 with a ratio of at least 1.61:1 (up to 2.61:1 possible)

Wave 4: corrective of wave 3 with smaller retracement compared to corrective wave 2, should not exceed 38.2% fib levels, usually sideways trend pattern, difficult to identify start and end of the wave

Wave 5: here is where many technicals differ, some say this is the strongest wave, others say it is weaker then wave 3.

So having this quick recap lets apply some of those theories on our current recession. Let me show you the waves first. Use the graph as a comparison.

Wave 1: during wave 1 many were still very bullish on the market. Look at commodities and technology 12 month price targets. All were still up sky high with forward P/E's of 25+. People were still buying into the "cheap" financials.

Wave 2: we retraced exactly 61%, many investors were very positive and kept their initial long term price targets.

Wave 3: our big crash, huge volume, we had no retracements to speak off while this wave was occuring and dropped substiantially in a short time frame. Very bearish sentiment.

Wave 4 (potentially current wave): retraced 25% thus far (my jan target of 945 I had posted in December). As you can see above its normally a sideways type pattern and hard to detect. We have been trading rather sideways and you can see in my forecasts I am unsure if we are already at the end of this wave or we still have a chance to get to the 38% retracement which is the 1000 mark I keep on hinting at.

Wave 5: So the question becomes can we get away with a black eye or will we get our legs broken. One thing we have to our possible advantage is the wave 1 to wave 3 ratio is normally 1.61:1 or only slightly more (on rare occasions up to 2.6:1), our ratio currently is 2.2:1 leaning towards the strong side (wave 1: 1575 - 1257 = 318, wave 3: 1440 - 741 = 699). This could give us a chance to have the final wave shorter as wave 3. So the question is will this be 640 or 480 as the final bottom?

Now you can understand why I have been so bearish since summer 2008 (went 100% cash at white dot). To take this further, apply this pattern to the dot com crash as an example and take a look at wave 5 there.

There is a possibility that my wave count for wave 3 and 4 is incorrect - in elliot wave theory wave 4 is the most difficult to count correctly from start to finsih and only becomes clear once wave 5 is confirmed. My bullish scenario (updated 2 days ago) ignores the trade action in november when we created the low. I said:

"* we have the exception of our Nov capitulation that created the low. How can we justify this key difference? - we were coming off one of the steepest down turns with VIX at levels never seen before and a fairly quick reversal leading to a rally from 740 towards 900 in just 5 days on extremely high volume. Is that enough to ignore or remove from this analysis? You be the judge."

This same can be applied here. If that is the case here it means we are currently ending wave 3 - this could have occured 2 weeks ago at the 804 low or the more likly scenario can occur next week when we dip into 700's as the market is waiting for Obama to create the new "savior" plan. I do believe on our next visit at the 800 we are breaking it to the downside. If this is to mark the end of wave 3 it should not drop below 765-770 and needs to break back above 800 within less then 2 days. If we are to break below the 765 and AND break the low of 741 it seems the count has been correct as this would indicate the start of wave 5.

My incorrect count here is very possible and would be inline with the wave 1 to wave 2 count and my bullish rally towards the 1000 mark as the corrective wave 4. What do you guys think?

So after all this review we do have to be more careful yet again on the break of the 800. I know it may be confusing and difficult to try to make out where we will head from here - I am in the same boat but I am confident now more then ever that we have covered everything to be ready for the next move. Next weekwill be deciding for all of us and will confirm our wave counts and of course the resulting trade action. Are we entering wave 4 or entering wave 5?

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