Light At The End Of The Tunnel

The bulls certainly have been on a roll lately and predictably the financial media spin machine has quickly kicked into high gear. Headlines suggesting the worst may be over abound and the collective sentiment among investors appears to be that there is light at the end of the tunnel. The DSI hit a whopping 85% on Friday – just a few points below it’s October 2007 high. So I guess the good times are back and our economic problems are finally behind us – Big Ben did the impossible and simply printed us out of a deep recession. Ladies and leeches – I must agree – there is a very bright light and I actually have a snapshot of it:

Oooops. That’s right – it’s the old 4 express subway – and it’s heading straight towards Wall Street. And once it arrives the bulls won’t know what just hit them.

At the end of February the bears were getting a bit tired – after a 58% drop in merely 515 days there wasn’t too much honey left to be squeezed out of the market. It’s not that the economy had magically recovered over night but bears have a good sense of seasonality and it was also time to rest up for salmon season. Besides, there was a traditionally stronger earning season ahead, as were various accompanying signs that it was time to retire for hibernation. The bulls pretty much had capitulated and the SPX was dropping but on waning momentum. The DSI was at 2% and there simply wasn’t a bull left on Wall Street or anywhere else on the planet where equities were being traded. The time was ripe for a correction – and boy – did we get one of those.

Since then the bear have been patiently living off their fat deposits, slowing down their hear beats to a bare minimum, curled in their cozy caves, and waiting for the right moment to arrive. As the prevailing mood is turning increasingly optimistic many are however starting to lick their chops as they recognize a bear market rally when they see one. So, let’s take a peek:

Only two months ago I myself predicted a ferocious Primary degree correction but I am still stunned looking at this chart. The NASDAQ has now logged nine consecutive weeks to the upside and frankly I don’t remember the last time this has ever happened. I’m sure 2sweeties has some statistics on that and I hope he’ll chime in here. In the interim I have taken the liberty to count all consecutive down weeks since the onset of Cycle wave c and the maximum I see is six weeks. Last week I postulated that a ninth up week would be statistically remote however not impossible – reminding everyone of the inherent nature of bear market rallies. Unfortunately the bulls proved me right and we now find ourselves at a new extreme. Where we go from here of course is the Million Deutschmark question.

If we look a bit closer however we are starting to see cracks in the dam as the recently high flying and leading NDX (here represented by the Cubes) is now clearly lagging the blue chips (Spiders on the left). Whether or not this is a first sign of an impending meaningful correction remains to be seen but in my mind the probabilities are starting to point that way. Let’s count some waves:

On Thursday I suggested that we might either drop lower into (X) or push up once more to complete a fifth wave. The bulls didn’t disappoint and presented us with another opportunity to load up on short positions. We are now facing three major possibilities:

Soilent Black: We completed Minor 5 of Intermediate (C) and are now pushing into A of (X). The inflection point for this scenario is the 900 – 905 mark. There is a nice little upwards diagonal that recently developed, which also happens to mirror a lower diagonal that defines the lows of a recent running triangle (psalm 50:1-43 of our bible) and which concluded Intermediate (B). Of course 900 also is a psychological line of defense for the bulls as it was just recently conquered – if that is relinquished I expect things to accelerate to the downside quickly.

Soilent Orange: Very similar to Black but we are completing Minor 5 at the rising diagonal trend line that has defined and supported this Primary wave since early March. Due to time shift the inflection point range is between 900 and 910. A very plausible scenario if you think about it. We are now embarking into OPEX week and I am seeing a lot of open interest in SPY and QQQQ puts – what would make more sense to those MMs than to squeeze some weak hands just a bit more? This is exactly how blow off tops happen – and although I’m positioned to the downside it’s a possibility I need to consider.

Soilent Green: The WTF scenario. We still get a little dip to the downside but it’s only a Minor 2 degree correction after which we probably rally towards 1000 on the SPX. I do have some doubts about this one but wanted to throw it out to you rats anyway. Of course we probably wouldn’t count three more consective up weeks as things are starting to look pretty tired. But we might finish lower this week and then snap back to the upside the following.

Last weekend I suggested that the Bullish Percent Index (a longer term indicator) could easily push even higher, despite its recent overbought readings. Well, we now find ourselves at the 75 mark – the last time we were at that level was in June of 2007 – or the ‘good old days’ as the bulltarts would call it. Can we push even higher. For sure – remember that extremes go both ways in secular bear markets. However, having said that – it seems obvious that at least an intermediate drop is plausible.

I keep scratching my head over the pattern in the McClellan – this is probably the cleanest triangle I’ve ever seen on this thing. Clearly we should be heading higher but maybe this is in fact another representation of a waning trend to the upside. Observe how the McClellan started to weave up ahead of the March 9th 666.79 low.

We are back at square one with your VIX sell signal. Unfortunately we didn’t a higher close on Friday – and even worse – we didn’t drop below the BB line either – so, we’re actually at square zero.  Better luck next time but thus far – no confirmation. Which adds to my ominous feeling regarding OPEX weeks. On the up side however I’m sure that Fujisan has plenty of cool calendars for us to play with 🙂

The old buck has continued its downward spiral and this is starting to look like an a-b-c correction. I have shifted the old wave A fibonacci lines to line up with the onset of what I think is developing into C. Accordingly equality should be reached around the 80 mark. What worries me is that this is quite a few days off and gives additional credence to a possible scenario in which we could see either sideways or further upside tape in equities until the conclusion of OPEX week.

Finally, my old nemesis – Gold. I am still holding those put butterflies but only because it’s not worth selling them anymore. We did bounce back at that red diagonal on the chart but Gold has not made any efforts to retreat back underneath the 900 mark. Of course the cascading Dollar has not helped in the very least. At this stage I must switch my outlook to neutral for two reasons: First I am not confident enough in my count to play the long side here plus we are way too high for me to start going long. And second Gold has been way too frustrating for option traders as of late – and I must say that there are easier ways to make a profit and I’m sick of looking at these mind numbing gyrations. Sometimes is best to step away from a particular sector and focus one’s attention where the pickings are easier. Admittedly equities are not exactly easy either but even so – I rather put up with one difficult count instead of two 😉

On Friday watched a very cool video over at INO on ‘The Art of Morphing‘ by Ron Ianieri, which really blew my mind. This is great material for option addicts like us – if you think you understand options in and out – well think again as this guy can teach you another thing or two. Ron not only explains the concept of synthetics very well, but he then takes that to a whole new level and explains how you can ‘morph’ from one positions into the other without throwing commission into the greedy paws of your brokerage firm (sorry TOS).

Now, this is not an attempt to turn a losing position into winning one – which never works and should never be attempted. This is simply about elegantly leveraging options to their fullest potential so that you don’t get stuck on the losing side. The added advantage, psychologically I believe, is that you also are able to ’switch sides’ a lot more painlessly, thus you might not get married to your own analysis. Anyway, go and watch the clip and you’ll know what I mean. It’s free but a pesky first time signup is required if you’ve never been at INO (only email address + name, so I think it’s tolerable). Once you are in you’ll find the clip on the bottom right under ‘The Art of Morphing’ – fascinating stuff but it’s not a short clip, so bring a cup of your favorite brew.

I leave you with this:

Cheers!

Mole

UPDATE 8:32pm EDT: I was able to vastly improve on resident.evil/ES – cumulated profit now 150% compared with 120% previously ($44.3k from $39.6k). Max drawdown actually decreased to 2.37% from previously 2.42%. I plan to update the graph later this evening. I’m also working on resident.evil/NQ but thus far I haven’t been able to replicate that type of a jump but it was originally already at 140%, so maybe the old settings are the sweet spot.