Caveat Ursi

The bears have reached a new level of exasperation as their wet dream of a sharp reversal out of heavily overbought conditions have been systematically smashed one positive week after the next.

We have now completed eight consecutive up weeks on the NASDAQ-100 (NDX) which is living proof of the old aphorism that bear market rallies are more violent and intense than bull market rallies. Take note that we actually completed five of those eight weeks in overbought conditions, the result of which has been a massive short squeeze during which a majority of bears have capitulated and moved to the sidelines.

Perhaps some regular readers remember what I wrote back on March 8th – in my Sunday forecast right after the very bottom of Primary wave {1} when the SPX had reached 666.79:

Do we really care about those ‘galactic cycles’ when trading on a daily, weekly, or monthly basis? Yes we do – because in a few weeks the nature of the market will begin to change. Initial cautious bullishness will quickly lead to euphoria and calls declaring the bear market as done and dead. I doubt that Primary wave {2} will last 500 days – after all this is a consolidation wave as part of a larger degree motive wave (see graphic above or in the sidebar on your right). But at minimum it will be measured in months and the characteristics of our daily trading reality will shift back to a climate resembling 2007. The pundits and politicians will exploit a market recovery as a sign that ‘the stimulus plan is working’ and that we are on the road to recovery. Do not be seduced and plan your trades accordingly, no matter at which degree of the wave cycle. The old buy and hold paradigm will only serve you well if your investment window is measured in months or weeks – not in years.

It’s fair to say that I was not exaggerating the intensity of the counter rally that was about to occur. Of course it’s one thing to write or read about it and it’s quite another to actually trade a bear market rally on a day to day basis. Many of you look at the combined economic data in conjunction with what’s currently happening in the credit markets and are stunned to see equities melt higher and higher without a meaningful retracement.

But that is exactly what we should come to expect from the initial stages of a 2nd Primary in a Cycle c wave of a secular bear market – it is a counter response to the initial destructive Primary leg and as such it is fueled by a unhealthy combination of hope, government interference, blatant manipulation, and a fervent belief that the ‘worst is behind us’. Although financial markets have grown considerably and have become vastly more sophisticated and a lot more fast paced in the past 200 years, the very essence of human nature and associated herd behavior has remained a highly reliable constant, which in turn continues to give us important clues as to the stage of the unfolding bear market wave cycle.

However, although we are about two months in this Primary {2} consolidation wave now various market sentiment indicators tell me that we probably are only half way through – if we are lucky. As you know by now – when counting all possible corrective wave types in EWT there are 11 possible kinds consolidations, ranging from simple zigzags to triangles, flats, threes, and a combination of all those. At this point it remains extremely difficult to accurately predict which shape this consolidation will take and how long it will last. However by carefully monitoring market sentiment in combination with our wave count we should be able to hit the target close enough once we are nearing the peak.

At this very point it is doubtful that we have arrived at the outer extreme of this Primary degree consolidation as the average investor is still weary of this sudden snapback and as bullish sentiment is still roughly around the 60% mark. Although that is quite a step up from the 2% bulls/bears ratio at the bottom of Primary {1} I expect to see bullish sentiment to approach the 90 percentile before this retracement has peaked and the third leg of this c wave is ready to unfold.

We cannot be impatient and need to give this retracement sufficient time – again, Primary wave {1} took us 500 days – and although I don’t expect Primary {2} to take that long a mere 60 days would be very short by comparison. As a matter of fact, it is possible that this Primary wave might take us well into August or even September. In that context it is however important to remember that the finale of [2} might not constitute its price extreme (e.g. in the case of a triangle) and it’s possible that we go sideways for several weeks before a break to the downside occurs which we can label 1 of {3}.

If you look at the very first chart above you will notice that we actually touched and surpassed the 200-day moving average on the NDX, which I deem to be significant. Although the NDX is way ahead of the SPX in terms of price advance it is therefore reasonable to expect some kind of meaningful retracement in the weeks ahead. This bull market rally is getting a bit long in the tooth and in particular after Goldman Sucks’ SLP program terminated on April 30th, we might see a disturbance in the force rather sooner than later.

However, there is a reason why I titled this post ‘caveat ursi’ – as in ‘bears beware’! IF we manage to breach the current high of 888.70 in the SPX (there is something about those triple series numbers) tomorrow or on Tuesday then I’m fairly certain that we will be visiting the 900 level in a very short order. At this stage the bears have been severely injured and will be very slow to jump into short positions – thus we could easily melt higher and as this rally has fed on bad news it might take a healthy dose of good news to put an end to it – at least temporarily. So, whatever camp you are in right now (and I know many of you are in the bearish department) – do yourself a favor and play it small. The odds at this stage are not as clear as you might want to believe – and there is an emphasis again on the psychological aspect of this. The market can stay irrational a lot longer than you can remain solvent – and that holds true in particular for bear market rallies.

At this point I see three different flavors for the coming week – two of them are almost identical:

Soilent Orange: We completed Minor 2 of either Intermediate (X) or (B) and are now pushing higher – much higher. The psychological 900 line should only be a hurdle on the way to what eventually might get us towards 1000. If we breach 847 the jig is however up and we’re talking Soilent Green.

Soilent Blue: Almost identical to Soilent Orange, the only difference being that we are still completing Minor 2. Turning points are either the 38.2% (SPX 860) or 50% (SPX 850) fib lines.

Soilent Green: We completed Intermediate (A) of {2} and are now at the onset of Minor A of Intermediate (B). If we breach 847 we probably dip a bit below that and then spike back up into Minor B, just to shake out a few more bears. This might be actually the best spot to get positioned for a drop towards 800 or even lower.

The NYSE McClellan – a medium term market oscillator – has traced out an almost perfect triangle which actually depicts the recent Minor degree consolidation better than either the SPX or NDX cash averages. This is another reason why I caution the bears at this stage – we are only in slightly overbought territory here and there is plenty of potential for more upside.

This might be of interest to you P&F fans out there. The more long term NYSE Bullish Percent Index just switched to a Bull Confirmed status and we are definitely in overbought territory.

This is how it looks like to the rest of us mortals. Yes, we overbought but frankly – it’s very possible we ride this thing higher. If you have doubts about the potential of this happening take a look at the inverse spike down at the bottom of 3 of {1} in equities. This game goes both ways and it’s not impossible that we might see new extremes here for another week or two.

Gold has done more than its part to test our resolve and might do so for a few more days. If I am forced to cut my GLD puts then it will be due to theta burn as they are May options. So, if I announce that I cut those do not take this as a signal that I have switched my outlook on Gold to the bullish camp – nothing could be further from the truth and only a breach of 968 would accomplish that.

In conclusion I would like to point you rats once more toward the fifth installment of Fujisan’s series on option spread strategies – if you haven’t had a chance this weekend (i.e. you have a life) then please hop over and read it top to bottom. Not only is it a first class tutorial on how to play those notorious butterflies you always wanted to know about but never dared to ask – but even more so as it will become the basis for a little experiment I am planning for the next few weeks.

First I have granted Fujisan some coveted EvilSpeculator powers which means she will now be able to compile her posts directly without me as the meddling (and most recently fumbling) intermediary. Second – the plan is to actually guide a number of intrepid rats through the motions of trading a small number of spread strategies (calendars, butterflies, verticals, etc.) over the coming two weeks all through the end of OPEX. This will allow us all to go through the motions and observe the behavior (and hopefully the pay off) of various promising spread strategies in real time. The added advantage is that – if the market goes against us – that we will modify our spreads in an effort to either retain profits or at least break even.

Again, more details on this will probably come directly from our venerable Fujisan – but feel free to throw out symbols of potential victims we might sink our teeth in. The previous thread already yielded a few good candidates if I remember it correctly.

That’s all I have in me tonight – believe it or not – this forecast has taken me 5 hours to put together (while I was concurrently backtesting various trading strategies) and I need some rest. See you rats on the other side.

Cheers,

Mole

UPDATE 11:15pm EDT: I just updated the evil.rat page – so go take a look. Admittedly the new graphs are a bit inaccurate as this is not what we’ve been trading in the past 10 days. However, as indicated, I don’t plan on changing the system around every week now and this should remain as is going forward.

The new settings on evil.rat/ES will take effect tomorrow morning as the majority clearly favors 2.0 according to the poll.

UPDATE 12:20am EDT: A preliminary version of the new resident.evil page has been posted – please note that it’s a work in progress. In that regard you rats might also be happy to hear that I labored all weekend to finalize a prime candidate for resident.evil/NQ.  The results of both the ES and NQ versions have been posted to the resident.evil page.

Finally, I managed to implement the notification module into resident.evil which means that it will be available to evil.rat subscribers starting tomorrow morning 🙂 Please note that you will only receive resident.evil email alerts – no SMS alerts will be issued as they are expensive (you damn freeloaders!).

And before I go let me dangle one last carrot: Something really exciting has been in the works for Zero subscribers and a select few will be allowed to test it starting tomorrow 🙂

UPDATE 1:00am EDT: I just realized that the resident.evil charts are slightly off – the shown statistics are about $1k too low – I will fix them sometimes tomorrow evening.

G’night!