SPX and Dow Update: Sentiment Still Favors the Bears

Sentiment continues to remain bullish, despite the declines in the averages last week. 

Rydex funds are reaching ridiculous extremes.  Rydex funds offer a good proxy for retail investor sentiment; retail investors are small money, and for lack of a better, more politically-correct term, are somewhat considered to be "dumb" money.  Retail investors usually tend to be "late to the party," so to speak.  So what does retail investor sentiment, as indicated by Rydex, look like right now?  Here's a snapshot: 

Rydex bear fund asset flow levels have dropped to readings not seen since at least 2008 (hint: these levels are lower than any seen during the entire bull run, including the March '09 bottom).  Conversely, the Rydex bull fund asset flow has now risen to levels not seen since at least 2008.

That bears repeating:  Rydex bull fund asset flows are now at levels not seen at all during the prior bull market, including at the March '09 bottom.  What does this tell us?

It tells us that retail investors are rabidly bullish right now, more so than they have been in years.  So why does that matter? (Warning: some of the upcoming is stuff my more experienced readers already know.)

These types of extreme readings are generally good contrarian indicators.  Contrarian investing is based on the concept that people act on their beliefs: when the majority of people are bullish, it usually means they've already bought stocks.  Obviously, the stock market is controlled by the same principle as any other free market: prices are determined by supply and demand.  When there are more buyers than sellers, prices rise; when there are more sellers than buyers, prices fall. 

So if the majority of small investors are bullish now (as are the majority of large investors), that means most of those bulls have already placed their bets on the market rallying -- which means the market is losing more buyers by the day.  Eventually, this lack of buyers will leave prices no choice but to respond by heading lower.  When buyers become scarce, prices will fall even if selling doesn't increase.  

As prices fall, more of these former buyers become sellers.  Really strong declines are marked by increasing momentum -- usually the middle of the third wave (at any degree of trend) is when selling pressure really starts to peak, as more and more investors unload their positions into the falling market.  Eventually, as a bottom approaches, people are bearish again, and the whole process starts all over in reverse.

It's the great Circle of Bear and Bull life.

Market psychology seems to reflect the natural cycles of the universe: when the sun reaches its zenith, it can only descend.  Likewise, winter is followed by spring, yet inevitably returns.  A star may be born from the ashes of former stars; years in the distant future, it may explode as a supernova -- and from its remains, new stars are born.   Humans go through a similar life-cycle (although few of us actually explode, as far as I know). 

The only constant in the universe is the self-renewing cycle of change.  As a result of the undeniable realities of our existence, these cycles, patterns, and rhythms are deeply etched into our psyches and behaviors; and our markets end up reflecting these patterns.  Or perhaps market waves and cycles are not simply a reflection of us, but are instead part of the cyclical natural order of all things.

What never ceases to amaze me is the way most people project the future in only a linear fashion, despite the obvious cyclical nature of things.  If the market goes up for 10 days, suddenly the average investor believes it's going to go up forever.  Likewise when the market goes down for a time; suddenly people act as if it's going to zero.  Very few things in this world move in a linear fashion.  Everything from our love relationships to our business careers seems to oscillate in waves and cycles.  The understanding of this is what separates the smart-money investor from the average investor (and separates the average investor from his money!). 

Anyway, back to sentiment.  

I don't view contrarian investing as a means in itself, for the simple reason that in bear markets, sentiment can remain depressed for a long time -- just as the reverse is true in bull markets.  So, in my view, sentiment is more of a confirming indicator.  Where sentiment becomes the most valuable is when it reaches extremes; especially when such extremes are disproportionately reversed from the market's primary trend.  High bullish sentiment in a bear market is a very dangerous thing; although, again, it can remain elevated for a time as part of the topping process, and, of itself, doesn't necessarily portend an immediate reversal.

I personally believe we're in a bear market -- so I believe the current bullish sentiment is confirming what the charts seem to be suggesting: we are on the verge of a new leg down.

Anecdotally, most traders I know continue to talk about a year-end rally.  It seems many investors are hoping Santa Claus will come down the chimney and deliver liquidity to all the good boys and girls.  (What should worry everyone is who is actually on Santa Claus's list... remember, he knows who's been naughty and nice!)  But I tend to agree that we might see a year-end rally -- I just think it's going to start from lower levels.

The charts are continuing to suggest that the snap-back rally off the November lows will eventually resolve to the downside.  The exact level from which this resolution will begin is somewhat challenging to nail-down, however.  Below is my best guess chart of the short term count:

If this count is correct, there may or may not be a little bit more upside due on Monday.  My count of the smallest time-frames indicates that Friday might have marked another short-term top, so a gap-down opening on Monday is quite possible.  However, futures are flat as I write this, so it remains to be seen. 

A breach above 1263.21 would negate this blue "1-2?" count, however it would not necessarily negate the potential for more downside.  Under the preferred count, a break of 1263 would only indicate that wave (ii) up is still unfolding -- wave (i) down can only be KO'd with a break of the October highs. 

In the search for other possibilities, I realized that, with a slight shift of viewpoint, it is technically possible that this is still Wave 4 of (i) down.  Below, I have annotated the Dow chart to show how this is possible, and also sketched in some annotations to show how Wave 5 might stair-step lower:

The arguments comparing Wave 4 vs. Wave (ii) are pretty simple:  In favor of Wave (ii), we have the deep retracement of the prior decline (62%); this is an unusually deep retracement for a fourth wave.  In favor of Wave 4, we have the sloppy structure of the retracement; second waves are usually sharper and cleaner.  I am favoring the Wave (ii) scenario by roughly a 60% to 40% margin. 

Also arguing in favor of the entire bear case, are Apple's chart and copper's chart.

There are also, of course, possible bullish interpretations to the current market (there always are, otherwise this would be ridiculously easy and I could have all my charts done in an hour!), but unless the market gives us some reason to start favoring those interpretations, I see no reason to spend too much time worrying about them at the moment.  The key levels to watch are still the October high and the November low.  The chart below shows my main bullish alternate count and the key levels to watch:

These are historic times, and this is a historic market.  There is potentially a lot hinging on what happens to the market over the coming days.  If there's one thing that makes me the most nervous here, it's that my calls have been dead-on hits for a while now -- so these are the times I start to feel "due" for a miss.  If the landscape suddenly seems to be changing dramatically, I will do my best to alert you to the changes, and on how they may impact future projections.  Trade safe!  

The original article, and many more, can be found at http://PretzelCharts.blogspot.com