SPX Update: Looking for Confirmation of the Crash Wave

On Tuesday, my readers and I were pretty much all alone, looking for a top.  How things can change in a day!  All the sudden, the masses seem to be waking up from the drunken euphoria of Wave (2) and realizing the world doesn't look as good without the beer goggles of Central Bank intervention.

I want to talk about the psychology of different waves for a moment, so readers understand why I will be telling them: at this point, it's okay for the masses to get on board with our top call.  Before we get to the present, let's take a quick look at the past.  Back on October 4, when I predicted the S&P 500 (SPX) would rally from 1074 to 1265 (close!), I wrote about the psychology we should expect going forward off the low:

Keep in mind that the psychology of investors will probably become quite a bit more positive in the near future, so that by the time we reach the Minor (2) peak, the majority will be bullish again. It always helps to anticipate the mood, because after Minor (2) completes, we will be presented with what (I believe) may prove to be one of the greatest shorting opportunities of our lifetimes (but due to the psychology, by the time Minor (2) peaks, no one will think shorting is a good idea anymore -- just as most don't think going long is a good idea right now).

I think it's safe to say that the psychology detailed above pretty well matches what most investors were thinking on Tuesday.  Tops are made a little differently than bottoms.  Due to short covering panics, bottoms tend to be fast and furious v-shaped affairs; tops take a little more time.  In my preferred view, Minor Wave (2) actually peaked on October 27 -- but this secondary, smaller Wave (ii) peak, which likely completed on Tuesday, helped stretch out the top and further fulfill the psychological requirements of Minor Wave (2).

AAII investor sentiment (right) was released on Wednesday, and again came in at elevated levels; bullish sentiment is almost 6% above the historical average.  Add that to the other sentiment indicators we've been looking at for several days, and you get some pretty frothy bullish sentiment, consistent with an important top. 

If my preferred count is correct, we are now in the very early portion of Minor Wave (3) down.  I liked being alone when calling the top of both second waves, but now for the third wave, I'll welcome company.  Third waves are the moment of recognition for the masses.  This is the time people will (again) start waking up to the world around them, and realizing what a mess it is.  Third waves are not waves in which to be contrarian; they are waves in which more and more people will pile on the bandwagon as the move accelerates. 

At some point, that bearish sentiment will become extreme (in fact, more extreme than is generally considered acceptable), and at the very bottom of Minute Wave 1 (the first leg of Minor (3)), people will believe the world is ending.  Then something will come along that is perceived as really good news: maybe QE3; or the announcement that the European Central Bank has been purchased by China and will be converted into an outlet store.  This good news will come concurrent with the Minute Wave 2 bounce, during which sentiment will recover slightly -- however, not nearly to current levels.

But I don't want to get too far ahead of the market here, so we'll examine these things again when the time is right.

Onto the charts.  While there are never any guarantees, the setup in the charts is as good as it gets for the beginning of a third wave down.  If the market takes out 1215 on a closing basis, many indicators will roll decisively.  If it takes out 1190 below it, these indicators should accelerate to the downside.  You can also see in this first chart that if the market breaks below 1190, there is no meaningful support until the low 1100's.

Additionally, the market is falling down from double retests of both the 200 day moving average, and the head and shoulders neckline.  Both tests have failed; it's hard to imagine that the market would feel the need to test these levels a third time, but stranger things have happened.  Add these facts, and the bullish sentiment, to all the other charts we've looked at recently, such as the dollar, copper, oil, and others, and it's hard to imagine that the setup could get much better.

But as yet, there is not any real, objective confirmation of the preferred count.  It is more a case of strong circumstantial evidence.  For this reason, I have presented an alternate count as the final chart, and despite the near-perfect setup currently, I would suggest remaining aware of that alternate potential.

There are, of course, still bullish alternate counts.  Collectively, I would give the bullish counts roughly 20% odds.  Because of the fact that this new wave structure has generated a number of different bullish potentials, I've decided it's no longer prudent to focus on only one single bullish knockout level.  Instead, I think the two levels to focus on are those just mentioned: 1215 and 1190 SPX.  Either of these levels breaking could spark a waterfall decline; these are really the last lines of defense for bulls until roughly 1115.  Below 1190, and a trip to the 1074 low is almost a given. 

If this is black subwave 1 of Minor (3) down (as shown above), it should eventually take out the 1074 low.  Assuming my preferred count is correct, I anticipate that the market will probably test the 1000-1050 zone before it finds any type of meaningful bottom. 

The next chart is the short-term SPX chart.  I have tentatively labeled the move as a nested 1-2 count, which means we've seen waves (i) and (ii), waves 1 and 2, and waves i and ii.  This count would imply a strong acceleration of the move once the market sees sustained trading below the recent low of 1226.

However, I must stress that this labeling is tentative.  I had to go study the ES futures to gain any insight into the possibilities, due to the fact that the wave structure in the cash market consists primarily of one giant red candle, which is indecipherable by itself.  The reservations I have with using ES for the count is that the futures, being a highly leveraged market, are susceptible to wave distortion.  So the count below is my best guess.  Basically, trade above the 1251.82 swing high would rule out the blue wave i and make it more likely that the whole move was one wave, depicted as the black "Alt: 1" and corresponding "Alt: 2" label and target box.

There are three KO levels marked on the chart; each one KO's the successive degrees of second waves. 

There is always the temptation, especially when things go almost exactly as predicted, to become lazy and complacent.  I therefore want to offer up a third possibility.  The challenge of Wednesday's move is that (again, using ES futures) it could be counted as a three-wave structure (we've seen this movie before -- several times over the past week); the problem here is that there's virtually no visible structure in the cash market, other than a clean five-wave move at the end, which could conceivably be a "c" wave.  So I would again mention that there is no confirmation yet, and present this alternate possibility (below). 

I would suggest being cautious of this potential only if the market were to trade above the 1251.86 swing high.  If trade stays below that level, then this count really isn't even a concern.  Even above that level, I would give this count low probability, unless we start to see internals strengthening considerably. 

 

So in conclusion, my preferred view is that this is indeed the start of wave (iii)-down of 1-down of Minor (3)-down.  It really can't look much more promising... well, it could, if we could decisively eliminate the potential of the 3-wave move shown above.  Barring the low-probability alternates, I would expect a bounce today for Wave 2, and a reversal either today or Monday.  Keep on your toes, and trade safe.

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