SPX Update: Is Your 401(k) Ready for a 70% Haircut?

If you knew with pretty good certainty that the market was within a few percentage points of a long-term top, how would you behave?  Would you warn your friends and family?  I would... and have. 

Could I be wrong about what's coming?  Absolutely.  But here's how I lay out the logic:

1)  If my long-term technical work is correct, the market will lose more than half its value over the coming two years. 
2)  A rally that breaks the 2011 high would prove my current outlook wrong. 
3)  At present, the Dow is only 4.5% below its 2011 high. 

From my point of view, that's a potential risk of more than 50% loss vs. a potential gain of less than 5% --  define "no brainer."  And in actuality, my technical work suggests the market could lose much more than this, likely in the neighborhood of 70%.  Investors sometimes forget that if one's portfolio suffers a 50% loss, one then needs a 100% gain just to break even.  In other words, your portfolio has to perform twice as well to earn money as it does to lose money.  Bear markets can be hazardous to one's wealth.

Let's take another quick look at my long-term chart.  This chart is drawn using a technique called Elliott Wave Theory.  Elliott Wave was derived from decades of back-testing; during which R.N. Elliott discovered that the market's price movements create patterns in the form of repeating fractals.  Market prices are of course shaped by investor psychology; and people tend to respond to situations in similar and consistent ways, which is what forms the patterns.  In other words: history repeats itself.

A key factor on this long term chart is the wave which lasted from 2007 to 2009, labeled with the big red A.  This structure is called a "motive" or impulse wave, meaning its fractal consists of a structure formed by five smaller waves (see chart).  Under Elliott Wave Theory, this particular motive wave must be paired with another five-wave structure of similar size, shape, and direction.  However, there is currently no wave to pair this A-wave with -- so the implication is that its "mate" has not yet arrived.  This type of understanding is what gives Elliott Wave Theory its predictive value.

The current wave, blue Wave (2) could end anywhere within the turquoise target box, and may in fact have already ended.

 
The chart above represents the 10,000 foot view.  Moving into the shorter time-frames, the hunt is still on for the exact top of Wave (2).  The market appears to be in the process of completing this top, but there are still numerous paths it could take over the short term. 

Yesterday really didn't help much in eliminating any short-term possibilities, and in fact formed an inside compression day -- meaning prices never traded outside the range of the previous day.  The implication of this type of day is that buyers will show up at prices above Wednesday's highs, and sellers at prices below Wednesday's lows. 

My short-term target box was hit, and the expectation now is for Friday's session to end in the red.  An interesting seasonal fact is that the last trading day of the year has ended in the negative on 9 of the previous 11 years.  The lower blue box represents the next short-term target; however, this target would be invalidated with trade above 1269.37.

The market is still living within the black trendchannel on the chart above and that suggests the possibility that wave 4 of the black alternate count was completed on Wednesday.  I don't believe that's the case, but that's what KO's and stop losses are for.

The next chart I'd like to share is a sentiment indicator, in the form of the ISEE put/call level.  ISEE excludes the options purchases of market makers and big firms, so their numbers are specifically indicative of small ("retail") investors -- the investors who, more often than not, are the ones getting burned at the casino.  When ma-and-pop investors become heavily bullish, the smart money knows it's time to start betting the other way.  After all, Wall Street pros make their livings taking money from the little guys.  Oh, you thought their goal was to "help" you invest?  Sure it is!  And someday trained antelopes will pilot the Space Shuttle. 

This chart below illustrates the last 3 times ISEE sentiment reached these levels.  In two of the cases, it was at the July top, right before the mini-crash.  The third case was in September, when the market bounced, then made a new low. 

AAII sentiment numbers were also released yesterday, and bullish investors came in slightly above the long-term average (40+%).  Both of these sentiment indicators are at levels which have been consistent with bear market tops.

In conclusion, my long-term view for this market is quite bearish.  Given the fundamental stresses, such as international debt levels, LIBOR rates, the economic slowdowns in Europe and China, and the overarching threat of sovereign default, it appears to me that the charts are once again leading the news.  The TED spread has been at "financial crisis" levels for over a month, and is still rising -- so the stock market's continued elevation appears to represent some degree of suspended disbelief in all the real-world problems.  It seems to me that something has to give; and given the fact that the world's problems aren't likely to be cured overnight, that "something" is much more likely to be the stock market.  Trade safe.

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