SPX Update: Pre-Eating Some Crow in The Analytical Trap

There's a trap that's easy for analysts to fall into.  Let's imagine you've been bearish for a while and anticipating a top.  Let's also imagine that the market has continued going up anyway, and yet continues to give signs of a top... but it hasn't actually topped (read: a bit of self-flagellation).  The longer this goes on, the more you are becoming increasingly trapped by your own prior analysis.  The signs are all there for a top, and are actually increasing, but the market's kept rallying anyway.  What do you do?

Do you shift your stance to bullish?  Well, you can't really just jump in and randomly start buying, because the rally is long in the tooth, the indicators are overbought, and every objective piece of evidence says the rally is due for a pause at the minimum.  Do you continue looking for a top?  That's challenging, because the market is blowing up the bear view and busting through resistance levels like they weren't there -- plus you're starting to feel like the boy who cried wolf. 

And then the real psychological trap comes: what if you shift to a bullish stance right before the market tops?  Oh, the humiliation! If only you'd held onto your views for a couple more days.  I think this is a trap that a number of analysts have fallen into, which locks them into being on the perpetual lookout for a top.  In particular, I'm referring to a popular Elliott Wave subscription service, whom I won't mention by name (hint: a large international Elliott Wave service whose initials rhyme with "See W. cry.").  They continue to be bearish because it's something of a tradition ("Bearish Since 1988 and Still Going Strong!") -- and they've been bearish for so incredibly long that if they suddenly give it up now, the market is almost certain to drop 4000 points the very next day, and they will have missed calling it.  As a result, they are effectively trapped on the wrong side of the market for as long as the market wants.

I believe this problem can present a potentially huge psychological trap for analysts.

Well, be that as it may, I'm not going to play the Perpetual Top Hunting Game for the rest of eternity, and I don't want my readers to either.  People who have only recently started following my work may mistakenly think I'm a perma-bear.  If you weren't following previously: I nailed the October bottom to the day and rode that first rally leg up to 1265 before turning bearish again south of the 1292 high.  Recently, I switched my stance to short-term bullish yet again after the 1300-1310 zone was successfully back-tested, and stayed bullish up to 1342. 

I do realize I've been top-hunting for a while and have failed to pin it down here.  I've been early at best, or completely wrong at worst -- to be determined.  But practically speaking, since the October bottom, I've only missed about 50 points of upside (3.7%) on the S&P 500 as of Tuesday's close (1265 to 1310 = 45 points; 1342 to 1347 = 5 points), while capturing nearly 200 points of the rally on the long side.

Now, all that said, here's the relevant conundrum.  On one hand, it is objectively difficult to give up the bear case here.  When top indicators are firing off daily and historic highs are being reached in overbought indicators, the odds suggest there's some kind of top nearby.  If it looks like a duck and quacks like a duck, then it's probably a top (or possibly a duck, but duck hunting is considerably easier).  On the other hand, and I've said this before: the only time I've seen indicators fail this consistently is in a bull market (or a nested third wave: more on this later).  This contradiction makes it a tough call.

So what's a trader to do?  The simple solution is to be aware of the indicators, but give precedence to the trend.  The indicators serve as a warning that when the trend finally does break, it might be a meaningful break, so caution is warranted.  When the market becomes as complacent as it is now, it's ripe for an "event."  To paraphrase the famous proverb: pride goeth before a great fall.  Bulls have been openly gloating for some time, attacking and mocking bears, and talking about how "smart" they (the bulls) are.  The market rarely respects a "smart" investor, especially one who's become complacent enough to gloat (more commonly called a "smart ass" investor).

But as I've been suggesting for a couple weeks, until the trend breaks, it must continue to be given precedence.  The key now is to avoid the temptation to chase and/or front-run.  If one wants to go long, then reasonable entries where one can mitigate risk must be found.  The same applies to shorts.

Yesterday, the Dow Jones Industrial Average knocked out its Minor Wave (2) count by exceeding the 2011 highs.  A few people have taken this as if it's some monstrous failing of Elliott Wave Theory, which is just plain silly.  If one takes the approach that a system must be 100% perfect for it to be considered valuable, then no trading or investing system on the planet is valuable.  In fact, if perfection is the standard, then pretty much nothing on the planet is valuable.  Fundamental investing fails at times, value investing fails at times, moving average trading fails at times, classical technical analysis fails at times, candlestick patterns fail at times, et cetera, ad infinitum. 

At the end of the year, nothing and nobody has a track record of 100% success.  Obviously.  We'd all be beating down the door to get in if there was.

I've said it many times, but the key to trading success is as much about an individual trader's ability to manage his money and his own psychology as it is about the system.  To draw an example I've used previously:  if one has a system that is merely 50% accurate (random) -- but one only suffers 3% loss on each losing trade and makes 10% on each winning trade, then that system will make money in the long run.

Some of the keys are discipline, careful choices of entries/exits, limiting losses, not taking overly-aggressive risks (such as overusing leverage via options, futures, etc.), and protecting profits.  Figure that stuff out first and you're on your way to making money.  There are entire books dedicated purely to the money management aspects of trading -- it's that important. 

Striding into the market arrogantly thinking one can "beat the house" is a fool's errand.  The edge one has is their money management system and personal discipline combined with their trading system.  Believe me; I learned this stuff the hard way too.

Back to the market.  Over the short term, the possibilities are myriad.  So for the moment, I'm going to limit my focus on the big picture counts.  I'll still present them, but looking beyond the next five minutes, it's going to be difficult to narrow things down until the market provides more info.  This is another challenge Elliott Wave sometimes presents for newer traders:  there is a temptation to get too focused on anticipation of the next move, which can throw one into bad trade decisions.  To turn an old saying on its head:  it can be easy to miss the trees for the forest.

What we do not want to become is the "see W. cry" type traders... i.e - looking for a top the entire way up from the 2010 bottom to the 2011 top.  Granted, bears can make money in bull markets, but they have to be quick, disciplined, and not the slightest bit greedy.  Slower swing trader bears get slaughtered during bull runs.

Once the trend begins to shift, and I see where that happens and how that happens, that information will allow me to narrow down some of the big-picture potentials.  Until then, for the big picture we're going to spend some time focused on good old fashioned support and resistance, overbought/oversold indicators, and pattern recognition.  When conditions allow, I will also present Elliott Wave price projections (I have done so today).  Ideally, this picture will clarify soon. 

I'm going to present my new preferred count, but I continue to believe that at this stage it remains more important to watch the trend.

Even though the S&P 500 (SPX) did not invalidate its Minor (2) count yet, I'm going to make the assumption that it will.  No guarantees of course, but generally, this assumption has served me well over the years, as the Dow generally leads the SPX. 

Below is my preferred count, which (still) depicts the SPX in the process of forming the y wave of a double zigzag.  This count is interesting because it revises the big picture count but keeps the double zigzag in the intermediate-term counts.  However, without the Minor (2) hard cap, this count could see the market tack on another 100 plus points from here, and puts the target for (c) of y from 1376 to as high as 1500. 

I'll break down the short term view in more detail after this chart.

What I like about this count is the fact that it explains the five-wave nature of the 2011 decline.  I have worked that decline eight ways from Sunday, and I continue to come up with a five-wave structure.  This decline is what convinced me, and many Elliotticians, that the bear market was just getting warmed up.  There are very few positions in which we find a five-wave decline that doesn't match up with at least one more five-wave decline, but one such position is in a 3-3-5 flat (so named because the a and b waves break down into 3-wave structures, and the c-wave breaks down into a 5-wave move -- as they all do on the chart above).  In this case, it is an expanded flat with an unusually large c-wave.

This count also reconciles the 2010-2011 (c) wave rally into a much cleaner 5-wave structure, which many technicians have boggled over.

Many Elliotticians are looking at that decline as wave a and this rally as wave b, with the next five-wave structure to come in wave c.  I have considered that count, and I don't like it as much because I have a harder time seeing how it fits into the larger structure without really stretching the imagination and using all sorts of x's and y's and failed waves.  In either case, over the intermediate term, it's something of a moot point, since both that count and my count should behave somewhat similarly for a while. 

The challenge now is going to be nailing down where (c) of y ends and trying to find good entries for shorts or longs.  Assuming the rally breaks through 1350 +/-, then the next target is 1376-1378, where wave (iii) equals a 1.618 extension of wave (i) and wave (c) equals wave (a).  This makes 1376-1378 a double Fibonacci target, which gives it an above-average probability of both being hit, and of marking some type of reversal.

In the chart above, you can see that my preferred view has shifted to the idea that this current rally is part of the third wave of a third wave (wave iii of wave c).  Third waves are known for blowing up indicators, so this fits well with the recent action.  The most likely count appears to be that the 1378 area will merely prove to be the zone from which a correction starts -- possibly a decent-sized correction, which could retrace down to the low 1300's or even the high 1200's.  The critical point here is that if this view is correct, the ensuing bottom to this (assumed) correction could then launch the market up into the 1400's.

If the alternate count is correct, then it will amount to much more of a decline.  As I said earlier, my focus is more on the near term right now, so we'll have to see what form the next decline takes (assuming we ever get one), and how well the market holds its trend channel, before I'm able to have more confidence in whether it will mark or not mark the end of the rally. 

One thought regarding liquidity and perhaps another reason to favor the new preferred count, which currently expects that the next decline will only be a correction, is that the ECB launches their next big financing operation on February 29.  It seems that operation could easily fuel another leg up in this rally.

In conclusion, the Dow invalidating its Minor (2) count has forced me to objectively favor the view that the SPX will do so as well.  The projections above are what results from accepting that presupposition -- however, all of this is completely predicated on the idea that the 1350 zone will be broken.  I continue to believe this zone represents formidable resistance, and so far it has at least caused the rally a two-day pause.  If this zone isn't broken, then all my hard work tonight will have been for naught, and we can go back to cheering on the Minor Wave (2) count, since the SPX hasn't technically invalidated it yet.  Wouldn't that be a hoot!  Welcome to The Analytical Trap.  Trade safe.

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