Previously, in my 1/28 Trader's Corner (click HERE), I was musing on the prospects of a 'complex' correction with another large decline to come after a limited rebound. Today's sharp sell off looks like the start of the weak second down leg in my forecast. The Market appears to be 'confirming in real time', conformity to the common corrective pattern of a decline, followed by a weak rebound and then another sharp sell off; and called an A-B-C correction in wave theory.

In the first rebound after a sharp decline, the bulls tend to assume the primary trend is READY to reassert itself. And predictably, as will be seen on the S&P daily chart below, the proverbial other shoe then drops, as "after a relatively minor rebound typically (e.g., a 38, perhaps 50% retracement of the first decline), another decline ensues." A second decline ('c') that will often exceed the first downswing 'a' by some fibonacci degree; i.e., the second down leg measures out to be 1.38, 1.5, or 1.6 times greater than the first decline 'a'.

As to the point above, the S&P 500 (SPX), after precisely retracing a fibonacci 38% of the prior decline, sold off sharply today. It appears the 2nd (up) part of a 3-segmented move completed itself and what remains to be seen in how FAR a second down leg will carry. It now seems that a return to where a bearish rising Wedge began in late-Oct/early-Nov (around 1030 in SPX) is more realistic as a target. Such an objective has been a relatively common outcome after the bearish rising wedge forms.

As to 'overconfidence' by the bulls, this was seen above graphically with my Sentiment indicator, which jumped from 1.36 on Friday to 1.74 by Tuesday and what I consider to be the threshold of a bullish 'extreme' in Sentiment. The thinking tends to be with the first rally, we're off to the races again! Not so fast! Typically in an ABC corrective wave, it’s the second decline that 'builds up' bearish sentiment.

SUBSCRIBER QUESTIONS, MY RESPONSE:

I haven't done a Q and A segment in a while but this past week there were GOOD questions and also that were relevant to a larger audience.

QUESTION:

"hello. I thought that was a great article that you sent out. My question is ..is this the theory you have applied every time the market has started to roll over and just saw what price action would do on the B leg back up to see if it was just a pullback or another leg lower to come? ...or, is this the first time you thought of an A-B-C correction since the March low and if so what made you think that this was more than just a pullback?

I guess my real question is when do you have this train of thought as opposed to just another pullback in an uptrend. I see a lot of factors of why your psyche on the market could have shifted but was curious on your input."

MY RESPONSE:

Your question is somewhat complex and I can't say for sure I understand all that you are asking. What I see is that this correction looks like it will have 'legs' so to speak and won't be a simple 1-part downswing as was the case back in June-July. the "Rule of Alternation" would suggest that this correction would most likely take the form of a more complex but still 'typical' a-b-c correction or a decline, followed by a rebound, followed by a another decline that would most commonly be deeper than the first down leg. (it doesn't have to be deeper as for example when a double bottom sets up).

An a-b-c (down-up-down) move IS a pullback in the sense of being an intervening correction within an overall uptrend. It's just that is has this form or pattern that is segmented. When the 3 parts of it run its course, you want to be back on the long side at the end of down leg 'c'. Now my prediction here is speculative in that this decline could be another simple 1-part pullback. I don't think so and that's based on feel and experience over a long process of trading/studying the markets.

Also, the 'rule of alternation' I've already mentioned and which we owe to R.N. Elliott's insights, comes into play in my thinking. Also 'sentiment' seems too bullish still for this current correction to not have a second pullback ahead as part of an overall correction. The bulls just don't 'get away' with buying EVERY pullback forever. Well sometimes it seems like 'forever' as in the internet/tech bubble. But that was a major bubble and those only come along rarely.

QUESTION:

You used, in your 1-23-2010 Index Wrap, the rising bearish wedge as the focus of your analysis. You wrote: "Such a view would also fit with what is a more common corrective pattern of an initial decline, a recovery rally, followed by another downswing. Such a second decline, could hold at recent lows (IF these turn out to be the lows for a while) OR go on to test the area where the bearish Wedge pattern began. The levels involved will be highlighted on my charts".

Your charts, except for the weekly chart, extended back to late September, 2009 and showed the bearish wedges to start about early October. To my eyes, the weekly chart you showed has a rising bearish wedge starting in early March 2009 and extending to about early January 2010, as shown here on an arithmetic daily chart for the SPX.

As you also wrote, the retracement from a rising bearish wedge (more so in stocks but also in times for indices) can go back to the origin of the wedge. In this instance. Back down to about 666. In my reading of you Index Wrap, you restricted you analysis to the action from October 2009 forward. Would I not be justified to use the time period of say ten month and arrive at a much lower price target than you did?

MY RESPONSE:

In terms of the weekly SPX chart, you could interpret a Wedge pattern beginning with the highs of Dec '08 to early '09 and the lows of March '09 and then extend those trendlines forward to the July lows, the October-November highs and lows, etc - the two converging trendlines then narrow in of course from there. Your observation is perceptive in terms of seeing the pattern on a larger scale. This interpretation would imply a major bear market downswing lies ahead.

[Interjecting here in my response back to our Subscriber, in the weekly S&P 500 chart seen below, I've drawn the major trendlines suggested by the reader's comment.]

However, the Wedge pattern (seen above) usually comes at the end of a prolonged advance, and I don't recall examples of such a formation STARTING at the end of a bear market. It (the wedge) is more typically showing a 'distribution' pattern of stock near the end of a prolonged run. Usually, the Wedge is a shorter-term chart formation that is traced out over a few weeks to at most 2-3 months. The pattern typically only suggests a short to intermediate-term correction lies ahead; e.g., 2-3 weeks or somewhat longer.

In terms of wave analysis, it looks like the second (of three) impulse waves higher ended recently, with another one to come. My best estimate of where we are is that we're in an intermediate correction and not starting a major decline. It would be one heck of a surprise if SPX was going to end up retreating back to anywhere near its prior bottom. Technical analysis has to also relate to the 'real world' of earnings and the economy. A major decline could happen if there was a 'double dip' recession ahead. I HOPE that's not the case as one recession like the one we appear to be coming out now of is enough for me!


GOOD TRADING SUCCESS!!