Most Violent Bear Market Wave Around the Corner?

From the recent EWI newsletter:

Is the most powerful of all waves right around the corner?

The short answer is “YES.”

The long answer will help you anticipate where and when …

First, let’s describe wave 3.

If wave 3 was a superhero, he’d probably be The Flash (though he could be The Hulk).

Like The Flash, there’s no mistaking wave 3’s characteristics:

* It gets to where it’s going in a hurry.
* It usually catches everyone by surprise, and
* You’ll know it when you see it.

Robert Prechter describes third waves in his seminal book with A.J. Frost, The Elliott Wave Principle:

“Third waves are wonders to behold. They are strong and broad, and the trend at this point is unmistakable. … Third waves usually generate the greatest volume and price movement and are most often the extended wave in a series.”

But to truly appreciate the power and lightening-speed of third waves – and be prepared to anticipate one – you must first know how to identify the waves that precede it, namely wave 2.

Here’s what Prechter writes about wave 2 in The Elliott Wave Principle (two words have been reversed to apply to bear markets):
“At this point, investors are thoroughly convinced that the (bull) market is back to stay. Second waves often end on very low volume and volatility, indicating a drying up of (buying) pressure.”
If you’re thinking the description of wave 2 seems eerily similar to today’s environment, you’re right.
On February 23, Robert Prechter’s Elliott Wave Theorist recommended aggressive speculators close their short positions to avoid being caught in a “sharp and scary” rally. Just a few trading days later, the market began a multi-month rebound – wave 2.
BUT … Volume has steadily decreased since that rally began in early March. Volatility is on the rise. And perhaps most noteworthy of all: The investment herd – more specifically, the financial media – has jumped to proclaim the “worst is over.”
All the classic characteristics of bear-market rallies are there. Even a quick online search turns up headlines like:
“Worst of the recession is over” ~ July 7
“Econ Crisis Not Over, But Worst Has Passed” ~ July 8
“June job bounce could mean worst is over” ~ July 7
“Wall St’s fear gauge suggests the worst is over” ~ June 28
Recognizing the personality of wave 2 allows you to prepare for what’s next, a move you really want to look out for, wave 3 – The Flash.
Third waves move far and fast. They make good opportunities for aggressive speculators, but they can become a death knell for longer-term investors’ portfolios.

I certainly agree that the current bear market rally has all the characteristics of a wave 2. How much longer it will last, only time will tell.

This chart, also from EWI, nicely displays the unrelenting optimism that we tend to fall prey to time and again during bear markets:

Bank Index

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Another Bear Market Rally Comes to an End

The recent bear market rally was kicked off on March 10th with the S&P500 at 676 and has most likely peaked on April 13th at around 858.

The market has been flooded with phoney reassurances, in particular for banks. It started with Citigroup expecting great results for Q1 and went on recently with Wells Fargo and Goldman Sachs. But as explained already, most of these announcements left a lot of doubts:

Citigroup – CEO’s phony statement sparks phony rally
Wells Fargo Needs Another $50 Billion
Goldman’s Orphan Month

Matt Theal at Minyanville writes:

The S&P 500 opened down today but quickly rebounded before selling off with Goldman. The index briefly tagged the 856 level before closing at 841. The market’s inability to get above the 850/860 square out (per Professor Cooper) shows that the level may be a top for the current rally.

Tomorrow will be a big day for economic data. First, traders will be watching the CPI, Empire Manufacturing, Net Long-Term Tic Flows, Capacity Utilization, and Business Inventories. These reports will be due out after the bell. Some market pundits blamed today’s sell off on weak retail sales, if there are any numbers that are worse then expected, watch for the market to sell off tomorrow. Right here I think all the positive data is priced in, it feels as if we are setting up for a sell off.

On top of that, it’s options expiration week. Today is Weird Wollie Wednesday:

“Weird Wollie Wednesday”, created by Don Wolanchuk, references the Wednesday prior to options expiration. The observation made by Wolanchuk stipulates that this day is made up of manipulated price action which is primarily related to the faster deterioration of options premiums during the week prior to options expiration; many traders are rebalancing and rolling their options forward. Using WWW as a guide, it is not uncommon to see strong moves down in the market place on the Wednesday prior to options expiration week.

To pick up on Mish’s S&P 500 Crash Count: In Elliot Wave Terms, we might have seen Wave 4 of 5 down and should now be entering wave 5 of 5 down.

Wave C down, broken down into 5 waves:
Click on image to enlarge.

Wave 5 closeup:
Click on image to enlarge.

According to Elliot Wave theory, Wave C down can extend wave A down by 1.618 times. Wave A was from 1,572 down to 800 which is a drop of about 772 points. This means that wave C down could be as many as 1249 points. Wave B peaked at 1,561, which means that wave C could take the S&P500 as low as 312.

It is questionable whether wave 5 of 5 down will take the S&P that low. It is probably reasonable to assume that it will bottom out somewhere between 312 and 600.

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