October 15th, 2011

Consolidation or Reveral, That is the Question?

I’ve returned and am anxious to share my thoughts about the market. An incredible amount has happened since my last post on June 21, a brief three months ago that seems like a totally different era. The market then was also stuck in a trading range and we were wondering whether it would bounce off the range’s bottom boundary or crash through. I wrote then:

  1. Will it or won’t it break below the 200-dma and the neckline? I hope and now don’t believe it will. I think we’re going to see the market attempt to form a right shoulder of the emerging head-and-shoulder reversal pattern. If it does, that will be our opportunity to lighten up further at more favorable prices. And finally,
  2. Symmetry would bring the market back up to around 1340, 5-6% above current levels, over the next few weeks. At that point we’ll find out whether we’re out of the woods for the next leg up or reversing again and put the final nail into the head-and-shoulder formation.

In fact, there was another bounce with a high close of 1353.22 on July 7 followed by other close at 1345.02 on July 22. The bottom then fell out. In a mere 11 trading days, the market collapsed to close at 1119.46 or a 16.77% decline. Waffling around for the next two months with high volatility, the market skyrocketed over the past 9 trading days from a low of 1099.23 on October 3 to Friday’s close of 1224.58, or a 11.4% gain:

We were having dinner at a restaurant this evening and I couldn’t help but overhear the man at the next table was saying that he now feels like he really knows how to play the market. He was mostly in cash and was hoping for a further decline after which he’ll jump in with both feet and buy at the start of what he believed would be a new bull market.

The question to be answered is whether the recent trading range, as wide and volatile as it’s been, represents a reversal bottom or a consolidation? The market is now conveniently positioned at what would have been the target level of the previous head-and-shoulder reversal formed in February-July.

Does that technical explanation provide sufficient justification for considering the trading range a bottom? Is there sufficient positive macro-economic news for the bulls to generate sufficient upside momentum follow through to propel a move through the range’s top boundary and much higher? Or will the bears succumb to the negative background noise to enable the bears to take over and resume their push to lower levels. Here’s what I see unfolding:

I’m firmly in the camp of those who see the current trading range as a consolidation at the midpoint of a bear market that began this past May-July. If I’m correct, then we should see another 17-20% decline from current levels down to the 900-950 area. Two additional reasons that the 900-950 level will serve as this Bear Market’s bottom are:

  1. the neckline of the 2009 bear market inverted head-and-shoulder bottom that ended the Financial Crisis Crash should serve as strong support and
  2. that level continues the path followed when the market exited from the last secular bear market in 1980-82 (for more on that analog see December 3, 2009, July 13, 2010 and May 2, 2011)

There definitely are many fundamental reasons for staying bearish but the last nine days have been unusually convincing to those of the bullish persuasion. This last run-up has been especially hard on those who’ve remained bearish and elected not to jump on the bandwagon of those calling the recent run-up another “generational low” and a “chance of a lifetime” buying opportunity. My market timing indicator flashed a yellow warning light on August 2 but quickly switched to red on August 11 proscribing a move to “all-cash”.

I’ve been out of the market (and in a net short position via some ultra-short index ETFs) since then. However, taking a bearish stance vis-à-vis the market has been a terribly bumpy ride and, in all honesty, an unprofitable one since we got stuck in another trading range. My discipline was developed from an analysis of market behavior over the past 50 years; it alerted me to exit the market in January 2008 and spared me from the worst of the ensuing Financial Crisis Crash. I intend to follow it until it signals the reduction of risk and that it’s relative safe to return to the market.

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  • Anonymous

    Welcome back Joe and thanks for the info.Will keep some powder dry.