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Here Comes the Santa Rally

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The market is perfectly positioned for a strong rally into the end of the year. Here's what to watch for which could negate that outlook -- plus, some education on Elliott Wave Theory.

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MINYANVILLE ORIGINAL Yesterday's update was unabashedly bullish across all time frames. I noted the market was likely to find a bottom directly, and wrote, "I am currently viewing the decline as a complete, or nearly complete, c-wave lower to wrap up yet another second wave. This suggests a strong rally is waiting in the wings."

While I felt I conveyed my bullish stance quite clearly, I later realized that I had neglected to detail (in plain English, anyway) exactly what I was seeing in the charts that caused me to turn bullish at Friday's low. I sometimes forget that, to those just learning Elliott Wave Theory, the whole thing can seem slightly more complex than trying to build a fully-functional suspension bridge entirely out of Spam and nachos. It has a language all its own -- but I use that language so often, I sometimes forget that readers don't necessarily understand what the heck I'm talking about.

So in this update, I'm going to discuss what I saw on Friday, why 1420 lost its significance for bears, what I'm watching going forward, and why.

One of the main markets that's given me the bull bug is the Nasdaq-100 (INDEXNASDAQ:NDX). Yesterday, I wrote:

The NDX has formed a fairly clean five wave rally off the November print low, and that does suggest trouble for bears. It's also now in a zone where a meaningful bottom could form. If the count shown below is correct, this represents a low-risk buying opportunity with the potential for a great deal of upside.

Hopefully, some readers took advantage of that low-risk entry. First let's take a look at the chart (for those following along at home), then we'll discuss why I wrote yesterday's paragraph and what it means to traders. I've added a number of educational annotations to this chart, to help detail my views.


Click to enlarge

There were two simple, logical conclusions that led me to view this chart as quite bullish. In Elliott Wave, five wave rallies move in the direction of the larger trend, and they cannot exist in a vacuum (in other words, you must pair the five-wave rally to the rest of the pattern; it cannot stand alone). So The first factor in my analysis is the five-wave rally off the November low. That leads me to the conclusion that the market must complete at least one more five wave rally in the upward direction (at the minimum). Two five wave rallies, separated by a corrective decline, complete an ABC. Three five-wave rallies, separated by two corrective declines, complete a larger impulse wave (a larger five-wave form). One five-wave rally cannot exist on its own in this position, so the rally from 2494 to 2699 must be considered as Wave-i or Wave-a.

Next, I zoomed in on the smaller time frames and counted five-waves down from 2696 to 2620, and that led me to another conclusion: If that decline is only the first wave down and not the end of the correction, then it appeared likely that the decline would ultimately retrace beyond where the larger Wave-i/a began at 2494... and that would break a cardinal rule of Elliott Wave, which says the correction to the first five-wave rally (the correction is called Wave-ii, or Wave-b) cannot retrace beyond where the rally began. This led me to the conclusion that it was quite likely the entire downward correction was over.

At this point, trade below 2620 would create a problem for that outlook, so that's the key level to watch for anyone who positioned long at yesterday's open.

The room for error lies in the fact that the market rarely forms "perfect" waves -- so it's always possible that my interpretation of Wave-i/a as a five-wave structure is incorrect. If it's not a five-wave rally since the November low, then the above points are moot, my preferred outlook is wrong, and the market is free to decline below 2494.

For now, we're going to assume that my interpretation is correct. Let's take a look at NDX daily to illustrate why NDX probably presents a problem for SPX bears. The bottom line is, it appears likely that NDX is headed to another rally leg of at least equal length to the leg from the November lows.

And if SPX follows suit and builds another rally leg of equal length to its previous leg, it will break above 1474 -- which then takes the bear count completely off the table (because of the retracement rule discussed regarding the beginning of first waves).


Click to enlarge

The next chart I'd like to examine, partially for educational purposes, is the S&P 500 (INDEXSP:.INX) bearish wave count. The scenario shown on the chart below is not my preferred read on the market for the intermediate term -- it's my first alternate outcome if I'm interpreting the higher degree wave structures incorrectly (in other words, if some of the waves I'm viewing as five-wave moves are actually three-waves, and/or vice-versa -- as I noted, the market rarely forms "perfect waves" and the majority of the work is left to the analyst to uncover and interpret).
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No positions in stocks mentioned.
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