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Reaction Rally or Meaningful Bottom?


The charts still appear to be pointing to lower prices, but here are the key levels to watch.

If W.C. Fields were still alive, he might change his famous punch line to: "I went to Washington, DC, but it was closed." On Tuesday, the market acted as if Washington's shutdown was the best thing it had heard in weeks -- a clear case of "sell the rumor, buy the news." However, I think the rally was a second wave fake-out, and I continue to believe that we're headed for lower prices. I don't believe that we're headed lower because of the situation in DC, per se -- I follow charts first and news second, and I felt the charts were pointed lower before all this started. However, the situation in DC could be the catalyst for the psychological shift that the charts were suggesting was due to occur.

How long will the shutdown last? Well, in one sense, politicians have already crossed the Rubicon and are past the hardest part of actually letting the government shut down. Now that the deadline has passed and the worst has happened, one would think the immediate psychological pressure to reach an agreement is at least somewhat lessened. In other words, if politicians couldn't reach an agreement when they were under the gun, it seems unlikely that they'll suddenly reach one tomorrow. I obviously have no idea how long it will continue, but by this reasoning, it could drag on for a while -- and this type of event tends to increase market volatility. Markets are generally uncomfortable with gross uncertainty, and the government shutdown is creating lots of future uncertainty.

There are some other effects from the shutdown that will impact the market in both subtle and obvious ways:

1. Economists estimate a loss of 0.3% of GDP for each month Washington remains shut down, so there is a direct and negative economic impact.

2. The Labor Department won't be reporting September's nonfarm payrolls (NFP), which impacts us as soon as Friday. This is probably fine, since it would only need to revise the number later anyway.

3. The Commodity Futures Trading Commission (CFTC), which is the agency that regulates the trading of options and futures, has only 28 of its usual 680-member staff monitoring for market manipulators and unusual activity. Since it's no longer watching, I wanted to personally verify that there was nothing suspicious going on in the futures market -- so last night, I put in a couple small orders, both to be filled at market. I'm happy to report that the market was functioning smoothly, and my ES (E-mini S&P) market buy order was filled instantly and seamlessly, at ES 25,392.50. I likewise had no trouble selling those same contracts later with a market sell order, and was quickly filled at ES 105.75. Maybe I'll stick to limit orders until the CFTC returns...

On top of the shutdown, we have the debt ceiling crisis still approaching. On October 17, the government has to stop borrowing money if an agreement isn't reached. This is, of course, a problem for a government that borrows $.40 of every dollar it spends.

The charts continue to suggest to me that further downside awaits, and the first chart I'd like to share is the 5-minute S&P 500 (INDEXSP:.INX) chart. The action on Tuesday caused me to revisit the short-term wave count, and there are presently two main options that could fit the structure. My preferred count is that the decline represents five waves, while the last rally was an ABC correction to that decline. The first alternate is just a variation on the theme, and an option that's simply unforeseeable: The market can string together a series of three corrective sequences to form a larger ABC, thus creating a more complex corrective rally. I can't predict that in advance; I can only anticipate it as it unfolds in real time. There are already enough waves in place for the reaction rally to be complete, so I'll stick with that interpretation until proven otherwise.

The more truly alternate count is shown in green, which considers the possibility that the market has declined in a somewhat oddly structured ABC fourth wave. That option will start to gain more traction if the market reclaims 1697, especially on a closing basis, but I'd have to see the form it takes to determine whether a break over 1697 is simply the black alternate playing out (which would be my first inclination). The only thing that looks even marginally iffy for bears here is the breakout and thus far successful back-test of the black channel; bears need to push the market back through the upper black trend line and keep it there.

That's a lot to digest -- so under the "keep it simple" philosophy: It appears most likely that the rally is over, and we're headed for new lows.

Click to enlarge

Next up is the Philadelphia Bank Index (INDEXDJX:BKX), which still looks like it needs further downside before we can start considering the potential of a complete fractal. Even if this is the intermediately bullish ABC, one generally expects to see a much better Fibonacci relationship between waves A and C than there is currently.

Click to enlarge

There are a few things worth observing on the SPX hourly chart. First, notice the breakdown and apparent back-test of the red uptrend line (bearish); second, RSI confirmed the low at 1674, which usually indicates that prices will break that low heading forward (bearish); third, note that black wave (1) hasn't been overlapped yet, which still allows the potential for a final thrust toward "alt: (5)" (this is not bearish or bullish, it's simply a fact). The black uptrend line appears to be absolutely critical for the bulls over the intermediate term, and of course, we're not there yet. If my near-term preferred count is right, we should at least test that price zone in the upcoming sessions.

Click to enlarge

In conclusion, I can see that there's outlier potential present for a bottom, but I don't feel it's likely the market has put in a meaningful bottom yet, so I remain in "sell the bounce" mode for the time being. If the preferred count is correct, the market is on the precipice of continuing the decline, and should pick up momentum heading forward. Since no outlook is ever a sure thing, stay alert to the alternate counts if the decline starts to look like it's three waves instead of five, and bears can't crack 1675. Trade safe.

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