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Persistent Buy-the-Dip Mentality Could Lead to Trouble


How the price charts help show us how traders are positioning themselves, and why they may currently be positioning incorrectly.

Last week, I remarked to a few other traders that the "buy-the-dip" crowd seems to have been out in force lately, and that if and when support broke down, those buyers should provide heavy resistance to any rallies. When observing a price charts, it appears every dip has been bought quickly. This is leading to a halting decline that doesn't seem to want to get rolling. From this behavior, we can extrapolate that almost everyone is anticipating a positive resolution to not only the government shutdown, but also to the approaching debt ceiling deadline (October 17).

This psychology of positive expectation is consistent with the latter stages of a bull run. Contrast the current psychology with the last debt ceiling crisis, at the end of 2012. The markets were fearful and panicky then, and lots of folks were convinced we were about to crash. Of course, the ultimately positive resolution then kicked off a massive rally that has continued largely unabated through the present. That psychology of fear was consistent with the early stages of a bull run.

I've talked about this many times, but in order to grow legs, bull runs need sellers just before the move starts. Those sellers then become buyers on the way up, and actually fuel the move. Conversely, bear runs need buyers positioning themselves wrong ahead of time, so those buyers can become sellers on the way down. The majority simply has to be on the wrong side of the trade for any extended move to occur -- and that's where the psychology comes in. Expectations have to be the inverse of the ultimate reality, in order for traders to position themselves incorrectly in the first place.

So sentiment has to be bullish for a bear move to start, and it has to be bearish for a bull move to start. Just as we watched sellers position for the negative outcome back in December, we may now be witnessing buyers getting positioned for a positive outcome that never materializes.

Obviously, I can't tell the future -- but what I can tell is that if things go south, they're going to go south quickly, because the charts are showing us this. Frequent readers have heard me use the term "nest of first and second waves." That's Elliott Wave terminology -- in simple terms, (in a decline) a nested series of waves shows us buyers jumping in at each new low, which prevents the move from gaining steam early on. This has a coiling effect on the market, and the price charts show us how the majority of traders are positioning themselves. Since they're on the wrong side, when the move finally breaks and kicks off the third wave, it runs hard and fast as those early buyers suddenly exit en masse.

On Friday, I noted that it's difficult to find a pattern that doesn't require new lows, and mentioned that we may see a big gap down come Monday. Right now, futures are suggesting a double-digit gap lower for the S&P 500 (INDEXSP:.INX) -- and Friday's action has allowed me to narrow down the potentials further, and also to provide some qualifiers to help sort one from the next. The chart below outlines the details.

Click to enlarge

It's worth noting that the NYSE Composite (INDEXDJX:NYA) has dipped below the first key pivot, and if Monday's gap down sticks, will have been firmly rejected on the back-test.

Click to enlarge

The first blue-box target zone on the legacy SPX chart has come within a few points of capture, and presently looks likely to be captured in the upcoming sessions. If the nest of first and second waves is unfolding, the market will ultimately blow through that target.

Click to enlarge

In conclusion, I still feel it's unlikely the market will escape new lows. To the contrary, the pattern continues to appear to be a bearish coiling pattern, and trade below 1665 is likely to lead to an extended sell-off. Presently, the most bullish pattern I can find (of good probability) is simply an ending diagonal c-wave that grinds a bit higher to start off the week. Trade safe.

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