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Morning Cup of Jo: Market a Trap or Opportunity?


Counter-trend rally may be coming.


Key Points:

  • Dramamine or Valium?
  • Opportunity or Trap
  • Possible counter-trend rally?
  • Cyclical Bear within the continued LT Secular Consolidation
  • Momentum/Price Divergence
  • What to watch for

Market Commentary:

Two Wednesdays ago the eldest sister (The Dow Jones Industrial Average) traveled northbound almost 300 points followed by an additional 200 on Thursday. The weekend passed and she went up another 135 on Tuesday – almost 700 in less than a week. Yet, as of last night's close, it remains a meager 170 points from the closing low of two weeks ago. The hell with dramamine, it's more like Valium that may have to be prescribed to some sideliners watching from afar.

When nerves abound it's important to remember that bear markets are much more volatile than bulls and contain many additional traps. The key is to be able spot an opportunity and rationally determine the probability when it's not a trap and take advantage – hence this Jo. As most of you are aware, my firm's technical prowess integrates price divergences with several different secondary indicators. I've penned a multitude of articles containing elaborate descriptions of Stochastic, MACD, RSI and Volume divergences. (You can access articles through a "divergence" search on the home page of our site.)

Before entertaining the possibility of a sustainable short-term counter-trend bull rally (defined by trend, not time) we have to look back to go forward – trends within trends. For simplicity's sake the definitions are Secular, Cyclical, Secondary and Minor. For those seeking an auxiliary perceptive, just over a year ago my firm published a special report updating our 100-Year Market Theory, which presented and defined these in grave detail.

Secular Trend – Consolidation:

This graph represents a monthly chart of the SPY (S&P 500) dating back over 10 years. The red horizontal line across the top represents the top of the secular channel and the very bottom black line represents the bottom. The two upward sloping blue lines represent smaller cyclical bull markets and the two downward sloping red lines represent cyclical bear markets. The two horizontal black lines in the middle represent long-term (LT) floors and ceilings where the market (viewed from a LT perspective) is likely to consolidate in either direction (≈ 1,150 followed by ≈ 960).

Click to enlarge

Cyclical Trends (weekly chart) – Bull to Bear:

Click to enlarge

The prior weekly graph of the SPX, which we have illustrated numerous times, demonstrates how the cyclical trend officially changed on January 16th of this year. That day we put out a Market Note stating that very fact. As most good market technicians will attest, there is traditionally a retest of the broken trend and it will likely coincide with the third point of the new trend. This occurred the third week in May and we posted another Market Note stating we were being "devil's advocate" to the recent six-week enthusiasm. In other words it was the first secondary counter-trend rally in the latest cyclical bear market.

Onto the short-term (ST) daily graph of the SPX to determine opportunity or trap.

Secondary Trends

Click to enlarge

The red downward sloping line represents the new cyclical bear market and as you can see in the numbers at the mid – top left of the graph, as of this morning it shows (OH -21%) where OH = Off High. This took nine months, from October 11th, 2007. As previously mentioned, bear markets have a tendency to be shorter in length than their counterpart bulls, but also encompass higher volatility and greater percentage swings. This, for investors that are prepared, can create opportunities in the form of secondary counter-trend rallies; the first of which occurred from the end of March to mid-May.

The first part of this 'Jo' mentioned the 700 point gain and subsequent loss for the DJIA all within two weeks. To me, that is not a meaningful opportunity. The risk reward is too high for my taste. All that truly occurred was a retest of the horizontal support/resistance from the January and March lows that were broke in late June.

With that being said, their have been some road signs that indicate that we may see a counter trend rally within the next week or so. On July 15th the SPX hit 1,200 as the volume was picking up and the momentum indicators (stochastic, RSI and MACD) were reading the lowest levels since this latest cyclical bear began. But this is only the beginning and doesn't necessarily mean that you can invest long with abandonment. What would make this a ST opportunity is a shakeout reversal day which undercuts the prior low of 1,200 with major pessimism and closes positive. If this happens with a reversal on the momentum indicators and volume the probability has increased substantially that the market is headed for at least a retest of the cyclical bear trend (≈ 1,370). Now depending on where you buy and when you get in this could generate a 12% + move on the long side.

On the other hand, if the market breaks 1,200 and continues to slide, all bets are off and I'll be looking for the next potential support.

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No positions in stocks mentioned.

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