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What Does the Expansion in Volatility Mean?

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Editor's Note: The following article is a free edition of Jeff Cooper's Daily Market Report. For a two-week FREE trial of his daily commentary and nightly day and swing trading picks, click here.

Last week, we offered that an hourly SPY/S&P 500 (INDEXSP:.INX) chart for February 2013 looked like a fractal of the dailies from July through October 2007.

Following the analogue, last week's high mirrors the primary high peak in July 2007 from which a violent shakeout occurred directly off the top.

Interestingly, that shakeout and our recent whiplash both began from roughly the same price level.

Note how the last 3 hours of the waterfall decline into the bell on Monday precisely echo the last 3 days of the plunge into August of 2007.

The question is, where are we now in this pattern?

It is possible to label the pattern differently as I have done on the hourlies with point B being the late July 2007 low (instead of the August low). In this case, the current rally is the first snapback prior to the plunge into August.

This would tie to another leg down in the S&P which would likely test 1454 to 1474. As you know, 1454 is 180 degrees down from our 1531 high and 1474 is the prior September swing high.

However, if we assume that Monday’s sell-off ties to the August low, then theoretically we are around early September 2007 on this roadmap with a creeping rally giving way to a final fling to a nominal new high.

Could this pattern play out, satisfying our 1550 projection?

Note how the authoritative break under the 200 dma in summer of 2007 was an early warning but that recapturing the 200 set the S&P up for a squeeze play above the 50 dma. The break off the July high accelerated once the 50 dma was snapped. The last ditch run into October was signaled by a large-range breakout over the 50 dma (Expansion Pivot signal) in September.

The October 2007 top was a mirror-image foldback of the decline off the prior July peak. In other words, the S&P declined 18 trading days following the break below the 50 dma to the August low while the top came exactly 18 trading days following the breakout back over the 50 dma.

Once again, it looks like recapturing 1500 S&P will be the key as to whether our recent high will be tested/exceeded.

I mention the mirror-image foldback from 2007 because it ‘feels’ like the market may be getting set up into Friday’s sequestration: is the rubber band being pulled back into more political drama just like at the end of December, which saw a pernicious squeeze?

In 2007, the rally to new highs, despite the financial crisis handwriting on the wall, seemed to send a false ‘all-clear’ signal to many market participants. It was perceived as a sign of strength and that everything was “contained”. That was the buzz by the ‘best and brightest’ -- that things were 'contained.'

Remember that following the failure of Bear Stearns, the market held on for months. The message of the cycles was that the high in October 2007 was a terminal top, a test failure of the July 2007 primary top, but Mr. Market made a lot of noise which obfuscated the obvious for the vast majority of market participants.

A few weeks ago, I wrote a piece about an 80-year market cliff. If I am correct, the object here will not be to pick the top but to sidestep the cliff.

Legendary market speculator Bernard Baruch exited the market in early 1929 and was ridiculed by the young lions of that era for missing the ride to the top.

The market always does its best to lure investors back to the flame when risk is the hottest because the most money is made in the shortest amount of time during end runs. Think about this for a minute: all bear markets in history have investors holding on to stock. They get religion, convinced by the prior period that serious declines are ‘gifts’, buying opportunities. Following the top in 1929, the chairman of General Motors (NYSE:GM) bought his company’s stock all the way down, until eventually he went broke and became a washing machine salesman.

He knew the fundamentals of his company, he knew the prospects. None of it mattered when emotion, panic. and forced selling dominated the tape. In the final analysis, arguably, he was too close to his company to take a bigger picture perspective.

The objective, if I am correct about the cycles, is not to get caught in an 80-year cycle top.

The recent plunge directly off a top followed an N/R 7 Week on the week of 2/15 may be pointing to the big-picture cycles due to exert their downside influence. We noted at that time that it was, in fact, the narrowest range week in many years. The presumption was for an expansion of volatility. The following week was an outside down week. Both of these indications were a warning: Monday’s up open was the mother of all sucker punches as anticipated: the market jack-knifed immediately.

What does the pickup in volatility imply? Let’s recap from a recent report, Connections:

“In the 4th quarter last year, we walked through the convergence of the 25-year cycle, the 50-year cycle and a 75-year cycle. They are all harmonics of the Biblical 50-year cycle of 600 months. 25 years is 300 months and 75 years is 900 months. If you connect the number of days from March 5, 1937 to the next 25-year cycle low on June 26, 1962, you get 9244 calendar days.

Click to enlarge

If you add 9244 calendar days to the June 1962 low, you get October 17, 1987. Since October 17, 1987 fell on a Saturday, the next trading day was Monday, October 19, the largest crash in a generation.

If you take 9244 days and add it to October 17, 1987, it brings you to February 6, 2013.

Note the first week of March high in 1937 which ties to the upcoming 4-year anniversary of the March 2009 lows. Has it really been 4 years since that capitulation?

Anyway, since the first week of February, the market churned until February 20.

What is interesting is that, dropping a digit and using 924 from the above cycle, points to February 20. On February 20, the market fell out of bed in a 90% Down Day directly off the top. In other words, 924 vibrates directly off February 20 on the Square of 9 Wheel.

From early February, did the market put two weeks of time on the side, as Gann would say?

When time is up, trend turns. Whether a nominal new high is eked out or not, February 20 may have marked a milestone.

Interestingly, February 20 is opposite August 24, the day of the high some 25 years ago, when the market topped following a 90-100 day rally mirroring the current advance from mid-November. That makes this March and April a pivotal period to watch with April being opposite October on the calendar.

If the S&P continues to carve out lower lows, March should be a down month. If 1510 and especially 1520 can be recaptured, the odds are a new high is in the cards with the possibility of a ramp up for quarter-end.

Conclusion. Despite the near 50 point plunge off the highs, the important 3 Day Chart has not turned down on the S&P. The S&P came close but stopped shy of testing the prior 1474 high and its 50 day moving average yesterday. Trade below yesterday’s low today will satisfy a turn down in the 3 Day Chart while at the same time satisfying a test of the 50 dma.

The first turndown in the 3 Day Chart and the first test of the 50 day moving average following a momentum wave is usually a good risk-to-reward buy. The market doesn’t owe us this, but it does look like yesterday was a little 4th wave rally with a 5th wave ahead. That would probably satisfy, a test/undercut of the 50dma.

That said, a possible measured move of 34 points has been satisfied. This ties to 1492 which coincidentally is 90 degrees down from the 1531 high. The S&P is struggling to hold this level of 90 degrees down despite Monday’s close below it. I remain suspicious of any rally until 1450-1460 is tagged, but you never know. That said, rather than a reversal, to these tired eyes, yesterday looks more like a Fed buy program to support the market in front of Bernanke’s testimony.

Strategy. Yesterday saw an approximate 50% retrace of Monday’s stab down. The overhead 20-day moving average is rolling over and is now at 1510 which should provide substantial resistance. Above 1510, I would not throw short logs on the fire.

The tape is mixed and many stocks look ragged. The nature of any rally following a hoped-for test of the 50 dma will tell us much about the market. Remember that any 5-wave decline may mark just the first 5 waves down of a larger 5-wave decline.

P.S. Today at 4:30 p.m. ET, Minyanville is hosting a free webinar with Buzz & Banter contributor Peter Prudden, who will give attendees an in-depth look at his macroeconomic outlook and trading style. To sign up for this free event, click here and hit the register button on the upper-left side of the screen.
POSITION:  No positions in stocks mentioned.