Market Structural Overview

As US stocks rallied during the last 5 weeks, sentiment also got more optimistic. This is not good for the market. According to Mark Hulbert, “The HSNSI is now 51 percentage points higher than where it stood a month ago. To put that in context, consider that over the first month of the last six bull markets, the HSNSI never grew by that much. In fact, the average increase in this sentiment index over each of those six bull markets’ first month was just 19.9 percentage points.” This kind of behavior symbolizes the fact that we might not be in a bull market, rather are experiencing a bear market rally.

We have already discussed the potential of a turn point based on Daily and Weekly Inflection Point Models. (Please review earlier IPM posts). Today, we will look at the markets from a structural point of view.

5 Wave Decline = Downtrend

All major US Indices (SP500, DJIA, Russell 2000 and Nasdaq) declined in clear 5 wave fashion from May 1^st 2011 to October 4^th 2011 (shown below  - figure 1). 5 wave movements are regarded as impulsive moves. Impulsive moves occur in the direction of the primary trend. This decline terminated in the form of an ending diagonal. Please note that October 4, 2011 turn occurred during the last turn date September 28, 2011 (+/- 4 days)

Figure 1

One of the characteristics of 5 wave declines is that 4^th wave does not enter Wave 1. However, in case of Nasdaq, Wave 4 entered the Wave 1 region (shown below – Figure 2). This means that Nasdaq carved out a wedge formation. Wedge formations either occur at the start of a trend or at the terminating location. In July 2010, markets carved out a similar wedge formation in the upward direction. This wedge was followed by a sharp decline in wave 2 through August 2010, retracing 0.786 (Fibonacci ratio) of the prior rise. In late August, many investors assumed that it was the start of a new downtrend, but soon thereafter markets staged a very sharp rally to new highs.

Since current wedge formation was to the downside and it was followed by a sharp rise, retracing 0.786 of the previous decline, it might be possible that markets will start a new decline phase to new lows below October 4^th low.

3-Wave Rise = Counter-trend Rise

Since October 4, 2011, markets have risen for almost 5 weeks. Although this sharp rise managed to entice many to believe that the uptrend has returned, it did not result in an impulsive rally structure (5 waves). Rather, we have seen only a 3-wave rise (figure 3). ABC patterns (3-waves) are a hallmark of corrective wave, and can retrace anywhere from 38.2% to 78.6% of the prior move. In case of 2nd waves, the retracements are steeper. Recent market rise since October 4, 2011 retraced almost 78.6% in all the major indices.  According to Elliott Wave theory, 2^nd waves are defined as: “Wave 2s are very deceiving, and they are technically broken.” It will be highly ironic to see Wave 2 end on the news that a bailout package was negotiated in Europe.

This article is continued for subscribers... If you want to continue reading about:

1- Counter trend rally

2- Anomalous behavior of the QQQs

3- Recent market action

4- Head and Shoulders Top

5- 8/4 Test

6- Supporting structures of Euro, Treasuries, US Dollar Index and European markets

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