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Friday 21 May 2010

Occam's Razor and a road to 870 SPX

After the amazing day yesterday I have spent a lot of time reviewing various charts. The first thing I have looked at is the wave count on SPX. After yesterday I don't think there can be any real idea left that the low on May 6th was just a 'fat finger' error. It was a powerful third impulse wave down, and the wave count so far looks pretty obvious from the SPX daily chart, even though I definitely wouldn't regard myself as an EW expert.

Whether we are in the first wave down of an ABC correction, or of a five wave bear market move, doesn't really matter at this point. I favor the first scenario for longer term reasons that I'll explain in a weekend post soon, but until we reach the end of the third wave down, it doesn't make a lot of difference.

For this first wave down though, it seems obvious enough that the first subwave bottomed at 1181.62, and that the third subwave bottomed at 1065.79. Subwave 4 was almost exactly a 76.4% fib retracement of wave 3, topping out out a few points below the bottom of wave 1. The subwave 3 low was taken out on ES last night in what is obviously the current subwave 5.

Occam's Razor tells us that the simplest explanation is often, if not usually, the correct one. I've seen a lot of EW counts over the last few weeks, but this count looks to be the simplest and most obvious explanation, and more than likely it is the correct one:

Where will this first wave end though? The third subwave down was 143.57 points, and the fifth subwave will probably be shorter, though not necessarily. From the subwave 4 top at 1173.57, that would give a likely wave range down to 1030 SPX for the completion of the first main wave down.

The target of the broadening bottom that I posted yesterday was 1044 ES, which is very close to the February low and would be a good subwave 5 target. If we do bottom there, it would strengthen a pattern setup that would be pure chartist poetry for the next two waves of this bear move.

It would confirm that there is a right angled and ascending broadening formation on SPX (66% bearish) and would also finish the head for a huge head and shoulder pattern within that broadening formation. Both patterns would indicate to the July low at 870, at what was (or is) the most important support and resistance level for the bear market. We would reach the top of the right shoulder on the next main wave up, and then the third main wave down would carry us through the neckline to the target:

The strangest thing about yesterday was the powerful move up in EURUSD at the same time as the powerful move down on ES. This may signal that the usefulness of this positive correlation between the two is at an end, but I suspect it just means that ES is lagging EURUSD by a few days, and that after making an interim bottom on ES shortly, we will see that return to normal. I hope so, as EURUSD has been a very good indicator for equities for quite a while now, and if the correlation fails completely, that will be a great loss.

In the short term, the IHS that I posted yesterday has now formed, broken the neckline and started to play out. The target is 1.282:

That's what I would expect from EURUSD, which bottomed where I expected it to this week within the current broadening descending wedge. These wedges are very good performers on EURUSD, as I mentioned earlier this week, and as you can see from this weekly chart of EURUSD over the last few years.

The only wedge that failed to make target on this chart was the broadening descending wedge that ended in late 2008, and that target failure was signalled both by the pullback in early 2009, and by the boundaries of the subsequent rising wedge. Another interesting thing to note on this chart is the rising wedge into mid-2007 that broke up, as rising wedges do 31% of the time. I mention that because EURUSD is currently in a broadening descending wedge, and these break down 45% of the time.

Barring imminent apocalyse though, EURUSD is due to correct up to the top trendline of the current broadening descending wedge, currently at 1.33 and declining rapidly. We may see a period of sideways trading where EURUSD slowly moves towards the line at a lower target of 1.282 to 1.30, but we are due a bounce here and one seems to have started already. During such a period, we would expect to see SPX trading up or at least sideways. It is disturbing that we haven't seen that since EURUSD bottomed early on Wednesday morning:

The right-angled and ascending broadening formation is perhaps the characteristic pattern for where we are right now on equities. There are quite a few of these as well as broadening tops across various indices. Here is another example of one on the FTSE, and seeing these is a large part of the reason why I think that if we don't bounce soon, then we may fall a great deal further over coming weeks.

As you can see from this chart, we are right at the bottom of the pattern, and it is an ominous sign that after a partial rise, the FTSE has returned to retest the lower trendline. That signals an imminent downward breakout 81% of the time, but until we see SPX break support at the February low with conviction, I would regard it as subordinate to the SPX pattern, as the FTSE is really just one tail on the SPX dog.

If SPX does break support there though, and then takes out the November low at 1029.38, then this subwave 5 would be longer than subwave 3 down, and the potential would open up to go a great deal lower in the coming weeks.

In that event the recent action on the daily chart for 30 year US treasuries would also look very ominous. For the past year, these treasuries have been trading in a large rectangle, and have broken up from it this week. These aren't always reliable when they take more than a few months to form, and the eight month rectangle on XLF that broke up in April failed to make target at 18, but FWIW, the target is 134, which is what I would expect to see if we get a very major flight from risk over coming weeks.

So there we have it. We bounce very soon, or equities continue falling into a chasm of unpredictable depth. Should be fun either way, but it will be a lot easier to trade this if we do bounce, so that's what I'll be looking for here.

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