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Sunday, November 15, 2009

Market Sentiment and Wave Structure

Financial markets are all about sentiment. Elliott Wave theory is the theory that attempts to interpret that sentiment, place ourselves on both the long and short term wave structures, and then make judgments and predict future outcomes. The theory proposes that human emotions on a mass scale, i.e - social mood - is governed by the same forces of nature (Fibonacci) that seems to govern many progressive systems in nature. Everything from snail shell growth to galaxy formation.

Indeed, it may be nature's governing mechanism to keep humankind from committing mass extinction at despondent lows and uncontrollable surge of greed during mankind's peaks. On the whole, it makes perfect sense. And taken through time, it likely reveals why great civilizations of the past always are doomed to ending. And on the flip side, why they are reborn once again in due time.

But back to the topic at hand. I'd like to try and make a determination of where things may be at in this near term wave structure based on a few time tested sentiment interpretations.

Looking back on sentiment readings during this rally, a lot of readings topped in August/September during the surge past 950-1000 SPX. This made sense as this was a key area and its break unleashed a surge in bullishness.

Even though bullishness has maintained high readings in certain indicators, the peak readings on many sentiment surveys were back in August to include the ones that gauge public sentiment. And as the markets went higher, the brief corrections unleashed a surge in bearishness. This indicates there is still a good deal of skepticism in the rally. And some peak readings of August/September have slowly dribbled away.

But this is not really consistent with market tops and that has been troublesome. The "public participation" phase has likely kicked in to some degree but its hard to say if its kicked in "high gear". The sentiment surveys suggests that it may have not.

Looking at my chart, the big bear line down from 2007 has finally been arrived at. As many expect this line to contain prices, indeed bullishness has been muted as we approached its arrival. But what if the market breaks upwards and holds on a backtest? (Or treads sideways and breaks it in a few weeks from a sideways surge) Surely that would unleash a final surge of bullishness and the persistent 10K + DOW that climbs ever higher will rekindle feelings of greed in the public. No one wants to look like a fool in missing the rally.

As far as the wave structure, I discussed the ending diagonal interpretation in this post.

The important point about that post is that all ending diagonals produce a dramatic price reversal. And that has yet to be the case.

The SPX chart also has something that I may have overlooked on the RSI. Indeed a double negative divergence took place on the RSI, but I may have not given it a chance for a "correction period" between peaks. Looking at where I place some red boxes may reveal that the market has some more rallying to do as perhaps the market finished the second corrective period.

The DOW chart shows that its line hasn't even been met yet. And out of all the indexes, the DOW has not broken its rising bear trendline from March in non-log scale. Its a "holdout" or in reality more likely a late bloomer index to the rally.

And its always been about the DOW as that is what the public knows. They understand the big 10000 numbers and such. I imagine if it stays elevated above 10K it will bring the public back in bigger droves.

Another chart consideration is the VIX charts that I discussed here in this post:

It suggests a breakdown is coming in the VIX. A final drop to a lower trading range and a sufficient "complacency" of under 20 readings. The VIX traced an expanding triangle and is back to getting hammered.

As far as the dollar it also should be finishing at an extreme bearish reading which as of late has not been the case. Yes the readings are bearish, but there are too many people watching it in anticipation of the dollar carry trade to unwind. And thats not surprising as the dollar has held support above 74.5. A break of that level will indeed likely produce a necessary bearish sentiment.

Gold is probably still in its run higher. Labeling its subwaves, it seems to suggest that it could be headed to a remarkable blow off peak. As a commodity that rises more in fear, unlike equities, we can only watch its subwaves unfold and try and get a decent read on things. I imagine it will run inverse to the dollar for the most part. But dollar's weakness could be amplified in the reciprocal of gold's surge.

Think of how oil's run went last year. As it grew higher and higher, more and more stories appeared in the national consciousness to "explain" it all like "peak oil" and all that stuff. Of course when it collapsed to $35 in less than 7 months the same people "explained" it all for you again in that "demand" had evaporated.

Of course you and I know that a "trade is a trade" no matter what the object. And if it has momentum behind it (think Amazon) it will trade until it exhausts itself. Until there are no more buyers (or no more sellers on the down moves) Doesn't matter if its baseball cards or a painting that sells for $50M. Asset trading works the same for everything pretty much. Housing is another example.

And it all comes back around to this: It requires public participation. For a wave to reach its extreme in this day and age of "asset mania" requires the public to get involved. And a trade will continue until they do. So in that regard, the equity markets and gold has an excellent chance of carrying on until the public is back into the game at sufficient numbers.

As far as the "technicals" go, I am not married to any one "sure thing". As far as I know, this rally could end on a peak in many indicators, not divergence.

But more than anything, looking at my EW world and fellow EW bloggers and EWI, all have this rally ending soon based on a few factors. But based on what exactly? For the most part is has been based on technicals. And it has been based on wave interpretations that may or may not ring out true.

But what perhaps has been avoided looking at harder is sentiment readings in general. After all, that is a hard thing to judge. And many start-up wavers are likely guilty of only looking at price waveforms (as I have been guilty too) and lack the patience to look at what drives the theory underneath. And that is sentiment plain and simple.

So what is troublesome is that important sentiment readings topped in August/September. And that would have been fine had the market followed soon after like I and many others assumed. But it didn't and has dragged on far too long for my liking. In fact it may have "corrected" in a sideways/up fashion as I suggest on my SPX chart. (perhaps a triangle is coming, no telling until this week).

I have been just as guilty judging this rally to be near over based on a lot of things the other Elliott Wavers including EWI has seen of the last 6-8 weeks. Yet it bothers me that all wavers seem to be on the "same side of the trade" so to speak.

I don't come to the conclusion lightly that the rally has more room to run. Packaging it all together, the VIX charts suggesting imminent breakdown, the sentiment readings, the likely coming GOLD blowoff peak, the continuation of a profitable dollar carry trade, it all bears out that it could run some more.

But most importantly the sentiment readings should indeed head back toward challenging peaks and maximum public participation should be clearer as a result.

Finally although this is not wave related so much but the coming 4th quarter earnings are going to blow the socks off of last years numbers of course. I can imagine those reports helping to whip up public sentiment in a frenzy in a non stop barrage. If the DOW keeps above 10K, feelings of greed on a wide scale will return. They always do. Human nature does not change. You can fool us again over and over.

And the very last consideration is that in a "perfect" Elliott waveform the advance of 5 waves (in this case 5 waves down from 2007) is met with a correction of 3 waves at a ratio of .618 to .382.
So if the 17 month drop = .618, the .382 correction would take about until the middle of January 2010. Just in time for the "January Effect" and the dumped on small caps could make an early 2010 surge.

Since I started this blog, I have been learning more and more about markets and EW theory as I go along. All my "mistakes" (and there have been plenty) are likely born out of one reason: an improper gauge of sentiment and the time it takes to go from extreme to extreme.

More than technicals and waveform, sentiment is the thing to watch for the peak of this rally. And unfortunately for the bears, I am not sure it properly peaked. That's the best advice I can give myself right now. It comes down to this: Did sentiment properly peak, particularly public sentiment and why has this rally diverged so far from those peak public readings?

The only answer I can come up with is that they have another peak coming.

Due diligence of course.

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