SPX and NDX Update: When the Rally Finally Reverses, Things Could Get Ugly

This Energizer Bunny rally continues to surpass every target I’ve set thus far.  My expectations leading into it were, quite frankly, wrong. 

The one consolation I can take is that — while my price targets are being blown through on the upside and short-changed on the downside — my short term direction calls for the upcoming day, based on the preferred count, are hitting 75% for the month. 

But getting back to expectations: a wise man once said, “Your expectations shape your reality.”  When I called the Minor (1) bottom back on October 4th, I was expecting an A-B-C rally into December.  On that day, I posted the following chart with my rough expectation of how this might unfold.  On the chart, you can see I was anticipating that we would have three distinct legs to the rally, drawn in gray.  I wasn’t at all expecting one giant leg like we’ve had.
 

You can also read the annotation “My time expectation for the Minor (2) peak is December.”  I have often pointed out to people that Elliott Wave is not intended to predict time, it is based on price movement only; yet here I was, doing that very thing.

My expectations for all this were based on certain presuppositions about the preceding wave structure.  Yet clearly things haven’t played out as I expected; so the logical conclusion is that my underlying presuppositions were wrong.  Forensics time… 

All the way back on September 18th, I talked about the wave structure of the NDX, and how it appeared to be further along its count than the SPX.  At that time, I posted this projection chart:

In the meantime, I began looking for ways to reconcile the two counts.  I gave more weight to the SPX than I did to the NDX, because I simply had a hard time foreseeing how the SPX could “catch up” rapidly enough to meet the NDX.  The thought never occured to me that the SPX might launch a 17% rally over the course of only three weeks… that’s probably understandable.  But as a result, I was expecting the NDX to “slow down” and find a way to reconcile its chart differences with the SPX; not the other way around.  Nevertheless, as you can plainly see in the two charts: the NDX performed exactly as expected, while the SPX did not. 

This leads to the next logical conclusion:

It now seems that the SPX has done the work required to reconcile the two structures, and as a result — assuming the big picture presuppositions are correct — Wave Minor (2) up is probably in its final days.  If the big picture view is correct, and this is indeed Wave Minor (2), then the beginning of the Minor (3) crash wave is just around the corner.   Below are some further arguments for this case.  

The first is sentiment: investors are finally shifting away from the extreme bearishness of recent months, and new polls are suggesting they are now marginally net bullish.  Here’s what I wrote on October 4th:

Keep in mind that the psychology of investors will probably become quite a bit more positive in the near future, so that by the time we reach the Minor (2) peak, the majority will be bullish again.  It always helps to anticipate the mood, because after Minor (2) completes, we will be presented with what (I believe) may prove to be one of the greatest shorting opportunities of our lifetimes (but due to the psychology, by the time Minor (2) peaks, no one will think shorting is a good idea anymore — just as most don’t think going long is a good idea right now).  I expect Wave Minor (3) to ultimately become a rapid waterfall decline to substantial new lows, although it will probably start off relatively subdued as it traces out the first couple waves.

In just three weeks, the core psychology of the trading community has shifted… a 17% rally which breaks out from a multi-month rectangle will do that.  So the second wave has done its job regarding sentiment.  It has also done its job in terms of price.  The NDX is approaching its 2011 highs, and the SPX is now within spitting distance of the head and shoulders neckline. 

Sentiment and price are where they need to be for a second wave top — which is not to say they can’t go higher, only that the second wave has so far done what it needed to do.

Further, we have a potentially big news event on the immediate horizon: on Wednesday, the leaders of the European Union will announce their plans to save Greece; protect France from downgrade; and insulate their largest banks from failure, among other things.  Certainly no small task, and one which could remind everyone that, even though we just had this wonderful technical breakout from a trading range, the world is still in pretty miserable shape.

So where do we go from here?  Here’s what the charts are suggesting.  First, the 60-minute NDX chart:

Something that should also be mentioned here: The structure which runs from the red (1) to the red A on this chart requires more imagination than I can muster to label it as a motive wave.  The fact that it’s a corrective rally implies new lows in the future… however, the red B-wave correction did hold above the 2035 low, so the possibility of other interpretations can’t be objectively ruled out. 

Here’s the other key point regarding the NDX: if wave (2) doesn’t end very soon, below the 2438.44 high, then we have to start considering the possibility that everything we’ve seen so far has just been part of a bull market correction.  I’m not ready to consider that yet; I simply can’t see it against the backdrop of the current fundamentals.  Granted, bull markets aren’t driven by fundamentals — they’re driven by liquidity, as demonstrated most recently with QE/QE2.  But I don’t yet see the source for the liquidity a new bull would need, either.  Doesn’t mean it’s not out there somewhere, but the market is going to have to prove it to me first, by breaking that prior high.

Should be interesting to watch, because the wave structure on the NDX looks like it want to run up very close to that prior high.  When I did some calculations on the wave structure — barring a failed fifth wave up — the number I came up with as a target was 2432.

Then there’s the SPX and its ending diagonal count.  I first proposed this ending diagonal as a hypothetical potential back on Wednesday, based on a couple minuette wave forms I was having trouble reconciling.  I keep trying to kill this count off, but everytime I think I’ve driven a stake through its heart, it comes roaring back to life like the cheesy-special-effects monster in some cheap horror movie.  Monday’s action could be part of a five-wave impulse up still in progress, which would finally kill off the diagonal — or the move could fit nicely as an a-b-c, with two roughly equal waves separated by a correction:

I honestly don’t think the diagonal is likely at this stage, but it can’t be completely taken off the table yet… and as the chart says, the move could still end up forming a bearish rising wedge.  The 60-minute chart below has been updated to reflect the fact that the alternate count has now become the preferred count, and this is C of Minor (2):

After a little bit of consolidation, the SPX looks like it definitely wants to take a crack at 1260; then maybe at the head and shoulders neckline.  Again: barring a fifth wave failure, which could be news driven.

You could call this a crash count — although third waves down generally sub-divide into one or two nice tradeable bounces before declining relentlessly.  But, as I see it, the rally has been too strong and too fast for anything other than a C wave… or part of a bull market, and as I said, I’m not quite ready to go there yet, unless the charts say we have to.

Once the rally peaks, we’ll start analyzing the form it takes as it declines, to see if this crash count is the real deal.

The last thing I want to mention is very important in regards to yesterday’s article.  A reader called my attention to the potential of a fourth wave triangle in the Dow, which is important because it raises the maximum possible price for the Dow (under the preferred count) by slightly less than 1% — from the 11,993 discussed yesterday to 12,093.50.