After the Santa Rally: A Technical Analysis

"October is one of the peculiarly dangerous months to speculate in stocks in. The other are July, January, September, April, November, May, March, June, December, August, and February." - Mark Twain

January has been a cruel month over the past decade. Santa Rallies hit January and fell in almost every year this past decade except 2006 (in 2001 it was already in free-fall). The STU has a nice chart of these January peaks, which shows:

• In 2007 we had a sharp fall on Jan 22 before resuming the final rally
• In 2008 the sharp drop started early, on Dec 26, 2007, and fell hard into March
• In 2009 we peaked on Jan 6 and fell a lot farther to the March low
• In 2010 we hit a major peak on Jan 19 and fell into February before resuming the rally into April

Will 2011 follow the same pattern?

Extreme Sentiment

This chart (courtesy EWI) from this month's Elliott Wave Theorist (EWT) captures the dynamic: sentiment is at extremes shown at peaks, and the wave structure is showing an ending pattern, but pundits almost universally are touting higher stocks in 2011. (The major exception is Citicorp, which I commented on recently.)

It gets worse. Every strategist in Barron's look-ahead piece last week saw only upside, no market decline. The vast majority (35 of 49) of economists expected the US economy to outperform in 2011. Yields on the S&P are back down to low levels right before the 2000 peak. 

Complacency is back. Margin debt is back to the pre-Lehman levels, and is higher than at the recent April peak just before the Flash Crash. Short interest is at its lowest levels since Dec 2007, as the market was peaking. 

Money is NOT on the sidelines. Rydex's Buying Power Indicator is at its lowest in ten years. Money in fact continues to flow out of mutual funds - until last week, for the 33rd consecutive month.  Last week we had a modest reversal, from a $2.4B outflow to a $0.3B inflow, likely predicated on a bailing out of muni's. (This also prompted a slight turn up in the Rydex indicator.) The equity outflows continue even as bond funds began to lose investors. The bond sellers are NOT rotating back into stocks other than perhaps some spillover from a panic move out of munis.

Conclusion: the increase in stocks is being fueled by new margin debt, not new cash coming in - a setup for a fall.

Even the venerable NYT put out a piece discussing how the glow was off US stocks. They then accompany the outflow from mutual funds with an optimistic assessment that the extreme bullishness must mean the small investor is about to come back in!  Maybe so, to be fleeced again.

Floyd Norris has a good analysis and graphic on the end of the American love affair with stocks (next sidebar chart).

Short-Term Warning

The ending pattern is so clear that Neely put out a bulletin, saying:

Wave structure warns the S&P is close to ending a 2-year formation that could end anytime between now and the next 2-4 weeks.

The STU lays out the wave count: the final wave 5 of C began on Nov16 (S&P) and Nov29 (Dow), and would hit suitable fib targets at around Dow11615 and Sp1291. You can see this count on the chart from the EWT. Neely has a different count - a neutral triangle since the Flash Crash - but a similar position: we are in the final push up, and it might go 50-100 S&P pts, putting an end between 1300 and 1350. 

The EWT has a wealth of analysis of the market, and I recommend it. For example. I have recently touted the extreme reading in the TRIN as indicative of a coming market top. Some readers have dissed the TRIN (as bulls would be wont to do), but they should read this EWT as Prechter gives an in-depth assessment of where the TRIN is useful and where is is not, and relates the current readings to what he saw before the 1987 crash (among other periods of extremes in the TRIN).  Also, he gives a perspective on gold and silver, metals he has called poorly recently (crying wolf! wolf! prematurely about a top) that is worth a look. Besides analyzing the market, it continues the theme of "all the same market". 

John Hussman also joins the Awful Time to Invest camp with an historical perspective, given the "overvalued, overbought, overbullish, rising-yields syndrome" we are in. His history makes him issue a warning:

The historical instances corresponding to [current] conditions are as follows:

December 1972 - January 1973 (followed by a 48% collapse over the next 21 months)

August - September 1987 (followed by a 34% plunge over the following 3 months) 

July 1998 (followed abruptly by an 18% loss over the following 3 months)

July 1999 (followed by a 12% market loss over the next 3 months)

January 2000 (followed by a spike 10% loss over the next 6 weeks) 

March 2000 (followed by a spike loss of 12% over 3 weeks, and a 49% loss into 2002)

July 2007 (followed by a 57% market plunge over the following 21 months)

January 2010 (followed by a 7% "air pocket" loss over the next 4 weeks)

April 2010 (followed by a 17% market loss over the following 3 months)

December 2010 ...

Timing the Market Top

The contrarian in me says some sort of top will hit in January. Maybe as early as Jan 3 or as late as the end of the month, with Jan 10 my most-likely day for a reversal to begin. But will it be the end of the Hope Rally?

What may surprise long-time readers is that Prechter is not that bearish right now. His EWT contains a look at timing. He has been hinting at this for a while, that as we head into 2012 we would be in the up part of the Four-Year cycle (driven by Presidential politics) and should be prepared for a continued bullish trend. The Tax Deal is symptomatic of the sorts of stimulative policies a President pushes to get re-elected. More is likely to come despite the new Tea Party Congress. 

Without revealing his timing, let me explore the implications of the EWI view. Take a look at the Hope Rally as described in the first chart above. It shows an ABC zigzag correction. Normally in a zigzag waves A and C are related in both time and distance by 0.618, 1.00 or 1.618. Wave A went from Sp667 to 1220 or 553 pts over 14 months. Wave C has so far gone from Sp1011 to 1262 or 251 pts over 6 months - not even 50%. Applying normal relationships gives targets of 340, 550 and 895 in wave C over time frames of nine to 23 months - much farther and longer than we have so far.

This suggests at a minimum C should go to Sp1350 no earlier than April 2011, and more likely goes back over 1560 by around Sep/Oct 2011. A sharp drop in January that does not go below the Sp1011 level then begins a rise again would fit this longer-term scenario. Note that EWI view does not go that far in distance, at least not yet, in part because they view the Hope Rally as a wave 2, which normally does not go much beyond 62% of the prior drop, and this one is knocking on a 67% retracement. It could , however, go back as far as 78%, which is the range of 1350, without doing violence to EWI guidelines. 

If we look back to 2000, the first three waves formed a classic irregular flat, with the drop from 2007 to 2009 the five-wave ending C wave. That wave appears to have completed, but the bearish EWI view has it but wave 1 of a deeper wave C, so-called P1. They have the Hope Rally as P2 of that C. What if the Hope Rally is not P2 correcting the P1 but either an X wave connected the perfect flat to the next corrective pattern, or even is the start of that next corrective pattern? 

The X Wave View

A look back to 1929 suggests that on an inflation-adjusted basis the 1929-49 period was a large correction, and the 1950-2010 period is the big wave that came out of the Great Depression. If so, it has so far only broken in four waves, as follows:

1. 1950-66
2. 1966-82
3. 1982-00
4. 2000-date

The prior wave 2 from 1966 to 1982 broke as a double-zigzag down on an inflation adjusted basis, and came back into the range of 1929-1949 correction, a much lower low than most people realize when they look just at the nominal Dow. 

Under the Rule of Alternation, we would expect the 2000-?? period to break as a sideways correction, which means either a flat or a triangle, or a complex correction that ties two or three sideways corrections together. Given that 2000-07 was a flat, the Hope Rally can be seen as an X wave connecting that flat to a future sideways pattern. An X wave is normally a zigzag, which fits, and given a sideways structure, could be expected to retrace back up close to or into the range of the 2000/07 tops, or the 1350-1560 range in the S&P. 

As to timing, given the relationships noted above between waves A and C of zigzags, the earliest would be April 2011 and the latest would be 23 months or out into Jan/Feb 2012 with the middle the classic Aug/Sep peak, in 2011. 

After that we would expect a second corrective pattern. Given that the prior waves since 1950 all took around 16-18 years, the ultimate end would point to 2017 +/- one year. 

The B Wave View

Joe Russo of Elliott Wave Technology has an alternative and fairly straightforward wave structure. Right before Christmas he put forth a two-parter which lays out his approach to Elliott Wave and his longer term wave count. He laid out a 2010 scenario last March which called the subsequent action remarkably closely, including the peak in April, the sharp drop to a July low, and the rally to new highs in December.  Here is his March chart:

He uses the nominal Dow count, which has a wave 5 beginning in 1974 and ending not in 2000 but at the peak in 2007. He notes that the low in 1974 is 34 years (a Fib number) to the low in 2008 (within two months), and the crash in 1987 points to another 34 year end point, 2021. While he leaves open if that is a low or a high, it does give a time frame for his correction after 2007: 14 years.

He presents three scenarios. For our purposes here is the one that matters. It makes 2000 the peak, not 2007, and the period from then to now a correction. As you can see, the perfect flat fro 2000-2009 becomes but the first A wave of a larger correction. Given that a flat is a "3". this means the larger pattern will either be a bigger flat or a triangle, and hence a sideways correction. We would be in the bigger B wave right now.  He sees it peaking sometime in 2011, and then falling into 2012. The whole pattern projects out to 2020 or 2021, when this large wave IV would end and a new super charged bull market would commence. 

Comments

[DG]

DG, on the :5 from July 2009 to Jan 2010, yes, I understand the problem. On the :5 since July 2010, much clearer: 1 went to Aug, 2 went to end of Aug, 3 went to Sp1228, then 4 went sideways, and we are now in 5.

Posted by: yelnick | Monday, January 03, 2011 at 08:30 AM

I still don't see the :5 in there. In real-time (and still do), I saw initial waves up from the July low as a :3. Look at the overlap of the price movement from the initial thrust upward to 1099, which would have to be your wave-i of 1 and the decline from 1120 to 1088, which would have to be your wave-iv of 1. That kind of overlap rules it out as a :5.

[yelnick]

DG, it only becomes an impulse as a Terminal since 2 and 4 overlap. Does Neely allow a Terminal in a wave 1 position? EWI does, although they are rare: a leading diagonal. STU has it as a leading diagonal.

[yelnick]

Waver, good catch! The Naz100 may now diverge from the other indices. The tech boom is on!

[Mamma Boom Boom]

People in the 'know' have said that this market will eventually take out CNBC. It appears to be getting closer, according to Nielson.

[Hockthefarm]

Ms Boom Boom:

I thought it was "I never met a drunk woman that I didn't like".

H

[DG]

Yelnick,

No, that kind of formation isn't allowed in NeoWave in that position. I tend to agree with Neely that the weakness implied by a Diagonal Triangle is best suited to the end of a formation.

[Paul]

The problems with the folks at EWI, is that they keep using (or misusing) the same indicators to aid in market predictions. Somewhere in "At the Crest of the Tidal Wave" Prechter claimed mutual fund cash levels being at record lows. And that was in '95. Here they are claiming the cash levels being at record lows again. Never mind that the Transports, Industrials, and Small caps have all been making new highs. They choose to ignore that info and just focus on technicals that look "bearish".