(07/30/10) Why August Could Be Tough for Long Traders

I enjoy making controversial calls based on human behavioral topping and bottoming patterns, often referred to as Elliott Wave Theory. This is a difficult pattern recognition model to follow, as there can be numerous interpretations. Instead, I look for additional clues like sentiment indicators, a few traditional technical indicators, headlines in the news, and covers of papers, etc.

Recently, I saw an article on Bloomberg indicating that short positions were at two-year lows, with the ratio of longs to shorts at two-year highs. I use those types of indicators to help confirm if I’m on the right or wrong track with a forecast.

Right now, I think the S&P 500 and markets are topping in a countertrend ABC-X-ABC rally that really started with the May 25 lows of 1040, to the June 21 highs of 1130, back to the July 1 lows of 1011, and now to 1121, the high so far. That 1121 number is a Fibonacci 50% retracement of the 2007-to-2009 highs to lows, and just nine points below a 61% retracement upwards of the April highs to July 1 lows. Evidence mounts now that August could prove tough for bulls, and some risk aversion here is a good trade, in my opinion.

Back in late June, I saw similar sentiment and Elliott Wave topping patterns in gold as well. The headlines were bullish, the talking heads on CNBC were all saying to buy any dip in gold and stay long. A 21-month rally was topping and I went ahead and stuck my neck out and predicted a multi-month correction. Since then, gold has dropped from $1243 to $1158 at its recent low, and should be heading to $1043 eventually if I’m right. It takes a while to knock the sentiment down from overly optimistic levels, just like with the S&P 500 top in April, which I forecast in mid April as well.

The S&P 500 would need to clear 1130 aggressively for me to cave in and call 1011 the bottom. That was a 38% Fibonacci retracement of the 13-month market rally, and it’s possible that was the bottom for sure. Normally though, you would at least get a retest of that low, and possibly a drop to the 942 area on the S&P 500, which is a 50% Fibonacci retracement of the 13-month rally. In addition, the pullback so far only lasted about eight weeks relative to 13 months of rally, so I think there are another several weeks yet before we can call a bottom in 2010.

Below is an interesting chart showing recent action since late May in the S&P 500 index. Investor’s like to act in patterns, and this seems to show a good one.

Click to Enlarge