Watching the Elliott Wave Count on SPY

04/19/2010 10:45 am EST

Focus: STRATEGIES

Markets move in large wave swing patterns based on the stretches and swings of investor optimism to pessimism. These are known as Elliott Wave patterns as theorized by R.N. Elliott in the 1920’s and 1930’s. I became a student of his work in 2001 amidst the market mess, and after a few years, became a convert that markets move largely on crowd behavioral patterns.

With the above said, I look for clearly defined wave patterns, if discernible, to help me with clues as to where we are in the market bear or bull cycles. Besides the chart patterns themselves, you can review investor sentiment ratings, consumer confidence numbers, and other data to help figure out which direction the crowd is leaning, and if that rubber band is being stretched too far both on the optimistic or pessimistic side.

Reviewing the recent wave patterns and investor sentiment surveys were certainly telling me we were in the home stretch after 13 months of bullish movements in the indices. Thirteen is a Fibonacci number, by the way, and crowds also tend to behave within Fibonacci sequence patterns, both during corrections and rallies. Here is some evidence I’m looking at for a decent corrective pattern to likely unfold over the intermediate time frame.

1) Investor Sentiment- Bulls in the latest April 13 survey were running hot at 52% versus just 19% for bears. This 2.8-to-1 ratio was the highest since July and October 07. The % of bears is similarly at the same extreme lows seen in the July/October 2007 tops, and the summer of 2009 interim highs.

1a) VIX or the volatility index levels were at extremes for complacency, another sign of impending tops.

1b) Fibonacci retracements of 61% would be at 1233 on the S&P 500 index from the October 2007 highs to March 2009 lows. We were within 1% or so of that figure and pretty close. The Nasdaq hit a 78% retracement level this week, also a typical topping point in a wave structure.

2) Bears are dead all over the roads, consistently wrong and consistently calling for tops nearly every day. I think they finally got exhausted, which would actually be a sign of a top.

3) Headlines in various newspapers exclaiming the strength of the bull (New York Times, etc.)

4) Elliott Wave patterns were clearly “impulsive” or bullish since the February 5 pivot lows. The key is figuring out when the fifth wave of a five-wave impulsive pattern ends, because that is extremely difficult. Fifth waves can extend and confound bears and run higher than most expect. In most cases, I don’t even attempt to determine where they terminate. However, you can watch seminal events and market reaction to give you clues, combined with the various indicators mentioned above.

Friday’s Goldman Sachs charges, as levied by the SEC, were clearly politically driven and rather old news. Anyone who has read Matt Taibbi’s articles in Rolling Stone over the past two years is aware of how they manipulated AIG and the government to cash in on bearish bets against the mortgaged-backed securities market, the one they helped pump to the moon. The impish lawsuit or allegations filed Friday are kind of a joke, a drop in a rather large bucket as it were. However, this event can serve to terminate a bullish pattern and shock the crowd into a “negative” swing or shift in sentiment. The crowd goes from “What, me worry; I’m a big risk taker and making huge money trading!” to “Hey, I don’t think I like this risk game anymore and I want to protect my money.”

So, Friday’s news is really nothing new or all that material since it is old news. But, it’s possibly a seminal event that terminated a five-wave bull structure—just nobody knows it yet. To watch Jim Cramer ever so briefly tonight tell everyone to buy the banks and chip stocks after the huge run they just had indicates that nobody is really worried.

I digress and will post my Elliott Wave SPY (SP 500 ETF Index Fund) below.


Click to Enlarge

It appears that five clear waves up terminated today, but we will need to see the market reaction or action on Monday to confirm. Friday was OPEX options expiration, and that by itself can cause volatility. If the market continues downward early on this week, we should be expecting a zig-zag correction to 113 on this SPY, or 50% of the recent rally.

If the market powers higher than Friday’s highs early this week, then the impulsive pattern has a bit more legs left, though it’s likely running on fumes. I moved to close out some positions quickly today in our ATP service to be defensive. The advice here is to go and do likewise for now.

By David Banister of ActiveTradingPartners.com

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