We are there – kinda

I have been asking Are We There Yet? recently.  On Tuesday as the Dow and S&P were making new all-time highs, stocks sold off later in the day and closed sharply lower.  That was the signal I was waiting for.  But for confirmation of a change in trend, I needed to see a small scale five waves down.

And I was not to be disappointed.  Here is the 15-min Dow chart I included in Wednesday morning’s Trade Alert to VIP Traders Club members:

From the Tuesday high at 22,180, the market fell hard in a clear five down with a long and strong third wave and a momentum divergence at the end of wave 5.  That is straight from the EW playbook.  And in overnight trading, the market bounced weakly and that gave the lie that any corrective rally was likely to be shallow.  I advised VIP Traders Club members to expect another leg d own and to position short.

This is the position as of yesterday’s close

As advertised, there was a weak bounce on Wednesday and the market started an even stronger slide into Friday.  This 30-min chart again is a textbook example of Elliott waves with along and strong purple wave 3 (which has its own textbook five down).  But there was a momentum divergence into the wave 3 low and that signaled a bounce ahead in wave 4.  When that wave tops out, we shall have another strong leg down.

This will be a large wave 4 off Tuesday’s large wave 3 high and will last several weeks at least.  We are only three days into it but already the Dow has lost over 300 points.  I estimate wave 4 will encompass over 1,000 Dow points.  But fourth waves are notoriously tricky to trade (unlike third waves) as they can throw up sudden large counter-trend rallies where nerves of steel are at a premium.

So has this sudden change from risk-on to risk-off shown up in that other market that is the epitome of risk – junk bonds.  These are the bonds of the most speculative of companies and in recent times, they have been issued in cov-light form.  That is, the entire risk of default is assumed by the holder of the bonds.  If the company suddenly can’t or won’t pay the interest, tough.  They rank alongside equity in order of payout in the event of bankruptcy.  That is – at the bottom.

Not only that, but the yield spread between risky junk bonds and rock-solid US Treasuries has narrowed recently to a record low.  The price-insensitive buyers of these bonds who are avid yield-hungry institutions have become completely and utterly complacent of the risk of defaults rising.  This is what the Fed and other major central banks has wrought by their stupendous money printing – the seeming elimination of risk in all financial assets.

From £200 million footballers (‘earning’ an astonishing £5k a minute, which is better even than lawyers) to record prices for art works to booming vintage car prices to Toronto real estate (where prices are now falling hard), the Fed-manufactured wall of money has not been channeled into productive industry but into the canyons of Wall Street.

But now cracks are suddenly starting to appear in this Alice in Wonderland scenario.  Here is the HYG Junk Bond Index

Last week, they have taken an almighty hit and now trade under the 50-day MA.  Note the lovely terminal textbook five waves in the rally off the March lows.  Remember, junk bonds trade more like equities than Treasuries.  This looks ominous.

Naturally, the pundits have been falling over themselves explaining that with increased tensions over North Korea, the world is suddenly a more dangerous place.  But North Korea has for years been a thorn in the side of the US and has uttered menaces before.  They say the game has changed with them capable of firing an ICBM some distance. I am not so sure but in any case, I doubt anything will kick off in the near future.

So next week, I expect a lessening of tensions and that will be a test of the stock market’s ability to rally as the dip buyers will likely come out to play.  But will they be catching a falling knife?

Trading the relief rallies is always very tricky.  At the start of a counter-trend rally, it is not clear how high the retracement can carry.  Sometimes it is shallow (as on Wednesday) and at other times it is deep – up to a Fibonacci 78% level.  If you short too soon, you stand a very good chance of being stopped out.  And by the time the rally turns, you may well have become too scared to take advantage!  And to add insult to injury, you see the market finally going in your direction – but without you being on board. Ouch!

There is no easy answer to this problem.  Each trader must tackle his/her own demons in this situation.  But typically, you will watch the market move some distance and finally you decide to jump on board only to discover you have entered just before a big counter-trend move!  That has happened to me more than once.  Nowadays, I tend to act early and if I am stopped out, so be it.  I continue searching. But eventually, I will latch on to a great low risk entry and ride the trend.

The stock indexes are becoming much more volatile.  VIX almost doubled last week:

I have excellent tramlines and a five wave pattern with upside break.  The lows around 9 will not be seen for a very long time.  Note the large MACD divergence at the 9 low.

Gold in strong uptrend as bullish sentiment lifts off floor

Our timing on gold this year has been excellent.  Despite the huge waves both up and down with no seeming lasting trend, I have managed to capture the nature of the patterns – the waves have been a series of zig-zags (see Prechter and Frost textbook).  Despite this, I have snagged some major wins – here are some of them

Many of my decisions have been based o n my reading of the sentiment picture.  Remember, gold is the most sensitive market towards trader sentiment because what is gold?  It is a basically lump of metal that has few practical uses.  What it has going for it is many view it as a store of value and is very pretty as jewelry.  For we traders though, it is also a means to make a significant positive impact on our trading accounts!

The latest low in July was accompanied by a near-record level of hedge fund bearishness as evidenced by COT data and DSI money manager survey.  That was a clue that the turn was close – and it was.

But now, with the price a solid $90 off that low, hedge funds have boosted their long positions but amazingly in the latest week did not add to their longs on the rally and only reduced their shorts somewhat:

Similar with the small specs. So my prediction for a hedge fund short squeeze back in July has come to pass, but they are not enthusiastically grabbing long positions.  That tells me the rally has much further to run.

But with the market in a fifth wave up, I expect some correction very soon

I have a textbook five up with a long and strong wave 3, and an three down in wave 4 to the lower tramline.  I believe any further gains will be hard won near term and odds favour a pull-back.

And that would tie in with my forecast for a turn down in the euro.

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