98 gap fill possibility

Today Serge Farra posted a somewhat radical bear prognosis on his blog The Stock & ETF Corner. As readers of this blog will know, I've been predicting a SPY gap fill at 106 for many months. I've always believed that the market would dip slightly lower, most likely to 102 and change. So I was at first skeptical of Serge's analysis but on further analysis he may be on to something.

Here's an overview of the SPY. Note the itsy bitsy gap at 98.07 which is around where Serge calls his bottom. I'm a big believer in gap magnetism, especially on the SPY. As a stopping point this is a good place as there is a boatload of support (Mega support) just below that point. Of course to get to that level the market would have to push through a ton of technical support created by the 2010 correction, the infamous 106 gap and then a boatload of prior support as evidenced by the DeMark support lines.

Let's zoom in to the daily action though and point out how Elliott Wave is giving us a hint that Serge may be correct:

Here's a closeup of the S&P futures which, until today, were giving an extraordinarily satisfying Elliott count. The momentum in this latest downdraft is clearly a 3rd wave and this validated the prior count including the little a/b/c corrective pattern that I thought was a dead giveaway. What this picture has always been hinting at however is a low well below 106 based on the size of the 1st wave.

One cardinal rule of Elliott Wave is that the 4th wave cannot penetrate the 2nd wave. Today's rally penetrated well into the 2nd wave of the overall trend which means that this could not be the end of the 3rd wave. What I believe it could be is the end of a 3rd wave sub-wave, the pink (iii) wave in the upper picture. Note how we had two "i" waves, an extending wave. That provides two more opportunities for this wave to extend.

It's always hairy to try and project extensions in a high momentum market but today's rally forces us to consider that this 3rd wave is not complete. The picture above provides a possible course of action that would explain further downside that doesn't create a bottom. The green and brown projected lines pair up with the green and brown "i" waves. This creates a 3rd wave that is long enough to allow an appropriately sized 4th wave retracement. I think this part is critical. The 3rd wave must be long enough to make room and currently it is not. In order for it to be long enough it must at a minimum get to 106 but probably lower. The bounce at that point is likely to be a fakeout.

What is particularly compelling is that the 102 and change area makes arithmetic sense again. In this example the 3rd wave is 1.618 times the size of the 1st wave. Next we assume a 4th wave bounce that meets resistance at today's market bottom. Finally, a 5th wave that is the same size as our 1st wave gets us right in the 97 gap area.

Next consider the amount of overall zig zag that this chart would end up having. We would essentially have tremendous support/resistance from 98 all the way up to 123. That would set the stage for an extended sideways market which makes sense given where we are in the historical context.

What If This is Wrong

The first thing that gives me pause is that I got caught blindsided by a similar analysis that was overly bullish at the market top. That analysis (and associated fear/hesitation) stalled my short entry into the market and cost me a lot of money:

That miscalculation cost me 5% profits. Totally ridiculous considering that the market had done every single thing I had predicted up to that point. I should have been massively short and allowed myself to stop out if I was wrong instead of hesitating. Luckily I snapped out of my haze quickly enough to still make a nice profit (missed the boat but dove into the water). So, is SPY 97 an overly bearish prognosis that flies in the face of months of analysis and will cause me to miss the bull boat?

Secondly there is the look. 97 is nice because it would create an overall 5/3/5 pattern with the 5 legs approximately the same number of points (25 v 23). However from a percentage basis 100 would be closer (18%) and given the steepness of the initial drop in the 5/3/5 my expectation is for the final 5 to be smaller overall. When one looks at historical crashes one just doesn't see a pattern like the drop to 97. One usually sees one of two things. Either, (a) the market bounces before going into a mega bear market (such as 2008) or it finds support with a second leg that is about 2/3 the size of the first leg. That would put us back in the 102 area. It just "looks" right that way, and for Elliott wave counters that is a huge part of the puzzle.

Finally there is timing. SPY 97 would require the market to descend well into November if not December. These are historically bullish months and given the length of this bear market I'm expecting bear fatigue to settle in at some point. Who is going to short the market past the 102 mark (below Dow 10000)? Currently I don't think there is enough bear sentiment to accomplish this (note bear sentiment levels are extremely high right now, so what I mean is there's not enough additional bear sentiment). The market needs a recharge before it can dive down that low and Elliott doesn't provide an obvious mechanism to do that without first allowing the market to surge back into the 120s or even 130s.

Summary

So what I can say with a reasonably high degree of certainty is that the 106 gap fill will not be the bottom. This is hardly news. I believe very strongly that there will be a bounce between 101-106 and that this will require daily monitoring of the wave patterns. What I still think is a likely possibility is that the market will then linger in this area as Elliott carves out either triangles or a flat pattern. Either one is a tip off that the next wave will be the final 5th wave. I believe that this will result in a slightly lower bottom that will essentially look like a re-test. In the scheme of things, 102 and 97 are not that far apart. What is more relevant is the daily wave patterns. Look for this market collapse to end in a subdued manner (with all the energy taken out) rather than a spike.

I also think that RSI will be providing plenty of signals at that point. The dollar and treasuries will likely have already turned around and some bellwether stocks will be rallying inexplicably.

My own personal trading strategy this time around is slightly different. Rather than trading the index I will be trading a basket of securities that have shown strength during this decline and that have hit technical support. This should provide some insulation against a premature long entry and also some extra juice if a bull rally ensues.