Securities Research Services

Tuesday, March 13, 2007

How the Crowd Could Turn Bullish Again

Last week we theorized that the market, represented by the Dow chart below, is in the throws of an A-B-C correction. Wave A represents the waterfall-like decline which occurred on February 27. This is generally followed by wave B, a countertrend rally, also known as a dead cat bounce. Finally, the pattern tends to culminate in a wave C decline, which oftentimes mirrors wave A.

So far the pattern has been developing exactly as predicted. As you can see below, the wave B countertrend rally has been moving up to the 50-day average as volume has been decreasing and the oversold condition, represented by the histogram at the very bottom of the chart, is being worked off.

This is a classic pattern and is setting up very nicely for a short.

But is it too obvious?

There may be a fly in the ointment however: Everyone can see the same pattern. It is too obvious. It makes us very nervous when we are members of a consensus on what the market should do.

Thus far this market has been very difficult to short. The countertrend rally has been a bit stronger than everyone anticipated. Breadth has been good on the rally, even though volume has been poor. Up until yesterday there were way too many put buyers anticipating more downside for downside to actually occur. These are challenges to the short position.

All of this said, we still expect this market to take another tumble. Perhaps it will rally one or two more days. The Dow, as you can see above, still has a bit more room before it tags its 50-day average at 12427. That gives it around 100 points of run time to squeeze the shorts and draw more people in to the bullish argument that "maybe, just maybe this market is going to climb a wall of worry."

A lot can happen over the next day or two to change market sentiment, which can help take everyone's focus off the obvious.

The bottom line:

Even though it's too obvious that this market is setting up for another drop it doesn't mean that it is not going to happen. We are already seeing deterioration in bearish sentiment and more and more are being won over to the bullish camp here. If the Dow can rally today like it did yesterday, it will likely win over many more. We will be watching market breadth readings carefully. Yesterday breadth on the rally was positive. We will be looking for breadth to start to wane as a signal that this countertrend rally is done.

Alternative scenario:

We have been comparing the current market correction to the correction which took place last April. During that correction we saw a large A wave down, B wave up, and then another waterfall-like C wave down again. But let's narrow our focus to just the B wave.

Within a large wave there are sometimes smaller waves. Note that the first phase of the large B wave there was a minor "a" wave up, a quick "b" wave down, and then another "c" wave back up again. All of this took place before the large waterfall C wave sent the market into a tail spin.

Such a scenario could easily repeat itself here and this would go a long way toward destroying the current consensus. If, for example, today the market takes a quick sweep down, no doubt a lot of people would rush to short the downturn. A wave "b" back up would then serve to stop out those eager shorts and more than likely everyone would turn bullish at that point. This would be ideal for lulling everyone into complacency before the next very large C wave down takes place.

We think this alternative scenario has a lot of merit.

Just keep in mind that the market is in a minor downtrend and that it pays to stick with the basics, which are short the rallies not the dips.


Anonymous said...

today it looks very bad for all long positions. dow seems to be returning to 12100. i would buy all the short papers in the market if i could. regard,wez*

SRSFinance said...

Nice call...