As you recall, yesterday was an inside day. We knew that we would see greater price action today. It was just unclear whether the action would be up or down. Now we know.
The market gapped up in the morning and made a dramatic move to the upside. I was not surprised because we were experiencing oversold conditions on a daily chart. See the 1-year chart for the S&P 500 Index at clearstation.com. Now, today can be best understood as a short covering day. In other words, investors and traders who were shorting the market had second thoughts and bought back their shares. This "forced" buying by short sellers propelled the market higher in a rapid fashion. A classic sign of a short-covering rally would be a gap up from oversold conditions in a rapid fire fashion up to resistance. Master trader Bruce Kovner has written that "the principal characteristic of a bear market is very sharp down movements followed by quick retracements....In a bear market, you have to use sharp countertrend rallies to enter positions." Jack D. Schwager, Market Wizards, page 70.
This circumstance is very striking. The fearful short sellers covering today are right about the direction of the market. The market will continue to go down below 1173. The short sellers fueling today's rally were just too early. I don't recommend short selling because investing for the long haul is less stressful. But it is instructive that you can be fundamentally right on the direction of the market but wrong in your timing. The smart short sellers were covering their bets on Tuesday afternoon when the S&P 500 Index hovered around 1173.
I would anticipate that the S&P 500 Index will hit the 1206 area tomorrow. That should prove to be a short-term top for this countertrend rally. Why am I so confident? Well, I could be wrong. No one gets the direction of the market right all of the time. However, I can list three reasons that signal a short term top is near.
Reason No. 1: The 0.618% retracement level.
Professional traders and money managers recognize that when a market retraces, a common retracement level is 0.618% of the previous move. The move could be up. The move could be down. It doesn't matter. When the S&P 500 Index peaked @ 1127 on November 5, I was fairly confident that that was a top of importance. 1127 represented almost a 0.618% retracement of the down move from 1576.09 on October 11, 2007 to 666.79 on March 6, 2009. I banked on major institutions and hedge funds having computer programs keyed into the 0.618 level. And the market came to a halt at that 1127 0.618 retracement level!
Similarly, the 0.618 retracement level of the 1227 (November 5) to 1173 (November 16) down move is 1206. Thus, I anticipate that high-powered computer programs will be fired up to sell the S&P at around 1206. I could be wrong but, if I am wrong, I would be surprised.
Reason No. 2: The Dumb Money Factor.
In an earlier post, I urged readers to do the opposite of dumb money. Dumb money would be retail investors who trade options on the index. They are wrong like clockwork. At the close today, options traders were as bullish as they have been in the past six months since June 28. And what happened on June 28? The market dropped 70 points in 3 days into July 1. So, the positioning of Dumb Money at today's close suggests that the market has more down side.
Reason No. 3: Corrective Wave Pattern (Elliott Wave)
Even if I ignored the 0.618 retracement pattern and the Dumb Money Factor, I would be mindful of the Elliott Wave pattern that corrections take place in an A-B-C fashion. First, there is the initial down move that takes everyone by surprise. That is Move A down. Second, there is the sharp short covering rally up to frustrate the short sellers who are right but weak. That is Wave B. In my experience, Wave B usually ends at the 13-day moving average. Finally, there is a Wave C down which suggests raw panic and capitulation. Wave C goes lower than Wave A and usually represents a good buying opportunity at the bottom. Today was Wave B. Wave C remains ahead of us.
Conclusion: For these three reasons, I see lower prices ahead. And then it will be a good time to buy.
I leave you with an insightful quote from trader Mark Weinstein about the art of using different tools and rules:
"It is experience and gut feel. I use all forms of technical analysis, but interpret them through gut feel. I do not believe in mathematical systems that always approach markets in the same way. Using myself as the "system," I constantly change the input to achieve the same output--profit!" Market Wizards, supra, at page 339.
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