On April 17th in Like a Hot Knife Through Warm Butter we posited that the $SPX was tracing out a B wave retracement that was chopping up shorts and confusing many market participants.
We have seen some bears in the street start to turn bullish on this rally as they get squeezed and see the potential for a breakout. This sentiment shift as we see a 3 wave move into the 618 sets up for a great risk/reward short opportunity once we get the April expiration out of the way. As always risk management is crucial so don’t get married to a position. If this is a B wave up it could last much longer than we expect so stay nimble and use tight stops.
B waves always last longer than you think they should and typically if the market is doing something we can’t figure out, we assume it’s a B wave. This was move up to the 1415 fit that description well and even as many were looking for a breakout, we stuck to our guns and continued to go with the plan. It was the initial 3 wave move from 1357 that kept us on the right side, looking for an eventual violent C wave once the B was finished beating up on the shorts. Tuesday’s better than expected ISM number was just the catalyst needed to squeeze them one last time in what ended up turning into a nice head & shoulders top going into Friday’s NFP.
The weaker than expected employment picture didn’t start out as a puke. We even heard on morning news that maybe the muted reaction (ES -5 points) was the market expected more QE from the Fed. We knew the C was in play and caution was warranted. In other words, C waves always punish the dip buying that had been so easy in the B wave.
The question for investors is how this C wave will continue to unfold. As you can see on the chart we have laid out 2 basic scenarios and either are in play. The first scenario is a deep C wave that targets 1340 support (4 of lessor degree) that everyone already sees. As we said in “Warm Butter” we think if the 1340 level is in play it will be sliced through, if nothing else to trigger stops and bring in some heightened fear. We will find subsequent lower support when we get there but just eyeballing we think 1300 is definitely a possibility. The alternative scenario is for the market to trace out a larger Triangle wave 4 pattern that corresponds to the 10% Oct/Nov 2011 correction. If we are in a triangle the market should look to find support in this 1360/1370 area and with the 60 minute RSI on the floor this is a distinct possibility. If nothing else the RSI should be good for a bounce.
We commented to a friend that how this unfolds could be up to how the shorts played Friday. The COT report showed large specs to be near the flattest they have been ES since last August. There was likely few who were positioned for the 20 handle sell-off so if they piled on in the afternoon, then the pressure could be to the upside for more torturous whipsaw. If they didn’t re-short and the market is still weighted to the long side, the deeper C would be in play after the RSI rising to generate more energy for the 1340 test.
Corrections are designed to shake you out of positions on both sides so try to avoid too much emotion and go with what the market gives you. Knowing these scenarios in advance will hopefully guide you as we approach the end of the month and summer trading. This is the essence of ex ante analysis.