Thoughts for Sunday, July 15...

There is a technique for wave counting that uses the Relative Strength Indicator (RSI) to assist with the identification of waves in a motive formation. The theory is that the Relative Strength Indicator peaks at Wave 3, or, in an extended formation, Wave 3 of 3. It is then followed by an RSI divergence as Wave 5 unfolds to new highs in prices without corresponding highs in RSI.

If we use this technique to characterize the rally up from March 2003, then we find an initial wave up from March 2003 that ended in December 2004. As the chart below suggests, the RSI peaked with a price peak in February 2004. This was followed by a three-wave flat corrective pattern, and a final surge higher from July to December 2004. As the S&P 500 rallied to new price highs at the end of 2004, we saw a divergence on the RSI that failed to confirm the new highs. True to form, this was followed by a ten-month corrective pattern that left prices a approximately the same level as they were in December 2004.

We saw a similar situation beginning to set up this year. As the chart above illustrates, the Relative Strength Indicator (RSI) peaked with the highs in February. We then saw a divergence on the RSI as it failed to make new highs with the rally into the end of May. All of this agreed with the many other indicators that suggested some sort of top was in order. Ultimately, equity prices are determined by the balance and imbalance between buyers and sellers in the market place, and not the tools that technical analysts use to predict future trends.

This was made abundantly clear as the S&P 500 and the Relative Strength Indicator both rallied to new highs. This suggests that the wave up from July 2006 is extending. Moreover, since this is the third wave up of the rally that began in March 2003, we might expect the RSI to rally to a peak above that made in February 2004. We can assume that the price of the S&P 500 will continue to rise with it. It is also possible that we will have another wave, after the one that began this week, in which the RSI diverges from even further price highs.

Thoughts for Tuesday, July 3...

The markets have entered into a period of consolidation. There will be gyrations up and down, but all of them will remain within the larger confines of a corrective wave structure. The more important questions are what formation and what degree.

One possibility is that we are in a sideways triangle formation. If we look back to the end of June on a line chart of the S&P 500, then we can see that we have made what might be counted as four three-wave formations. The current wave up would be wave D of the triangle. Triangles are composed of five three-wave formations. That would imply that our next wave down would be limited in magnitude, and remain within the narrowing channel formed by the last two highs and lows. If we bounce off the lower trend-line around 1490, then that would suggest that we have a final wave to run about 75 points higher.

The second possiblity is that we break the 1490 support and make another lower low. This would suggest that the high in mid-June marked the end of the five-wave structure up from March. It would also be consistent with my hypothesis that we have already entered Wave 4 of a longer-term wave structure. Whether this is Wave 4 of the bull market that began in March of 2003 or Wave 4 of the rally that began in July 2006 remains unproven. Nevertheless, I am of the opinion that the market will need to test the 200-day simple moving average.

I think it is important to reiterate that the markets have seen a marked narrowing of breadth, a definite decline in volume, and unmistakeable divergence between price and momentum oscillators. Since the beginning of June we have also seen a lower high and a lower low on the S&P 500. Our current rally has not gotten close to the 1540 highs, despite greater strength on the NASDAQ Composite. These all support the bearish case.

Over the short-term (1-3 weeks), I am mildly bearish on the S&P 500. Over the intermediate-term (1-3 months), I am also mildly bearish. That said, I remain bullish over the longer-term (1-3 years) and continue to expect a bull market into 2010. The direction of the shorter term price movements will be defined by the magnitude of the next downward movement. If we break the 1490 level, then I expect an eventual test of the 200-day moving average that could even reach the March 2007 lows. If 1490 holds, then the next logical resistance would be 1565.