Stock Market Structure + Cycles + Divergence = Corrrection?

By: Andre_Gratian

Current Position of the Market

SPX: Very Long-term trend - The very-long-term cycles are in their down phases, and if they make their lows when expected (after this bull market is over), there will be another steep decline into late 2014. However, the severe correction of 2007-2009 may have curtailed the full downward pressure potential of the 40-yr and 120-yr cycles.

Intermediate trend - SPX continues to progress according to its structure. If the count is correct, an intermediate reversal could still be a little ways off.

Analysis of the short-term trend is done on a daily basis with the help of hourly charts. It is an important adjunct to the analysis of daily and weekly charts which discusses the course of longer market trends.

STRUCTURE+CYCLES+DIVERGENCE = CORRRECTION?

Market Overview

Last week, new highs were set by most major indices, thereby continuing what appears to be a very strong bull market. Why all this strength? Tony Caldaro has an explanation for this: We are in a cycle 1 bull market since March 2009 and, breaking it down, since October 2011 we are in waves 3 of 3 of 3 (primary-major-intermediate). If he is right, that would certainly account for it. And it would fit right in with Laszlo Birinyi's projection of 1900 for the S&P 500. Last week, titan hedge fund manager David Tepper - founder and president of Appaloosa Management -- made essentially the same assertion. We will find out in due time if they are correct but, for the time being, this market has all the characteristics of one of the strongest bull markets in history!

That should certainly be kept in mind by analysts, but since traders are primarily interested in the shorter-term phases of the market, let's see if we are now ready for a short-term correction.

Structure: Last week, I suggested that we could be approaching the top of minute wave iii from 1536. It is now possible that it could be complete over the next couple of days. Afterwards, wave iv should bring about a decent correction and then, on to wave v which would also mark the end of minor 5 and intermediate III, leading to a more severe decline.

Cycles: There are some important cycles due to make their lows in the first week of June (see chart below). They should have some influence on the market commensurate with their stature. It is very possible that they could cause the reversal that is anticipated in the SPX after it has completed minor wave iii from 1536. (because this still applies, it has been left essentially unchanged from last week.)

P&F projection: Since the conservative counts derived from the 1536 base have been exceeded, we have had to move into weaker count territory to arrive at one that would match what SPX has created during its mini-consolidation around 1655. This would suggest that another few points could be required to satisfy the completion of wave iii.

Resistance zone: What resistance? Last week, I had suggested that the top of the channel assisted by some internal trend lines could stop the rally, but the index blew right through the top channel line and traded above it most of the week. That action often ends an uptrend temporarily.

Sentiment: Supportive sentiment figures have been the missing link in the overall picture warning of a short-term top. Last week, the SentimenTrader -- which had remained neutral all this time -- finally consented to move into the lower portion of its red zone.

The picture now seems to be just about complete, and a few more points on the upside may do the trick - unless structure calls it quits early with a missing small wave 5, something which occasionally happens.

Chart Analysis

The daily SPX chart above (courtesy of QChart) contains much of the information that I listed earlier and which helps us evaluate the market position. We start with the structure, which shows the market coming into minute wave iii of minor 5 and intermediate III. When iii is complete, we should expect a correction to take place in the form of wave iv. Considering the fact that we have a cluster of important cycles bottoming in the first week of June, that would be a perfect time for wave iv to make its low.

We will have a better projection for the wave iv bottom after we are certain that iii is in place, but we can already pretty much estimate a level at which the correction should end.

There is too much strength in the daily indicators to suggest that this will be more than a short-term correction. The MACD is still in an uptrend and its histogram has gone flat for the past 7 or 8 days, but has still not turned down. It's a different story with the breadth indicator at the bottom. It has declined for several days down to the zero line and is showing some strong negative divergence at Friday's top. It is normal for this indicator to lead price, so there is nothing unusual about the collective action of the 4 indicators.

We will have a confirmation that wave iv has started when price breaks below the pink MA and follows through by also moving below the blue one. If my analysis is correct, this could happen by the middle of next week.

The hourly chart (also courtesy of QCharts) shows the potential topping process more clearly.

First, let's acknowledge the strength of the SPX which has only had minor retracements since it started this uptrend from 1343. It has moved to the top of its short-term channel with every rally, and refused to show any price deceleration. When wave iii completes over the next couple of days (if it has not already done so) the index should again move to the top of the channel. The strength of the SPX really sinks in when you realize that it has already exceeded its 2007 former all-time high by almost a hundred points!

Underlying the short-term strength, however, there is technical deterioration which shows up best in the momentum indicators. Both are displaying negative divergence with SRSI staying well away from its top range, contrary to what it does routinely at the top of each short-term move. The A/D is still basically in an uptrend, but that should change quickly over the next couple of days if the SPX does a small wave 4 and 5 to complete its wave iii, as is shown on the chart.

Cycles

The daily chart shows the various cycles that I follow and, as you can see, three important cycles are bottoming during the first week in June: 14-15wk, 22wk, and 29-30wk. I realize that cycles have been muted during this strong uptrend, but this combination should coincide with structure which calls for wave iv to bring about a correction.

Breadth

The following are courtesy of StockCharts.com. In the past week, even though the market has recorded new all-time highs, the McClellan oscillator has pulled back to the zero line. This is a form of negative divergence. As a result, the NYSI has flattened along with its RSI, which is overbought and looks ready to correct. That would be in conjunction with the decline in market prices being forecast by other indicators.

Sentiment Indicators

Are you sitting down? After weeks of showing neutral readings, the SentimenTrader (courtesy of same) has finally moved into the lower portion of the red zone, displaying the most negative reading of the past 10 weeks. That does not mean that it's time to liquidate your entire stock portfolio, but it does mean that, at last, warnings of a potential market top has been given more substance.

At best, this warning should only suggest that a short-term reversal is at hand. It will take penetration into a much deeper shade of red to suggest that an important top is about to be made.

VIX

VIX continues to prepare for its next spike which should correspond with the next decline in equities. It has now been diverging positively from the SPX for two months, so it obviously takes more than divergence to trigger a market decline. The pattern from the top of the last spike consists of 5 waves, so it is in the same position as the SPX, but in reverse, and a move in the other direction can come at any time.

XLF (Financial SPDR)

The financial index continues to move in concert with SPX. It has even broken above the top line of its short-term channel as SPX has. That puts it at the top of the larger channel where it should find resistance. Note also the well-defined 5-wave pattern in the last wave from the 17.75 level. More signs that this move could soon come to an end with the completion of minute wave iii.

BONDS

TLT briefly broke out of its correction channel and above its 200-DMA, but could not sustain the move, and it has now retraced deeply inside the channel. This is a sign of weakness which could mean that the index has not yet finished its correction and is ready to move lower. It is trying to hold a major trend line, but looks as if it will eventually break it after more of an attempt at remaining above. A market correction would help it temporarily, but when the SPX resumes its long term trend, it should bring more weakness to TLT. The amount of distribution at the former top hints at a potential drop to 106-108.

GLD (ETF for gold)

After a brief and volatile period GLD has resumed its decline and is currently testing its former low. It is very possible that the correction could last until the bottom of the 25-wk cycle which is still about two months away -- but not with the same intensity. At some point, deceleration should set in and a base will start to be formed in anticipation of the next rally. For now, at least, there is no sign that the index is even hinting at resuming its long-term uptrend and, if everything above its major support line turns out to be distribution, the decline has a long way to go! The onus is on GLD to prove otherwise by showing that it can still attract enough buyers to turn it around.

UUP (dollar ETF)

UUP is responding positively to a weak euro, and Gold is responding negatively to a strong dollar. This interplay is still in process and may have to continue at least until UUP reaches 23.30, which is the projection that it is given by the P&F base that it formed above 21.60. If it is making an a-b-c pattern, then c=a would also project to about that level.

The question is whether or not the dollar is beginning a major move, or is still in a long-term corrective pattern. If the a-b-c pattern turns into an impulse wave, it could signal the start of a major move in the dollar with negative repercussions for both the euro and gold -- and perhaps many commodities as well. UUP will need to be monitored closely after it reaches its current 23.30 projection.

USO (United States Oil Fund)

USO has rallied from the bottom of its two converging trend lines and is now challenging the top one once again. If it goes through it, it will eliminate any hint that this is a triangle pattern -- if its recent action has not already invalidated that possibility. However, if the market is about to correct, USO will most likely follow it, so let's see what happens over the next two weeks.

Summary

Last week, I suggested that we could be close to completing wave iii from 1536. This week is even more suggestive of that possibility, especially with the SentimenTrader showing its first negative reading in about 10 weeks. The next two days should be critical in determining if we are ready to have a short-term reversal which could last into the first week of June.

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