Sentiment Speaks: Let Me Explain What Caused Thursday And Friday's Rally

This market has certainly provided much stress to both the bulls and the bears alike. And, unfortunately, that is the nature of corrective structures. They provide frustration to both sides of the trade. Yet, one of the most important pieces of information for a trader or investor to glean from the market is the ability to recognize these environments before they begin in earnest, so you can adjust accordingly.

Once we began the pullback off the recent high struck in the 4195SPX region, I warned the members of ElliottWaveTrader that we have moved into one of these types of environments. Such environments provide whipsaw to both sides of the trade, which probably best explains the action seen over the past month.

And, while I was able to recognize the nature of the market environment and appropriately prepare our members for it, I also honestly told them that I was unsure exactly where we would find a bottom and begin the rally I still expect to the 4300+ region.

You see, analysts have to understand their limitations and recognize when they have to take a step back and simply allow the market to progress a bit more in order to clarify how the next setup will develop. As Frost & Prechter noted in The Elliott Wave Principle:

Of course, there are often times when, despite a rigorous analysis, there is no clearly preferred interpretation. At such times, you must wait until the count resolves itself. When after a while the apparent jumble gets into a clearer picture, the probability that a turning point is at hand can suddenly and excitingly rise to nearly 100%.

So, I warned our clients about being too aggressive in such a corrective, whipsaw environment, provided them support and resistance regions, and told them I was going to have to be a bit more patient in order to allow the market to clarify how we begin the rally I expect to 4300SPX.

Yet, some of our members pointed out in our chat room that other analysts did not take a similar path. Instead, when the market moves against their expectations, they simply claim that "the market got it wrong." And, as I have said in prior articles, this is probably the extreme in ego and hubris on display. Price is the market. And, if your perspective does not comport with price action, then it is YOU that is wrong and not the market. How one can view themselves as right and the market as wrong is simply beyond my comprehension.

There are times you will be right and times you will be wrong. So, the ultimate goal for any analyst that seeks to do best by his clients is several-fold.

First, clearly, the analyst must be right much more than they are wrong. And, they must utilize a methodology that can identify when they are wrong relatively quickly so as to avoid a large drawdown. This keeps clients profitable over the long term.

Second, they must recognize their own limitations. Sometimes, the market will not be clear. And, an analyst must be honest with their clients about this perspective. So, rather than double down on a wrong perspective, they must realize there are times they will have to say "I am not sure." This is where patience is the key, and anyone with experience will tell you that it usually does not take long for the market to clarify itself.

Third, they must recognize that they are the ones that are wrong when price moves against them and not the market. Therefore, they should never be fighting the price action while they wait for the market to "prove them right." This is when analysts allow their ego to get in the way of their analysis, and it is how many lose big money in the market.

Sadly, I see way too many analysts tell their clients that the market got it wrong, thinking they are saving face. But, I believe the exact opposite is true. They are actually insulting their clients when they try to claim that they are right even when price action, which is driven by millions of investors worldwide, moves against them. And, as I noted above, they also need to utilize a methodology which can identify that they are wrong quite quickly so their clients can avoid a large drawdown. Maintaining a belief that you are right and the market is wrong will only hurt your clients as you try to save your ego. And, as I tell my clients all the time, their hard-earned money is much more important than my ego.

Now, I will get off my soap box, and move into the analysis. First, I want to remind you what I said last weekend:

For now, this is how I see the market. But, remember, corrective structures are quite variable and difficult to navigate. So, I am simply going to let you know that our support is now in the 3770-3858SPX region. We are now waiting for the market to find support, and then begin a 5-wave rally off that support. Should we see that in the coming weeks, then I will be preparing for a rally to 4300SPX (with some potential we can even extend as high as the 4500/4600SPX region, depending on the size of the initial rally off the low we strike). I will also be outlining to our members how I will be deploying some of my raised cash in a low-risk fashion. And, until I see that structure develop in the coming weeks, I intend to maintain the levels of cash we raised over the last year.

To get a bit more technical this week, I identified the top of our support noted above as being the point at which the third leg in the corrective structure would be equal to the first leg in the corrective structure as calculated from the high of the second leg in the corrective structure. This is a common ratio we see in the markets quite often.

However, this past week, rather than seeing a ratio tending toward equality, the 3rd leg in the corrective structure only traveled .764 the distance of the first leg in the structure. This happens in a minority of circumstances, and this may have been what we saw last week. What led to indications of this potential, as I warned our members, was that we were seeing significant positive divergences in our technical indicators on Wednesday and Thursday, which suggested the market was trying to find a bottom well above our ideal support region. And, on Thursday and Friday, the market certainly reacted accordingly in the opposite direction.

It again brings to mind the quote from Alan Greenspan:

It's only when the markets are perceived to have exhausted themselves on the downside that they turn.

The positive divergences we were seeing in our technical indicators evidenced the exhaustion of sellers, which is when the market then turned sharply in the opposite direction.

Please also take note that there was no real news associated with that rally. While I am quite sure someone is going to try to fashion some contrived "reason" for the rally in the comment section, if we are going to be honest, there was no solid news upon which such a large and strong rally was based. And, while some are pointing to statements by the Fed, all that was said was that the Fed was going to do exactly what they said they were going to do before. So, at the end of the day, there were no real new catalysts for which one can claim caused that rally.

So, many were scratching their heads, or simply claiming the market got it wrong. But, as I have noted many times before, while news events can act as a catalyst to a market move, the substance of that news is not always indicative of the direction of the market move. In fact, we often see markets move in the exact opposite direction one would assume based upon the substance of such news. And, the best examples were seen in the reaction to the CPI report in October and the PPI report in December of last year.

Moreover, there are many times when the market even sees strong moves without a news or economic catalyst. Allow me to show you some examples of studies conducted that support this premise.

In a 1988 study conducted by Cutler, Poterba, and Summers entitled "What Moves Stock Prices," they reviewed stock market price action after major economic or other types of news (including major political events) in order to develop a model through which one would be able to predict market moves retrospectively. Yes, you heard me right. They were not even at the stage yet of developing a prospective prediction model.

However, the study concluded that "[m]acroeconomic news bearing on fundamental values explains only about one-fifth of the movement in stock market prices." In fact, they even noted that "many of the largest market movements in recent years have occurred on days when there were no major news events." They also concluded that "[t]here is surprisingly small effect [from] big news [of] political developments . . . and international events."

In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker, who conducted his own study of 42 years' worth of "surprise" news events and the stock market's corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news. Based upon Walker's study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.

In 2008, another study was conducted, in which they reviewed more than 90,000 news items relevant to hundreds of stocks over a two-year period. They concluded that large movements in the stocks were NOT linked to any news items:

Most such jumps weren't directly associated with any news at all, and most news items didn't cause any jumps.

In 1941, Elliott stated, regarding the financial markets, that "[t]hese [Fibonacci] ratios and series have been controlling and limited the extent and duration of price trends, irrespective of wars, politics, production indices, the supply of money, general purchasing power, and other generally accepted methods of determining stock values." As you can see, the more research conducted into this subject, the more support we find to Elliott's theories set out almost 100 years ago.

In moving onto studies conducted on individuals rather than stock market history, these will likely be of great interest to those who are seeking the truth about the human thought process. So, when asked by many of you about what causes changes in market sentiment, and my response is "biology," I hope this article helps you to understand.

In 1997, the Europhysics Letters published a study conducted by Caldarelli, Marsili, and Zhang, in which subjects simulated trading currencies, however, there were no exogenous factors that were involved in potentially affecting the trading pattern. Their specific goal was to observe financial market psychology "in the absence of external factors."

One of the noted findings was that the trading behavior of the participants was "very similar to that observed in the real economy," wherein the price distributions were based on Phi. Consider that a bit more carefully. This means that there is potential we would see the exact same structures in the market if we did not have news or reports being published constantly. This, to me, is somewhat mind-blowing.

And, it leads me to again quote Robert Prechter's point made in his seminal book The Socionomic Theory of Finance (a book that each and every investor should read in my humble opinion):

Observers' job, as they see it, is simply to identify which external events caused whatever price changes occur. When news seems to coincide sensibly with market movement, they presume a causal relationship. When news doesn't fit, they attempt to devise a cause-and-effect structure to make it fit. When they cannot even devise a plausible way to twist the news into justifying market action, they chalk up the market moves to "psychology," which means that, despite a plethora of news and numerous inventive ways to interpret it, their imaginations aren't prodigious enough to concoct a credible causal story.

Most of the time it is easy for observers to believe in news causality. Financial markets fluctuate constantly, and news comes out constantly, and sometimes the two elements coincide well enough to reinforce commentators' mental bias towards mechanical cause and effect. When news and the market fail to coincide, they shrug and disregard the inconsistency. Those operating under the mechanics paradigm in finance never seem to see or care that these glaring anomalies exist.

But, I digress. So, let's move into the analysis.

Does Friday's action mean we are ready to rally to 4300+? Well, I am not sure yet. As I outlined last week, we would need to see a clear 5-wave rally off a support level to provide us with a strong indication that the rally has begun in earnest. And, once that 5-wave rally completes, we would then need to see a corrective retracement which retraces anywhere from .382-.764 of the prior rally. So, this is what we are going to be looking for in the coming week. And, should we complete a 5-wave rally off last week's low and then see such a corrective retracement, that will likely be a buying opportunity for the next rally to 4300+.

So, while I cannot tell you with certainty that we have begun the rally to 4300+ just yet, I have given you an outline as to what you should be looking for in the coming week or two.

And, for those that have been asking about my perspective on bonds, well, I find it quite ironic that certainty about rates heading to 6% seemed to be pervasive among pundits these last several weeks. Yet, I have been outlining to our members a bottoming structure which, when completed, would likely signal a resumption of the rally begun last year in TLT, and likely pointing us to the 120 region.

In fact, a number of my own members took me to task for the expectation of a continuation rally in TLT rather than heading to lower lows. Yet, I maintained my expectation and provided clear objective guidelines as to what I am looking for in order to signal that the rally has potentially begun. For those that are interested, I penned the following article on TLT last week which outlined the general guidelines.

Sentiment Speaks: Approaching Potential Reversal In Rates

Have a great week.