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Turning Points

Fibonacci shenanigans? I have been warning for some time that some unusual market action could occur this past week because it was the 89th week since the bottom of the 4 year cycle. The sudden sell off on Thursday qualifies, mild as it was. Does it have any important technical significance?

Under Market Trends in my last newsletter, I said: "Short term trends, by their very nature, are always in the process of reversing as they compose the longer term trend. This is the fractal aspect of the market." This week we had a short term trend reversal--or was it a short-short trend? Is it the beginning of something important? So far, the answer is no! There is no such evidence. The momentum indicators had been giving some caution signs, but the total market perspective remains positive.

Most analysts speak of the "stock market" in gross generalities. An analyst should be more specific and differentiate between the various trends. Currently, the long term trend remains up, the intermediate term trend appears to have turned up, and only the short term trend has turned down. In fact, this pull back may be just what is needed to facilitate a decisive penetration of the area of resistance that has been holding us back. With prices extended, there was not enough strength left to effectuate an immediate rally to new highs.

I am still of the opinion that, structurally, we have probably begun the 5th wave of the rally which began in March of 2003. As we know, the 5th wave of any degree is itself usually made up of 5 smaller waves. This pull back may represent wave 2 of the final 5 wave pattern before a larger correction takes hold.

During the sell-off, the volume did not increase materially and the advance/decline ratio showed little weakness. Here is the score: on Wednesday, the A/D had a net 1522 positive. On Thursday, the day of sell off, a net minus of 464. On Friday, a net plus of 978. Below, I am including a graph of the advance/decline line which shows that it is very close to making new highs. This is not the kind of behavior one would expect at an important top. Two days of negative numbers in the new highs/new lows index were probably the result of end of quarter portfolio adjustments.

The daily momentum indicators are no longer overbought and, importantly, they were not showing negative divergence at the recent short term top! Only the hourly readings did. This adds up to the probability that we are only experiencing a short term pull back and not the beginning of a significant decline.

It is interesting that GE, one of our leading indicators gave us advance warning once again by selling off sharply two days before the market. The Dow Transportation index is much stronger than the overall market, and the QQQ is a little ahead of the S&P 500.

A 50% Fibonacci retracement of the recent rally would take the S&P back down to the 1110 level and the QQQ to about the 36 area. This would be perfectly normal. NOT retracing to these price levels before resuming the short term up trend would be a sign of strength.

Summary:

Having said all of the above, we have to be mindful that somewhere along the way our much advertised 10-year cycle which is expected to make its low in the Fall will begin to exert downward pressure on the market. The 5th wave scenario is not something which is written in stone. As I have mentioned before, the stock market is akin to a mystery novel which reveals its plot chapter by chapter. It is important for the analyst to have logical expectations about the future course of the stock market, but it is even more important to have a model that is open-ended and which is revised when called for. We'll keep a watchful eye to see if our preferred scenario is confirmed or if we need to change our mind.

The charts which appear below should demonstrate clearly why there is no evidence, yet, that the market is making an important top.

Chart #1 is a chart of the advance/decline line. As you can plainly see, there is no weakness showing. On the contrary!

Chart #2 demonstrates why the market is having trouble in this area. We are up against important long term resistance. However, you will note that we have not really been pushed back by it, but rather that we seem to be slowly but surely eating our way through it. The Dow Transportation average is clearly the stronger index having decisively penetrated its overhead resistance.

One final reminder: A few weeks ago I pointed to the bullish readings of the put/call ratio, and NYSE specialists and members activity. Historically, these are not indicators that have predicted ephemeral conditions. This is not the time to be a contrarian and ignore their signals. It would be a little like betting against the gold commercial traders.

Gold and the dollar: The COTs show that the commercials have begun to increase their short position, but it is still at a relatively low level. This indicates that gold is in a position to extend its rally. The XAU, whose chart appears below, is relatively weaker than bullion. This has to be seen as a negative for gold, since the XAU tends to lead. However, the XAU could still move up to the 92/95 area to complete what might be a wave 4 pattern from the top.

The best current interpretation for the price action of the dollar is that it is in the process of testing its recent low in the form of a wave 2 or B. In doing so, it is expanding its base which, when complete, could be followed by a strong rally. This also fits nicely with the current action of gold.

For those of you who take a special interest in market cycles, you should read Clif Droke's excellent recent article on long term cycles and what they forecast for the next 10 years. Just click on the following: K-wave Winter and the Financial Markets.

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