Spiky Dike Broken, Now Where To?

The divergences yesterday resolved to the downside. The top is in. Question is how much of a top, and how serious this drop will be.

The S&P joined the Dow in breaking Friday’s low (Sp1041) and the Aug28 intraday high (Sp1039). The Naz has broken Friday but so far has only gotten within 10 pts from the Aug28 level (Naz2060). The Aug28 level is critical in that it represents the top of wave i in the count which would have allowed a final wave v up; but once we break into the range of wave i, this is no longer a wave iv and the top is in.

Let’s see how the next two trading days settle before picking a direction, but here are the main options:

1. The bullish count (yes there is one) is that we are in wave 4 off the Mar6 bottom. The correction from Jun11 to Jul8 is wave 2. That broke as a zigzag, so this one should be a triangle or flat – essentially a trading range not a serious drop. Now, it is very difficult to count the Mar9-Jun11 move as impulsive (5 waves); it counts quite easily as a zigzag (3 waves). So I think this count is a misdirection. But the move off Mar03 initially fooled a lot of ewavers, so keep your eyes open to this possibility.

2. The bear-rally count is that this is a second X wave, the first being Jun11-Jul8. The move so far is a double zigzag tied together by that X wave; it could certainly morph into a triple zigzag. If so, this X may look like that X – about a month long and relatively steep down. Then up we go in a third zigzag. The Obama Hope Rally lives!

3. The retest count is that we drop to retest at least the Nov08 lows if not the Mar6 lows, then bounce. The continuation is a long rolling wave into summer of 2010, and then another serious drop towards a major bottom in 2011.

4. The P3 count is we crush through the Mar lows and head towards Sp400/Dow4K. If so this break should be a hope-crushing steady decline with occasional sharp and short rallies – like 1931.

Let’s look at the psychology of two periods to give guidance: the next two quarters, and next summer. Right now we are in a Grand Experiment (yes it deserves capital letters) to see whether massive global stimulation can get us out of the deflationary depression that inevitably follows a credit bubble. Greenspan successfully made this magic work in 2002-4 to create the Greenspan Indian Summer, a reflation that put off Kondratieff Winter but led to an even worse bubble than 2000. Indeed, it could be said Greenspan postponed Winter for 20 years, since 1987. Yet since 2007 the psychology has broken and the Bernanke Reflation is not working, at least not to change behavior in the private sector. At least not yet. It might change. As more green shoots pop up, the psychology could flip. Hence it has been rationale for market participants to push up on hope, and stay emboldened as more green shoots appear.

Over the next two quarters we should se a positive Q3 report (3% or so) and a somewhat positive Q4. Consequently the market could quite reasonably watch as economic news comes out, and stay buoyant hoping for upside surprise in Q4 and Q1. After all, economic growth often has the same starts and stops as market patterns. Hence option (2) above is quite reasonable. Some negative tea leaves recently have spooked the market; if more positive news begins to appear about the Xmas selling season, we could zip back up. This is not the market watching news so much as extrapolating future earnings.

Over the longer run a different psychology comes into play. In Hope and Disillusionment in Obama I described how he will inevitably disappoint his supporters who have dumped too broad a range of hope into his lap. Now, he has pushed hard for a more radical agenda than independents hoped, so he has already lost them. Next summer he is likely to lose his more radical supporters as he fails to get much more of his agenda passed. (Change freezes in an election year.) The dynamic of the election of 2010 is highly anti-Obama today, and while this could change (as they say, a year is a long time in politics), I expect the politic dynamic to ratchet the market dynamic. Hence scenario (3) is also quite likely.

I am not in the P3 camp. Serious economic chickens will come home to roost over the next two years, but not right away. Sure, option ARMs and HELOCs will be reset over the next two years – (click chart to enlarge). Various steps may be taken to delay this, but it is too large to put off. Also, the Fed needs to unwind its financial support for commercial paper, mortgages, and so on, and this will happen over the same period, but gradually. Hence it seems more likely markets meander for the next two years rather than drop precipitously.

In the short run, watch for whether we have a trading range off a shallow drop, or a sharp but relatively short month-long drop. Once past that we can see whether we stay in the relatively bullish scenarios (1) and (2) or the more bearish (3) and (4).

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