The Return Of The Count Right Now

06/21/05 08:20:55 AM

by David Penn

With a close above the 1215 level, the S&P 500 closes in on a 100% retracement of the spring declines.

Security: $SPX
Position: N/A

It was about a month ago when I suggested that the Standard & Poor's 500 could reach the 1215 level as part of a three-segmented, a-b-c countertrend correction to the spring of 2005 declines ("Will Divergences Doom The Rally?" May 23, 2005, Traders.com Advantage).

Specifically, I pointed out that by multiplying the length of the first "a" leg of the correction by 1.618, and then adding that amount to the value at the bottom of the second "b" leg, traders can approximate the upside of the subsequent third "c" leg of the correction. This was the thinking that led me to believe that the S&P 500, which at the time was trading between 1192 and 1188--and could move significantly higher.

Figure 1: Breaking out above the 78.6% retracement level in mid-June, the S&P 500 closes in on a test of its year-to-date highs.

Graphic provided by: Prophet Financial, Inc.

So what are the implications, now that the S&P 500 has reached this point? The Fibonacci retracements shown in Figure 1 tell an important story: the countertrend rally since late April has almost retraced the entire move down from the March highs. In the context of the Elliott wave counts I have been providing, this development is consummate with the behavior of a second wave. Second wave, as Robert Prechter and A.J. Frost have shown, tend to retrace "so much of wave one that most of the profits gained up to that time are eroded away by the time it ends."

In the context of a second wave in a declining market, this might be reworded to point out that most of the losses incurred during the wave 1 decline are recouped by the deer-in-the-headlights investor or trader during the countertrend rally of a wave 2. If the wave count is accurate, of course, this recouping of previous losses is actually a curse in disguise insofar as it encourages the investor or trader to believe that the worst is over and that a new bull market has been born. Such hopes are then dashed in the subsequent wave 3 decline.

If the mid-April to present advance does reflect a wave 2 advance in a declining market--as I suspect it does--then the rally should not take out the March 2005 highs on a closing basis. That means there should be a ceiling at 1229.11--at least as far as closing prices are concerned. The wave 2--to recap--consists of a wave "a" from mid-April to early May, a wave "b" from early May to mid-May, and a wave "c" from mid-May to present.

What other technical signal supports the notion that the current rally might be running into a reversal? The S&P 500 entered a second, more aggressive trend channel in late May, a channel that was confirmed by the market's action in early June. Because of its positioning in the second channel, the S&P 500 will have to move almost vertically to avoid plowing into the side of the increasingly steep trend channel. While the S&P 500 could continue to advance using the upper boundary of the old trend channel as support, I have pointed out that when markets break down from secondary, more steeply inclined trend channels, such old boundaries are often the last chance for the market to continue to advance in the near term.

In other words, if the S&P 500 broke down from its secondary channel and then broke down back into its old channel, the possibility that the rally would end would increase sharply.

Another technical development worth watching for is the potential for a negative stochastic divergence between the May and June highs. Already in June, the stochastic appears to be rolling over at a level lower than the stochastic peak in the previous month. In the current context, the development of a negative stochastic divergence would be a powerful warning that the potential for reversal was high.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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