A warning sign for stocks

Many think that summer is a bad time for stocks. “Sell in May and go away, don’t come back till St Leger Day”, as they say.

Although this was pretty good advice in many years before the great crash of 2008, since then stocks have actually risen in the summer months in every year of the past four, except in 2011.

So this particular trading rule has absolutely no value to me, based on its historical performance.

For a swing trader, there are opportunities at all times of the year. And currently, there appears to be an interesting situation developing in stocks.

Interesting situation in the Dow

As we all know the Dow has just reached an all-time closing high, although it has not yet exceeded the intra-day high set on 22 May at 15,540.

This brings up an interesting question regarding the Elliott wave count.

I have been using the following count off the November 2012 low:

Dow Jones spread betting chart

From the wave 3 high on 22 May, wave 4 has declined in a clear A-B-C. So far – textbook.

And from the wave 4 low on 24 June, the rally is my wave 5 – a final wave before the big decline sets in. And this 5 wave top should exceed the 3 wave top.

That is the roadmap I’ll be using until I’m proven wrong.

But the question is this: has this final thrust done enough to call the end to this fifth wave? The closing high has exceeded the wave 3 closing high all right, but the absolute high of 15,540 has not yet been beaten.

The jury is still out on that, as there are no clear-cut rules in Elliott Wave theory to help decide.

But I have a further clue to help me.

What form should this final wave 5 take? Ideally, it too, should contain a clear five-wave form. Let’s examine this final wave 5 in detail.

Here is the hourly chart from the 3 July low:

Dow Jones spread betting chart

And I have drawn some impressive tramlines. My central tramline sports great touch points and several prior pivot points.

These are very reliable tramlines, so far.

Of course, a break below the lower tramline would be negative for the rally, but so long as this does not occur, the next target will be my central tramline in the 15,600 – 15,750 region.

This sets up the likely Elliott wave labels here:

Dow Jones spread betting chart

If the market can make it to the centre tramline, that should be wave 3 of the final wave 5 from the June low.

Then, a dip in wave 4 and finally, a new thrust up into new high ground for the final fifth wave, as shown, perhaps to my highest tramline in the 15,800 region.

That will be my roadmap for now. But I will watch carefully for a lower tramline break.

Herding in action?

The market is heavily long, as shown in the latest commitments of trader data for the Dow:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
$5 X DJIA INDEX Open interest: 115,832
Commitments
43,682 7,976 551 46,348 83,990 90,581 92,517 15,099 13,163
Changes from 2/7/13 (Change in open interest: 11,573)
5,255 3,669 81 5,010 6,481 10,346 10,231 1,227 1,342
Percent of open in terest for each category of traders
41.3 7.5 0.5 43.9 79.5 85.7 87.5 14.3 12.5
Number of traders in each category (Total traders: 98)
32 17 5 33 22 69 40

Hedge funds are still over five-to-one long to short, and became even more bullish in the past week which was a rally week. Remember, hedge funds are trend-followers and will always look to add to longs on a rally.

But ominously the small investor has suddenly become very bullish, after generally distrusting the four-year rally. The pros have been wildly bullish, while retail investors have been mostly neutral in the past four years.

Here is the latest AAII data:

Bulls Bears Neutral
49%  (up 7% on week) 18% (down 6%) 33%
Long-term average 39% 30% 31%

Suddenly, the small investor has discovered the joys of equities with a big swing to the bullish camp! Never mind that valuations have mostly been pushed up into historically high territory and they run the risk of piling at a major top, as they always do.

This is classic herding in action.

And this is what occurs at big market tops – and why monitoring sentiment data such as this can help you pinpoint turns.

And using my tramline method can give you an edge in your timing –a most essential component of successful trading.