As I forecast Friday, stocks are jumping

What a difference a day makes. No sooner had I written in Friday’s post (always penned early in the day): “With yesterday’s move to a new low, I may have the final wave 5 in place. Now that would be an interesting development. While every shoeshine boy – and financial journalist in mainstream media – is busy shorting shares (see my post of 1 February), can this be a great setup for a counter-trend rally of some magnitude?

“That would shock the vast majority with bearish sentiment so strong – and that is what markets do, they hand the biggest majority the biggest losses.

“I have potentially a complete five down – and there is a huge momentum divergence forming. If this is not corrected by a move to new lows soon, it will stand as a forewarning of a corrective rally ahead.

“If the market is going to shock the bears, this is as good a place as any to start!

Of course, a move above my upper tramline would reinforce the bullish case and a move to the 1,880 level at least would be likely.”

And right on cue, the counter-trend rally that I had pinpointed started in earnest off Thursday’s low. And guess where the S&P is trading this morning? Right at my 1,880 target (on Friday, it was trading at 1,830. Bullseye!).

Naturally, the pundits are scrambling for explanations using their conventional (and wrong) “news makes the markers” model.

I have scanned the morning reports, and all I can find for a “reason” for this surge in stocks is that the Chinese yuan jumped on the back of a record trade surplus report. Hmm.

But my loyal readers know better: the real cause of the jump in shares was the completion of a five-down pattern with a lovely momentum divergence at Thursday’s low.

The above-mentioned China trade surplus data was just a result, not a cause of the jump. Most get the cause-and-effect order the wrong way around and put the cart before the horse. The cause was a highly oversold market that used whatever “news” emerged as a trigger to inflict the most damage on the greatest number.

If the market were running up to new highs instead, and thus highly vulnerable to a decline, then if that same trade report emerged the market would likely take it as bearish news and sell off, not rally (it came “under expectations”).

How the market views a certain news report depends entirely on how it is viewed – a report is neither bullish nor bearish, but depends on how the market takes it. Here, the path of least resistance was clearly up – as I highlighted.

This is the hourly chart of the S&P 500 I showed on Friday:

S&P 500 spread betting chart

Not only was there a divergence in momentum on the hourly chart, but also one on the daily chart – as I highlighted.

This is the updated chart this morning:

S&P 500 spread betting chart

The strong rally on Friday pushed decisively through my upper tramline – a short-term bullish signal according to my tramline trading rule.

With this information it is easy to see why I picked my target at 1,880, is it not? Not only does it lie at the Fibonacci 62% resistance level (a typical point of either reversal or a pause of the short-term trend), but that level also lies at the wave 4 high of the 5 down. According to guidelines of the Elliott wave theory, the previous wave 4 extreme is a common counter-trend rally target.

So I had two very good reasons to pick that 1,880 level as my target. But note that I set that target well in advance of the big Friday (and into this morning) push.

And that highlights just one of the many benefits of using my tramline method. Provided certain criteria are met (the upper tramline break), I can set targets with some confidence – and be ready with my trades. You will find fewer surprises using tramlines.

There is little that is more satisfying to a trader than to see his or her target met. And the quicker, the better. Of course, this occurs while most traders are snoozing and wondering what is happening to their much-researched short positions. Remember, most will be shocked by this rally because bearish sentiment is tending towards extreme levels (egged on by the media).

Here is the latest Commitments of Traders (COT) data on the e-mini S&P (which is the most heavily traded stock index) as of last Tuesday:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
($50 x S&P 500 index) Open interest: 3,829,352
Commitments
332,113 569,052 421,735 2,462,398 2,497,414 3,216,246 3,488,200 613,106 341,152
Changes from 02/02/16 (Change in open interest: 204,895)
8,667 -6,523 44,913 95,131 168,685 148,711 207,075 56,184 -2,180
Percent of open in terest for each category of traders
8.7 14.9 11.0 64.3 65.2 84.0 91.1 16.0 8.9
Number of traders in each category (Total traders: 165)
140 137 151 250 266 463 481

 

While both the large and small speculators did become more bullish in that week, they still hold a very high ratio of short to long futures positions. That made the path of least resistance more likely to be a rally than a decline. And that is what occurred.

But what now? Will this “sudden” shock to the shorts induce them to throw in the towel? And will the bulls again believe in the power of the central banks to bail them out of their huge losses?