Bearish news everywhere – so I knew a rally was coming

In my posts, I frequently invoke my headline indicator. This is a very simple, yet effective, test of market sentiment and social mood. As long-time readers of mine know, it is social mood that drives all freely-traded markets. Whether the high degree of government interference in today's markets renders them 'un-free' is a valid question and we can discuss that another day.

But for practical purposes, because they obey the Elliott wave principles and also my Fibonacci and tramline ideas, we can consider them free in the sense that it is sentiment that drives them, not government fiat.

And sentiment hit rock bottom in yesterday's headlines. In fact, I have never seen such starkly bearish sentiments expressed in the media. For me, the standout was this from The DailyTelegraph: "RBS cries 'sell everything' as deflationary crisis nears".

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Here are two others: The DailyTelegraph again:"These are the big bets [ie, shorts] against the market you should be making right now". And from Bloomberg: "Goldman: Stocks may fall further".

In all my years in the markets, I cannot recall reading such definitive advice to "sell everything". This must go down in market lore.

And the second quote is just as bearish. Imagine a journalist recommending shorting markets. Whenever I read about shorting in the media, it is always accompanied by its dictionary definition, as if the outlet assumes the reader has just come across the concept for the first time. This aligns with the beliefs of the average investor, one who believes that only buying shares can produce wealth, and will do everything possible to 'invest' his funds. Keeping money in cash is anathema to him (but he will learn of its attractions this year).

To me, this display of extreme negativity means only one thing: according to my headline indicator (which is off the left-hand side of the scale), stocks are poised for a significant rally.

And this morning, they are doing just that. Uncanny, isn't it?

Note that last weekend, the pundits were advising that "There is nothing we can do except step back, hunker down and wait for the carnage to play out".

In just two days, they have thrown in the towel and abandoned their hunker down stance and signalled a pause at least in the bear trend. In fact, the timing is immaculate the Dow and FTSE lows were made on Monday when journalists were working on their articles advising selling everything. They were gripped by the very negative mood out there.

When the rally really gets going, you can be sure the news will turn more positive and encourage the public to begin buying again, just before the next wave down. It's a cruel world.

Now why does my headline indicator work? If you have been thankfully weaned off the belief that it is the news that drives markets, you will appreciate that financial journalists who universally fail to understand how markets work are responding to the current social mood, which is now very negative. That's how their articles attract attention and sell newspapers. Their careers literally depend on it.

Sometimes a journalist will refer to the bearish sentiment out there, but only as a result, not a cause, of the market rout. Remember, markets top out when bullishsentiment is high and bottom out when bearish sentiment is high.

And now unsophisticated investors, who are generally very late to a trend, have finally decided they had better get out fast (RBS says so). But the smart money boys are already short from much higher and are eyeing their juicy gains and some will decide to cash in by covering their shorts. It is this buying power that helps turn markets around.

In fact, I anticipated a recovery in Monday's post,"Watch out for the stock snap-back rally".

My view was based not just on sentiment but on the Dow hitting the Fibonacci 62% support level:

That was a really nice hit on the Fibonacci 62% support area for the wave 3 low and now the market is bouncing up in a wave 4. That will likely take a lot of late shorts out before wave 5 down can start.

Public sentiment hit rock-bottom on the wave 3 low, and even the professionals were heavily short here is the chart of DSI and the S&P 500 I showed last Friday:

(Chart courtesy www.elliottwave.com)

So now both the pros and the public are aligned in their ultra-bearish stance, the market has the potential to surprise to the upside and produce a sharp rally. Here are the possible Fibonacci targets for wave 4 on the Dow:

They are the 16,800 level (Fibonacci 38%) and the 17,000 level (Fibonacci 50%). The market is currently at 16,570.

Naturally, if the market can recoup 50% of last week's losses, that would devastate many late bears who have become convinced the end of the world is nigh.

But if the market really catches a bid and exceeds the wave 1 low at around 17,100, all bets are off and the move down would be more of an A-B-C correction, implying new all-time highs.

Remember that fourth waves are often very complex with many sharp ups and downs in quick succession and is therefore a nightmare to trade when using close stops. Unless presented with a superb opportunity, I generally avoid trading them unless I can spot their ending. I then love to ride the wave 5 down.

And because I anticipated this wave 4, I decided to take partial profits last week and keep the remaining short position with my protective stop and break even. No matter what happens, I have a profit on this trade.

Ominously crude oil, which has had a similar degree of bearishness, is appearing to start a counter-trend rally and I may have more on that in Friday's post.