Fear is stalking the Dow Jones index

A lot has happened in the stock markets since I wrote Friday’s post. Later that day, the market entered free-fall territory. The Dow had closed off 333 pips by the time the session ended.

I would say this action has confirmed that the gap I identified on 2 January is a breakaway gap.

Over the weekend, the pundits were out in force ‘explaining’ the collapse. But while their entrails examination was very entertaining, it actually has zero forecasting value. Where were the ‘experts’ when the Dow was making its all-time high a few days ago? That was when we could have used their expert analysis.

So that’s why serious traders concentrate on their charts and analytical methods – it lets us position well in advance of any large move.

The power of tramline analysis

The ‘reasons’ for last week’s collapse have been well known in the market for some time – yet the market still rallied. We all knew emerging-market currencies were already getting weaker, and that China’s economy has been slowing for some time. These are two of the favourite rationales used.

So why did the Dow suddenly turn tail mid-week? And why did this not happen at some previous point? These pundits have no explanation. It all seems so obvious to them – after the event, of course.

But I do have an explanation. And it has nothing to do with the news.

The market turned because my Elliott wave labels showed a completed rally and the Dow had made a precise hit on my long-term tramline – I showed that chart on Friday. I am posting a copy of it just above my screen as a reminder of the power of tramline analysis. It is sure to become a classic.

One other factor is behind the big falls last week – the sentiment picture. Bullish complacency had reached epic proportions. In fact, the Vix (the ‘fear index’) was near record lows. During such conditions, I always ask: where is the new wave of bulls coming from to drive the market ever higher?

One usual source of buying is from the bears who are being squeezed. But they appeared to be few in number, especially in the Nasdaq. That gave me the idea that the decline should be very sharp and deep. Last week’s action certainly confirmed this thought.

Is the Dow’s third wave complete?

So what is the position this morning?

On Friday, I believed the Dow was in an epic third wave down of various degrees of trend. This was my chart when the Dow was trading at the 16,200 level:

Dow Jones spread betting chart

And this is the chart this morning:

Dow Jones spread betting chart

Overnight, the market dropped to the 15,850 level – a full 350 pips below Friday morning’s level shown in the first chart. But in the process it has become deeply over-sold in the near-term. And that means it is due a bounce. This current bounce could be wave 4 – if wave 3 has completed.

But the move down is enormous – and backs up my contention that it is a third wave of several degrees of trend. The A-B-C interpretation carries much less weight now given the steep decline.

This third wave is certainly long and strong, but it may not have finished its work. Still, it has fallen to the important Fibonacci 78% retrace of the last major wave up, and this level is usually good support. The odds of wave 3 having now completed is high, and wave 4 up is very likely in progress this morning.

Naturally, short-term traders could take their well-earned profits of at least 600 pips this morning.

Forecasting the extent and form of wave 4

I can now make some rough forecasts for the extent and form of wave 4.

Dow Jones spread betting chart

Wave 4 will be a relief counter-trend rally and could be in the usual A-B-C form. And because wave 3 was so fierce, wave 4 could be short. It would then only reach the Fibonacci 23% level before turning down again in a fifth wave. That is my best guess scenario. If this occurs, then I expect wave 5 to be deep.

Whatever shape wave 4 turns out to be, the market has been hit hard and the bulls will need time to recover. But will the market give them that time, or will there be another sharp leg down very soon?

It appears I am well on my way to my first major target at the 15,000 level.