Global stock markets get a reality check

I have a feeling that this week will go down in stock market history as marking many all-time highs. Yesterday’s panic selling was a slap in the face to the bulls – and a game-changer, I believe.

There has been much comment on the peculiar nature of the US stock market rally in recent months. Much publicity has been given to the low volatility, the complacency, the lack of any serious declines and the huge and growing divergence between the booming stock market and the lackluster underlying US economy.

And while pundits have been scratching their collective heads over the amazing market performance in recent months, stocks have continued their relentless climb – until this week. I have noted that a whole army of pundits have been calling for a ‘correction’ all year – while the Dow has climbed barely 3% to last month’s high. This seems to be the received wisdom.

But because markets rarely satisfy the majority, the market refused to correct – until yesterday, which saw a massive 312-point decline in the Dow – the largest one-day drop since January.

Also, the vast majority are calling for just a correction – and then a move to new highs later in the year (another Santa Rally, perhaps?). Very few are calling for a complete collapse, as I am.

So today, I want to examine the question: have stocks finally started their much-anticipated correction (or bear market), as I believe?

Why I’m on high alert for a top

If you have been following my posts, you will know that I have been expecting the bull run since March 2009 to end and a massive decline to ensue. My upper target has been in the 17,100 – 17,500 zone for the Dow.

I have been working off the daily chart with my huge wedge pattern and the Elliott-wave pattern:

Dow Jones spread betting chart

The market had scope to rally to my upper wedge line, which set my upper target. And on 17 July, the Dow made an all-time high of 17,148, which was just inside my target zone for the top. This move into my zone put me on high alert for a top.

Is this the final wedge before the decline?

In addition to the wedge on the long-term chart, I have been following another smaller-scale wedge pattern since the start of the year:

Dow Jones spread betting chart

This is a truly terrific wedge! On the upper line, I have a great PPP (prior pivot point) (just like that on the first chart) and multiple accurate touch points. Similarly, my lower wedge line contains multiple accurate touch points. This is a very reliable wedge, which means that when the lower line is broken, the move is likely to be very strong in a downward direction.

And so it is proving with yesterday’s sharp fall.

My trading policy on wedges is very simple: with upward-sloping wedges (which usually resolve to the downside), I set a resting sell-stop just under the lower line to position short. This method removes any emotionality when deciding whether to believe your eyes as the line is being tested! I recommend it.

Have the markets finally turned down?

To help decide if markets have finally turned down, I want to see a clear motive five-wave pattern. Here is the Russell 2,000:

Russell 2,000 spread betting chart

From the high made on 1 July, the waves down are pure textbook, with a long and strong w3 and a nice big positive-momentum divergence at w5. From there, we have a wonderful A-B-C upward correction, leading to a fresh decline to yesterday’s move below the w5 low.

This is all part of the larger pattern where I have marked waves 1 and 2. We are now in w3 down. To confirm this, I need to see very sharp moves down.

Here’s what’s happening to markets around the world

Of course, I want to check on other major indexes to make sure they are taking part in the overall decline.

Here is the S&P 500:

S&P 500 spread betting chart

The top was made on 24 July and the market has traced out waves 1 and 2 and the long and strong move yesterday was wave 3. The market is currently testing support at the 1,920 level.

Was the selling repeated across the pond in Europe? Here is the German index:

Dax 30 spread betting chart

Again, I have a superb rising wedge with a PPP on the upper line. The lower line was broken in late June and the market then staged a traditional kiss and scalded-cat bounce. I have written about the power of the kiss for establishing low-risk trade entries, and this is a terrific example.

How about the French market?

CAC 40 spread betting chart

Are you seeing a pattern here? Markets have been forming wedges into their highs and when the lower line was broken, the floodgates opened. Also in every case, momentum divergences were the canary in the coal mine, warning of a coming break.

A rising wedge is like a spring being wound tighter and tighter. Eventually, the spring breaks and unwinds in a very rapid explosion.

But what about China? After all, if world economies are inter-linked, shouldn’t stocks markets move more or less in parallel? Here is the Hong Kong Index:

Hang Seng spread betting chart

Aha! While US and European indexes have been falling, China has been breaking out to the upside! This leads me to the idea that a long China/short US spread may well work out.