How I made a perfect trade in the S&P 500

The party ended on Friday.

How do I know this? Well, this is how the four most important measures of inflation moved that day:

Dow – down nearly 300 points – all-time high: 2 March.

June Treasury Bonds – down almost 400 points – all-time low in ten-year yield: August 2012.

Gold – down $30 or so – all-time high: October 2011.

US dollar – EUR/USD down 200 points or so – all-time high in euro: 2008.

US Treasury bonds, gold and the dollar are already in multi-year bear markets. The only hold-out has been the Dow (and other stock indexes), which has been powering ahead blithely with little regard for the land mines it has been placing along the way.

So what do these different markets have in common? They have been pumped up by unprecedented levels of highly leveraged QE (quantitative easing) dollars that had no other home.

The simultaneous decline in all four of these markets means that the forces of deflation have taken over all major markets.

But why is deflation such a horrific nightmare for the markets? Surely a reduction in prices is good news?

I regard deflation as a reduction in the supply of money and credit. Consumer prices sometimes respond to these changes. Because there are gargantuan levels of debt in private and government hands, debt is now being acquired to sustain the existing debt – and that is unsustainable.

With interest rates pinned to the floor, any hint of an increase will send shock waves of horror through the massed ranks of over-leveraged banks and hedge funds who have piled in to assets. Such a hint was given on Friday with the ‘strong’ US jobs report.

At last, a viable way to trade in volatile US equities

In my post of 27 February – The Nasdaq is a bubble in search of a pin – I suggested that the tech-heavy Nasdaq index of US shares was showing extreme bubble-like conditions.

I also mentioned that I had no intention to trade on that index: with new highs being made almost daily, my tramline methods were not appropriate.

Last week, though, that situation suddenly changed, and I now have some superb trading setups.

I will focus on the S&P 500 since that index is the most representative for US shares of all descriptions.

Here are my lovely tramlines on the weekly chart from the major low of 2011:

S&P 500 spread betting chart

My Elliott waves are virtually textbook, and conform nicely to the trading channel between my tramlines. But the rally has failed to reach the upper tramline – that means it’s weakening.

Crucially, the large negative-momentum divergence at the recent highs (see red bar) indicates a severe drop in buying power into last week’s highs. The smart money is getting out.

My Elliott waves gave me a position too good to ignore

In the Elliott wave model, one of the signatures of a trend change is to be able to detect a five-wave motive pattern in the opposite direction, so let’s see if there is one.

Indeed, from the 2 March high, I have a valid five down on the 15-minute – not pretty, but it works – and there is a positive-momentum divergence at the wave 5 low.

S&P 500 spread betting chart

With this information, a swing trader can now start looking to short on a rally off the wave 5 low. As a practical matter, it is not advisable to jump in just when you have identified the five down pattern. Remember, timing is crucial.

Here is the very best trading strategy: because the most common relief pattern following a five down is an A-B-C up, it is best to see if this pattern does trace out and to short the market near the C wave high, if it presents. And if the C wave reaches the Fibonacci 62% level, that is the absolute textbook place to enter shorts.

So let’s see what happened after the five down:

S&P 500 spread betting chart

 

Lo and behold – here is the A-B-C rally with the C wave reaching the precise 62% level.

That was a gift that could not be ignored. This five down/up and three up/down is one of my favourite setups.

A short trade on Thursday near that level, protected with a close stop just beyond the 62% level, was the ideal position: you were making a high probability/low-risk trade there – the swing trader’s Holy Grail.

Even if the trade did not eventually work out, it was still a perfect trade. You had followed your disciplined analysis, had put on the trade at the right place and protected with a close stop. Nothing more could be asked – it was a trade a true professional would be proud of.

As it happens, the market began a steep slide on Friday and this is the result on the hourly:

S&P 500 spread betting chart

I can apply my best guess Elliott waves to that sharp fall: I have a series of 1-2s with the second waves in the tell-tale corrective A-B-C form (green bars).

The implications are stark: the third of a third pattern is the most powerful in the book and the omens are clear. The only thing that could cancel out this forecast is for the market to rally above the purple wave 2 high.

I can start using my tramline methods to trade the stock indexes with some confidence.