Is the Dow Jones rally nearing the end?

Next Tuesday, the US Fed will be releasing its deliberations of its latest meeting, and all eyes will be on what it has to say about tapering its bond purchases.

This unprecedented buying programme of $85bn every month of a mixed bag of bonds has been seen by many as providing the liquidity that has kept markets of many kinds supported.

It seems everyone has a view on what they will do, and there is no doubt that the stock market expects little or no impact from their plans – the Dow has rallied back by a wide margin from the late August lows.

Personally, I have no firm views – I prefer to observe market expectations and trade off these.

After all, the market doesn’t care what I believe. The key to successful trading is to observe what others think – and to trade with this knowledge. It is best to stay agnostic on the macro factors.

Let the market speak, and never fight it.

Using classic Elliot wave theory

I have been working with this Elliott wave picture of the final C wave off the November low:

Spread betting chart

This is the daily chart I posted in my article of 4 September.

I have a clear five waves up and a break of the line joining the wave 2 and 4 lows. This indicates that the rally has topped and the new trend is down. That is standard Elliott wave theory.

The decline off the top would end in wave 1, leading to wave 2 up. That was my forecast scenario.

And this was my best guess on the hourly chart:

Spread betting chart

The market had fallen to the Fibonacci 78% retrace support level in what I believed was wave 3.

And the market did make a poke below my wave 3 low to the 14,780 level, where it hit support.

So I had my five waves down. That could be my large wave 1 low.

The market then became hugely volatile with 200 pip plus swings in rapid succession in the first week of September.

That made labelling the waves a very difficult task!

But this morning, I believe I have a realistic count:

Spread betting chart

This is the hourly chart showing the five waves down in wave 1. Then, I have an A-B-C up to wave 2.

The market has reached the Fibonacci 62% retrace

Why have I put the A wave there? I could have chosen one of the other highs, surely?

The reason is that the A wave lies bang on the Fibonacci 23% level – a significant resistance zone. The other highs fall short of this level.

Now let’s examine the C wave in more detail. If I can count a five wave move, that should be it for this rally because fifth waves are always ending waves.

Spread betting chart

I have an excellent wave 1, wave 2 and wave 3. The third wave is long and strong, which is a requirement for third waves.

And I have drawn in my working tramlines – and the lower one has been broken this morning. This tramline joins the wave 2 and wave 4 lows – the correct Elliot wave procedure.

Is this a signal the turn has arrived? After all, we have a huge potential negative momentum divergence.

But I have a difficulty – I do not have my final fifth wave in a new high above wave 3. That would make the picture complete. But so far, it looks incomplete.

Two possible outcomes

So I have two probable outcomes this morning: either the market will rally up towards the underside of my lower tramline to make a kiss and then a ‘scalded cat bounce’ down. Or, it may decline from here, having broken the tramline.

My preference is for tramline kiss into a slightly new high above wave 3, but the market will decide.

Either way, it appears the rally is nearer the end than the beginning.

And my long-term picture also shows the rally has carried to the underside of my lower tramline:

Spread betting chart

Isn’t that interesting?

Sentiment is off the scale

And bullish sentiment is rampant – and that is typical of second waves, especially in stock markets. In fact, bullish enthusiasm is often greater at second wave tops than it was at the actual high.

It is as if people have short memories – September is one of the worst months for stocks on average. Already this month, the Dow is up over 500 pips!

Here is one indicator that I follow – the AAII.com survey of private US investors:

Spread betting chart

Source: www.aaii.com

For the seven days to Wednesday, the public have been bitten by the bullish bug – and how!

There was a massive swing to the bull side, and just compare with the long-term averages – we have a lop-sided market again as next Tuesday looms (this is Fed-Day).

The public are certainly expecting Christmas to come early this year!

This is just one of the several indicators that show me that sentiment is off the scale as wave 2 nears its end. This is entirely consistent with history.

The bottom line: the odds are great that the bulls will suffer a major disappointment and when wave 2 does end, wave 3 down will be a sight to behold.