Should traders sell in July, and wave goodbye?

Stocks markets are front page news now and I shall cover them much more often in my Trader posts.

Remember the ‘Sell in May, and go away’ episode this year? Every year in May, pundits come out of the woodwork and wonder if this infamous advice should be followed by investors seeking to dodge stock market declines in the summer.

If memory serves, the consensus last May was to ignore it – and keep buying shares for the well-rehearsed reasons that the Fed was keeping interest rates ultra-low, and Western economies were reaching ‘escape velocity’ and did not need the Fed’s QE (quantitative easing) support anymore.

The markets did make further upside progress since May to the tune of around 4% in the Dow. The ‘sell in May’ advice was looking decidedly foolish.

As it has turned out, these assumptions were entirely accurate. Interest rates have hardly moved and the UK economy is growing quickly with the US economy chugging along with no apparent shocks. That was a great forecast.

But the stock market is not the same thing as the economy!

So here we are in early August and last week, markets plummeted. What a difference a week makes. The Russell 2,000 is down 8% from its July high, and interest rates and the economy haven’t budged. So what gives?

My advice to pundits: look at the charts!

Pundits are falling over themselves digging up rationalisations for last week’s losses based on the news. They needn’t bother. Just a glance at my charts I showed in last week’s posts would have told the story: markets were over-stretched and over-hyped.

So I have coined a new axiom: ‘Sell in July, and wave goodbye’.

Will it catch on? The time-honoured May adage is alive for a reason: markets usually did take a break for the summer in pre-electronic trading days. It was usually prudent to sell in May and return on St Leger’s Day. It is by no means great investment advice today.

Are there any precedents for major tops to occur in July? As it turns out, not many, but there are several major tops occurring in the third quarter in the past 50 years, including tops in 1976, 1987, 1989, 1990, 1997, 1998 and 1999.

Personally, the 1987 October crash was especially memorable, because I was with a trading firm in Los Angeles at the time and watched the S&P futures in freefall on Black Monday on my blinking green Quotron screen.

Selling was so intense from ‘programme trading’ there were periods when there were no bids at all, just masses of offers. It was sheer panic and I have never seen anything like it since (although I expect to do so again).

Watch out for congestion zones

On Friday, I showed two wedges on the Dow charts: one a long-term wedge and the other a shorter-term wedge.

A rising wedge breakout is a very bearish omen, especially when it comes at the end of a long and strong bull market (opposite for bear markets).

The short-term wedge has already broken down:

Dow Jones spread betting chart

Here it is and shows the market has fallen rapidly to the Fibonacci 38% support level. The question is this: will this support be enough to produce a relief rally of some kind?

Just glancing at the chart, the market has now entered chart support provided by the congested trading zone in the March-May period. Congestion zones offer support from the traders who shorted the market in that period, but saw the market go against them in June and July. With the sudden drop back to their entry point, they are only too happy to grab this lifeline and cover their shorts for a wash trade.

You should always keep an eye on congestion zones, because they can offer further clues where markets may pause – and where short-term profits can be taken.

But if support is weak here, my next target is the Fibonacci 50% level in the 16,200 area.

Here’s what’s happening right now

At this stage, are there any Elliott waves that I can label? This is the scenario as I write this morning:

Dow Jones spread betting chart

Last week’s heavy losses is easily seen as my w3 – and within it, I can see a clear five sub-wave pattern with a large positive-momentum divergence at the low. This heralded the temporary end of the decline. My w2 is a classic A-B-C affair, and w1 sports a lovely motive five-wave pattern. This is all very textbook.

And this morning, we are in w4 up. So, where will it end?

The rally has not even made it to the first Fibonacci 23% level yet and remains weak, so far. And with momentum at overbought levels, the rally may not have much further to run before w5 gets under way, taking the market below my w3 low.

That is my best guess scenario.