The Dow Jones reaches another Fibonacci level

The first few days of January were hard down for stocks in a lovely textbook five-wave affair, bolstering my belief that the December tops were in.

But because nothing is 100% certain in market analysis, we must leave open the possibility that the markets may not have finished the almost six-year rally off the 2009 lows. That must always be kept in mind.

And since the lows of Tuesday, the markets have staged one of their characteristic deep upward retracements.

But Tuesday’s reversal was well flagged to those traders who could read the signs:

Dow Jones spread betting chart

The market made an accurate hit on the Fibonacci 78% level and on a large positive momentum divergence. That is all I needed to tell me to lighten up on my short trades for a gain of over 600 pips.

Remember, a momentum divergence indicates that the motive power behind the trend is weakening. Here, the selling was drying up and if it persisted, the buying would be enough to reverse the trend, as did occur.

The move down was terminated with a lovely positive momentum divergence – one of the tell-tale signs I look for when knowing to expect a reversal.

Now, if you use my split bet strategy, you could take half off and leave the other half open with protective stop moved to break even. Then, you would be free to re-instate the other half position on the subsequent rally.

When will the market turn?

Following the accurate hit on the Fibonacci 78% level, the market has embarked on a relief rally. This is a normal reaction to the first down wave off a major high. As of yesterday morning, the Dow Jones has experienced a Fibonacci 62% retrace – all within normal expectations.

This was the picture at mid-afternoon yesterday:

Dow Jones spread betting chart

For traders looking to short on this rally, the burning question is this: when will it turn?

For the past few years, retracements off highs have been generally deep – above the 62% level, and some have been above the 90% level. So we should not be surprised if we see another such event this time.

That was the main reason I had for expecting the rally to be deeper than 62% – and so it has proved.

This could be a great place for a reversal

Incidentally, the reason the media gave for yesterday’s rally was ‘hopes the ECB would start QE’, according to one report. But as I mentioned last time, these old-hat stories are efforts at providing a ‘logical’ reason why the market has made a particular move. Pundits must have a drawer full of such stories marked ‘bullish’ and ‘bearish’ which they can pull out when markets either rise or fall to fit the fact – after it has happened, of course!

The absurdity of such logical contortions is readily apparent when you look over at the euro. If this logic is correct, the euro would be expected to decline – instead, it rose yesterday! How do you square that?

As sharp-eyed traders we can use this information to our advantage. If the euro did not decline on this ‘news’ and stocks rose, is the path of least resistance for the euro now up (see Wednesday’s article)?

But now at mid-afternoon yesterday, the market is heading for the Fibonacci 66%-78% zone (pink area). If it stalls out there and a negative momentum divergence could form, that would be a great place to look for a reversal.

January is shaping up to be a lively month

Updating to this morning, here is the hourly Dow chart as I write:

Dow Jones spread betting chart

The market did make an accurate hit on the Fibonacci 78% level but with no clear momentum divergence, although a flat red line is encouraging because the sharp rally yesterday could not produce a higher reading. That was a moral victory!

But that Fibonacci 78% hit is the mirror image of the previous retracement in a lovely show of market symmetry – thanks to Sr Fibonacci.

That places the larger Elliott wave labels in a very interesting light. The wave 2 rally is not a clear A-B-C, which would have been ideal. Rather, it is a series of several over-lapping small waves.

So, if the relief rally has indeed run its course – or will do soon – we should be at the start of a large third wave down. Remember, third waves are long and strong and would take the market well below the wave 1 low.

The implications of this scenario are vital for the outlook in other markets – in particular the euro. In Wednesday’s article, I outlined my case that the EUR/USD is so unloved with only 4% bulls that it is highly vulnerable to a short squeeze. And if this pans out, it would fit in perfectly with a declining stock market.

January is shaping up to be a most lively trading month!