What does bitcoin mania teach us about the Dow?

Bitcoin, the digital currency, was on the cover of the FT last week. It’s a terrific example of how widespread attention and the mass media eventually ‘pop’ a price bubble.

Bitcoin’s value rocketed just this year by many multiples, and on Wednesday, the market crashed by a stunning Fibonacci 62% in a couple of hours (the red bar on the right in the below chart).

I had been monitoring the press coverage of bitcoin and noted the mania surrounding it was getting more intense. It is positioned as an alternative to fiat currencies.

Apparently the Russians love it – totally understandable following the recent treatment of their Cyprus bank deposits.

This is reminiscent of the situation in gold in 2011, as it approached the $2,000 level. Then, bullish enthusiasm was similarly off the scale.

Bitcoin bust - four-hour chart

(Click on the chart for a larger version)

The chart also illustrates the old maxim that markets fall out of the window faster than they climb the stairs.

This market was almost entirely speculative – apparently, few bitcoins have been used in commerce – and interestingly, they are bought for cash with no leverage unlike the financial markets.

Even so, when many try to abandon ship at the same time, they capsize the market – quickly enough to crash the servers.

The larger question is this: is the bitcoin collapse the canary in the coal mine for all asset markets, indicating a more general switch from ‘risk-on’ to ‘risk-off’? Or is this just a one-off in a very thin – and non-shortable – market?

I subscribe to the idea that markets are driven by mass social mood or sentiment. And once the mood begins to reverse, markets turn in sequence, one after the other.

With this debacle in mind, let me turn to the Dow, which has been flying of late.

Amazing climb in the Dow

As a long-term bear, I have been amazed at the market’s relentless recent climbs. As a measure of that worry, here are just a few recent titles in seekingalpha.com articles which give a flavour of the skepticism out there:

Three reasons why stocks could plunge

Dow Jones Industrial Average about to plunge?

Have S&P 500 earnings peaked out?

The S&P 500 tops out here

Daily state of the markets: things are looking dicey

There are many others, but you get the idea.

And the latest AAII.com survey also shows massive negativity in retail-land:

Wk ending 11 April Change  Long-term avg 
Bulls 19% -16% 39
Bears 55% +26% 30
Neutral 26% -10% 31

This is a huge swing to the bearish camp – and in just one week.

Of course, with such doubt prevalent in the market, many are shorting into the rally, searching for the elusive top. And so far, they are being crushed.

My view is that the ‘wall of worry’ is so high – and possibly climbing – that stocks will have difficulty making a lasting top.

On the way up I put out a few shorts, but either exited at break-even or took a small loss, well within my 3% rule limits.

But this public bearishness is matched by an equal and opposite bullishness from the professionals.

Here is a recent chart showing the Daily Sentiment Index from trade-futures.com, who survey professional financial advisors:

Daily Sentiment Index chart

(Source: elliotwave.comclick on the chart for a larger version)

Bullishness is at record highs.

Incidentally – observe how the degree of bullishness swings up and down with the market.

So the battle lines are drawn: the pros are super-bullish while the folks are super-bearish.

This huge degree of divisive opinion is very unusual. To me, it indicates that when the market turns, the moves will be historic.

OK, I have an interesting long-term tramline pair working:

Dow Jones spread betting chart

(Click on the chart for a larger version)

And now, the market is up against the upper line. Note that in the past four-plus years, the market has failed to break decisively above it, except for a brief overshoot in the summer of 2011.

Also, I have a short-term tramline pair working:

Dow Jones spread betting chart

(Click on the chart for a larger version)

The market has been rising along these tramlines all week, although without prior pivot points (PPPs), I do not consider them too reliable. But they are all I have for now.

Prior to these tramlines, the market made a classic A-B-C corrective pattern, which heralded a rally continuation.

The next target is the upper tramline in the 14,900 area.

But note the position of the momentum indicator. In order to erase the negative-momentum divergence, the market will need to scoot smartly towards this target.

If it does not, then there is the potential for a down move if the lower tramline is broken – and the negative-momentum divergence will hold.

And if this occurs, it could be the start of a much larger move down.

I shall be on the alert for a tramline break.

But all bulls should glance over at the bitcoin chart before they become too complacent. They have had it their own way for a very long time… and all good things come to an end eventually.

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading

Advanced tramline trading

An introduction to Elliott wave theory

Advanced trading with Elliott waves

Trading with Fibonacci levels

Trading with ‘momentum’

Putting it all together

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