In my May 4th missive, I suggested that the greater-than-anticipated decline off the May 1 high was not consistent with my Elliott Wave Theory-based short-term optimism toward the S&P 500 Index. The weakness experienced to that point, while slight in an absolute sense, was sufficient to pose a risk to the intermediate-degree uptrend in effect since last Fall, in my view. My wave count regarded the April 23 low at 1,359ish as a line in the sand, of sorts, separating the potential for imminently higher highs from the possibility that the intermediate-term correction (which, by that point, I had been calling for months) had finally commenced. One week ago today, with the violation of the April lows, the S&P 500 offered evidence that the tide had indeed turned for equities and that the bullish sentiment pervasive since the calendar flip, which elevated equities into double-digit return territory had finally abated. After that signal, stocks fell meaningfully for three days and then consolidated for the next two, and now, as of just yesterday, it appears that the next leg down has commenced.
From an Elliott Wave perspective, ‘zig-zag’ or ‘5-3-5’ corrections (such as the one developing off the May 1st high) are, by definition, comprised of three waves. The first and third waves tend to be approximately equal in length. This notion of ‘wave equality’ implies a near-term target of 1,298 for the S&P 500 Index (derived by subtracting the length of Wave (a) from the presumed starting point of Wave (b)). The following chart shows the S&P 500 Index with minute-degree Elliott Wave annotations that reflect my preferred wave count. The arrows indicate the directional expectations for future price that are consistent with this count.
Of note, ‘wave equality’ is an Elliott Wave Theory guideline, not a rule. Accordingly, there can be no assurances that the current Wave (c) will equal the recently completed Wave (a). Alternately, 1,324 is an intermediate price target derived based on the assumption that Wave (c) only achieves a Fibonacci 61.8% of the length of Wave A. On the more aggressively bearish side, an SPX target of 1,257 assumes that Wave (c) spans 161.8% of Wave (a)’s length—0.618 and 1.618 are also commonly observed relationships between the two primary waves in a zig-zag correction.
In spite of the range of targets outlined above though, I still favor the idea of equality for a couple of reasons. For one, so far the development of Wave (c) does appear to be mirroring the formation of Wave (a). Moreover, my short-term momentum model is implying that prices should exhibit weakness through May 22. Given that Wave (a) endured seven days, and assuming that Wave (c) started at last Friday’s high, the idea of equality suggests that Wave (c) should persist through May 21—within one day of bottom implied by the momentum model. Since the notion of ‘wave equality’ and short-term momentum both hint that Wave (c) weakness should be roughly on par with that of Wave (a) from the perspective of time, I am inclined to make the assumption that the parallels will also extend to price. The middle pane of the next chart shows the condition of daily momentum for the S&P 500.
With that said though, my best guess is that the bottom that now looks likely to appear early next week will not mark the end of the correction. This view is influenced by the observation that the weekly Coppock Guide appears slated to worsen into the second week of July (refer to the lower pane of the previous chart). Additionally, several measures of intermediate-term sentiment have yet to register oversold extremes (see the following chart for an example). Taken together, these conditions intimate that a completed zig-zag is likely only the opening leg of a larger degree correction that will probably require the remainder of this month and some or all of next month to resolve.
Notwithstanding the down draft already underway and the potential for several more weeks of, at best, choppy trading, I encourage investors to resist the temptation to pare risk exposures down to extreme levels. I continue to expect another multi-month surge to meaningfully higher levels following the current malaise. This conviction owes to still supportive long-lead sentiment and improving momentum of quarterly S&P 500 prices.
Intra-market (technical) analysis likewise backs this hypothesis, as small caps appear to be setting up for a long-term buy signal vs. large caps and emerging market equities seem to be preparing for an extended period of outperformance versus developed market stocks. Leadership by small cap and emerging market stocks indicate ample liquidity in the marketplace, an obvious positive for equity prices.
More fundamentally, while margins are extended and probably unsustainable over the next several years, corporate earnings are still managing to surprise to the upside and the party could carry on for another couple or few quarters. Also, the recently released Fed senior loan officer survey for Q1 suggests that lending standards eased somewhat relative to prior quarters and demand is on the upswing for C&I loans. The New York Fed, the ECB and others have demonstrated an empirical link between credit standards and economic output (and I believe that economic growth is a crucial indicator for risk asset performance in post-bubble environments). Thus, liquidity, sentiment, corporate profits and credit conditions each appear condusive to rising equity prices in months ahead.
In closing, the intermediate-term correction is upon us. In days just ahead, news headlines are likely to be dominated by reports of failed attempts to forge a cohesive government in Greece and all of its ramifications: the potential for a run on Greek banks; the possibility of Greece’s exit from the EMU; min-blowing calculations of the aggrgate level of contingent liabilities related to this still-hypothetical parting of company. Moreover, the renewed distrust of U.S. Financials, compliments of JPM’s unexpected $2 billion in trading losses, is not likely to spur an increase in domestic risk appetites soon. Against this backdrop I expect prices to deteriorate in days just ahead. However, I am looking for a short-term low early next week. While any rally that materializes next week is likely to be largely retraced down the road a bit, I do expect a more sustainable upside thrust by early summer.
Accordingly, it probably makes sense to review exposures and perhaps nervous investors should even reduce some risk at current levels. However, there is compelling evidence that the patient will be rewarded in months ahead, so now is not the time to retrench from risk entirely.
Until the market gives us the ‘all clear’ signal though, stay nimble and trade safe.