The S&P 500 has been consolidating for almost three weeks, having hit its high just over 1420 on the 2nd of April. There is a lot of speculation over the next move. Sell-side analysts are advising buying, as the correction is over and the long-term bears are suggesting that this is an intermediate term top. So which is correct (assuming we don't just drift sideways)?. I have the following thoughts:
1. If you are a bull, the market has risen from an intra-day low of 1074 on the 2nd of October, 2011, to an intra-day high of 1426 on the 2nd of April, 2012. This is a rise of 32.7% in 6 months. Fibonacci retracements of the 6-month gain of 23.6%, 38.2%, 50% and 61.8% give losses of 83, 134, 176 and 218 points, and so downside targets of 1340, 1289, 1248 and 1208. These would be your buying areas.
It would seem to me that in the short term, the correction is not yet over and has some more room to run on the downside. Technical analysis proves correct about 60-65% of the time, so the probability of hitting one of these downside targets is approximately 60-65%. Those seem like reasonable odds to me. The decision point for the bulls is which of the areas highlighted is the correct buying zone.
On that point, I would suggest that the area around 1290 looks the most likely to me, as this is the area around the 200-day moving average at 1273 (on the 22.4.12). It also seems to me that a gain of 32.7% in 6 months is likely to result in a reasonable correction and this would be a correction of 9.5% (so feels about right). I would also add that I will be very surprised if we do not at least reach a 23.6% Fibonacci retracement or 1340 on the downside.
Regardless of my opinion, if you are bullish, these seem to be the areas that you should consider buying in.
2. If you are a bear then things are just starting to get interesting. The Elliott wave count seems to have finished a 5th up wave, which should lead to a correction at the very least. For the bears, the same counts as above are valid to exit any short positions. I would add that the first down wave of this correction ended at 1357 and corrections come in 3 waves, so going below 1357 is 60-65% likely.
3. The more interesting bearish question is ' what type of top are we witnessing here?'
- A short-term correction
- An intermediate top
- A long term top
I wrote an article here on the fact that I believe that the markets are now in a waiting pattern. Which of the 3 above is correct is dependent on the answer to how the US resolves its fiscal position. My present answer to the above question (which may well be subject to change) is,
I don't know!
As this is extremely unhelpful, I would add the following:
1. This is still a long-term bear market and until the US has returned to a fiscally sustainable path, it will remain one. Most of the gains we have seen over the last 3 years will be reversed when the US finally faces its fiscal challenge. Whether the S&P500 reaches 1500, 1600, or any other figure first, is difficult to predict. It is often said that timing is everything in financial markets - unfortunately I have no good insight into the timing of when fiscal prudence will come to the US.
2. I am unsure of the trigger that will return the US to fiscal sanity, but am sure that eventually something will. In the meantime, I am reasonably sure that the present policy of trying to hold off any recessions, until the US has corrected its debt and housing problems, will not be successful. The next recession, when it arrives, will be met with ever more intervention and result in even less confidence than we have now. This has an eerie Japanese ring to it.
3. Monetary policy is not very effective at the zero bound for interest rates. Only fiscal policy will lift the US economy out of its present range of 1.5-2% growth. However, with the 2012 deficit projected at 8.5% of GDP, there is no room for further fiscal stimulus. However the markets are reacting very positively to more liquidity, which leaves the upside of the market still very open, as the economy is presently growing, which will result in higher earnings (albeit at a slow rate moving forward).
4. I have not seen any predictions as to the future makeup of the house or senate, so it is presently unclear whether congress will be divided (as it is now) after November. This seems to me to be important.
5. Unless it is politically impossible due to timing (the economy only reaches the downside momentum needed to trigger QE3 very close to the presidential election) then QE3 will be with us in 2012. Will it have the same effect as the 2 previous episodes?
I am not sure at this time what type of top we have reached, as I think it is unlikely that clarity will be reached for some time on the fiscal issue. However, I would be very surprised if we do not do some more work to the downside in the next 2-3 months. If we see levels under 1300 on the S&P500 and there is no clarity on any fiscal issues, I am sure that the temptation to quit short positions will be too much for me to resist!
One unrelated point - gold has been consolidating and following the equity markets lower. It looks to me (if the equity markets do consolidate further) that it will challenge the recent lows at $1550. If this does play out, it looks like a good entry point. Gold will only enter a bear market once the US does resolve its fiscal issues and I will be a buyer of dips until this happens.
I am presently reading 'This time is different' by Reinhart and Rogoff. It is very analytical and full of useful information. It will add much to my knowledge base, but cannot be described as a good bedtime read!
Additional disclosure: Long RIMM, RWM and short S&P500 futures, EUR/USD.
Disclaimer: This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.