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Rally Over - What Comes Next...

|Includes:SPDR Dow Jones Industrial Average ETF (DIA), QQQ, SPY

The bull/bear cycle says we are in the a High Risk -blow-off bull - phase looking for a peak that will start the next major bear market. This is confirmed by action of stocks this year, with the black line of 2013 in the chart below closely tracking the orange line of expectations in high risk years. I have filled in the data using yesterday's close for April, with that subject to change since April has not concluded yet. Update continues below chart…

High risk phases are expected to be sideways churn once the first quarter rally peaks. I believe that opening rally - trade #1 - ended this week, and now I am looking for entry on trade #2. That requires the trend to turn negative, which should happen later next week, or early the week after. High risk - blow off bull - phases are known for their surging blow-off rallies, so it does not pay to jump the gun on jumping on the short side of the trade here, and my exit of stocks this week should be viewed as seeking a place to lock in profits on trade #1, rather than looking for a spot to place short positions in trade #2.

My research shows that waiting for the trend to turn negative as the trigger to enter short positions is the way to go at this juncture. Do not be fooled by the apparent smoothness of that orange line, as the averaging process excludes the really big moves that makes the line a lot more smoother than can be expected in reality. Sell-offs in high risk phase are swift and brutal for those caught on the wrong side, and so too are the rallies coming out the other side. Also do not be fooled into believing the year will end well, thus using that as an excuse to hold onto longs. The next major bear market - thus the maroon extreme risk line in chart above - can start at any moment, and may have already started!

Going forward, the stock market can be expected to move from an extreme overbought condition to an extreme oversold one, back to an extreme overbought one, and then back to an extreme oversold one again as trades 2, 3, 4, and 5 play out - with the white contrarian line moving from the red circles to the green circles in the chart below, back to the red circles - which is essentially my trading plan for the remainder of the year.

The contrarian line has slipped below the extreme overbought line that signals the race to the extreme oversold green circles has likely began. The prime question now is which of the rally phases have we just completed, the middle or final? The middle rally position best fits the blue 2007 line, while the final rally position best fits the 1987 experience, especially in regards to the white contrarian line for 2013 closely tracking the purple contrarian line for 1987. Update continues below chart...

We should know the definitive answer to that critical middle rally versus final rally position question once the stock market reaches oversold extremes in the next month or so. If the ADX is trending south at that time then we are likely in the middle rally position, and I would look to buy at that time expecting one final breakout run to unfold going into the summer to mark the final rally.

If the ADX line is trending north by the time the stock market becomes oversold the final rally is likely already complete, and I would look to hold short positions expecting the white dotted of the trend indicator line (for short trades once trends turn negative next week, or the week after) to race into the yellow circle that represents the big win for the bears that signals the bull market is over, and next major bear market begun.

So in short: 2013 is tracking the expected path of a high risk - blow-off bull - phase near perfectly, with trade #1 complete, with trades 2, 3, 4, 5 expected to be a prolonged sideways churn period that sees the market move back and forth between extreme overbought and oversold levels. Once the bears score a big win that drives the trend trading indicator at the bottom of the chart above to the yellow circle then the blow-off topping process is complete and the next major bear market begun. Such a big bear win is either currently underway, or after one final rally into the summer following a swift and painful correction here.

Have a great weekend!


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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Stocks: DIA, SPY, QQQ