Where is the US Stock market headed rest of 2017 ?

Where is the US Stock market headed rest of 2017 ? 

The answer to this question dictates not just the stock market but to a large extent world economy.  Let’s discuss how to find the answer and create a confidence percentage around the answer.

Although the above chart does evoke both fear and greed.  The fear comes from “ohh my god, it’s gone up so much, it can therefore fall a lot too”, the greed comes from “what if it keeps going up, I may miss out”.

But what if I were to tell you that this way of looking at it is highly inaccurate.  Firstly, people (including funds) look at every asset as a percentage growth over time.  Therefore, it will be better for us to look at it using a Log graph (below):

As you can see, the moment we put that in, one realizes that we haven’t travelled much higher since the top of 2000.  In fact the Dotcom burst in 2000 and the 2008 financial meltdown did cement a very strong base for the market.

I will point out 3 things in the chart above.  This will require knowledge of the basic components of these.  I will explain all 3 in simple terms right below.

  1. Elliott wave theory.  https://en.wikipedia.org/wiki/Elliott_wave_principle
  2. Fibonacci Numbers, Fib ratio or sometimes referred to as the Golden Ratio.  https://en.wikipedia.org/wiki/Golden_ratio
  3. The law of large numbers.  https://en.wikipedia.org/wiki/Law_of_large_numbers

Let me try to explain all 3 in easy language.

Elliott wave theory:

It states that market moves in 3 steps forward and 2 steps back. So Step 1 is up and 2 is down, then 3 is up and 4 is down and then 5 is up.  Elliott wave founder Ralph Nelson Elliott https://en.wikipedia.org/wiki/Ralph_Nelson_Elliott theorized this based on his understanding of collective investor psychology. Elliott further theorized that these waves work one within the other just as the second hand has a full rotation within a minute and then the minute hand has a full rotation within the hour.

My understanding is that these 5 waves are linked to 5 phases of human collective emotion and inertia and these are:

  1. Wave 1 : Usually this happens when the market is below fundamental value or book value.  This happens in a extreme downturn like 2008 when everyone is fearful and liquidity has eroded from markets.  This is when certain experienced traders come in the market and pick stuff at pennies on the dollar. At this point there is lack of surety.  No one, not even most of the experienced traders are sure if this is the bottom and if the market will bounce from here.  But most often these traders have very deep pockets and a clear understanding of all market forces.  So they know that if not “at the bottom”, they are “very close to the bottom”.  They therefore hold it for good times to come.  This first bump up is mostly seen in Warren Buffet’s favourite companies.  These are solid, stable companies with great dividend payouts.  So buying them makes you feel like you are getting a great product at a discount.  And even if it does not appreciate in price for a while, at-least it will keep paying dividends.  Technically they are constructive, there’s more volume and larger breath (more stocks participate in move up).  Don’t buy Call Options in this wave as unless timed very cutely, they have a great chance of loosing all their value in the coming wave 2.
  2. Wave 2 : At this point, the market has gone up a bit but there is still pervasive fear in the market. A lot of investors take the end of wave 1 as a short term high to sell short.  Technically, second waves often produce downside non-confirmations and Dow Theory “buy spots”.  In these buy spots, low volume and volatility indicate a drying up of selling pressure.  Wave 2’s usually retrace almost 61.8% of Wave 1, unless if there is Quantitive Easing happening by the Reserve Banks.  Wave 2’s usually are the best time to buy Call Options. Premiums are low due to pervasive fear.
  3. Wave 3 : By now fundamental changes are visible in the economy and a rally ensues which is broad (almost all stocks participate) and strong. Wave 3’s produce maximum volume and price appreciation. “Rising tide raises all boats”.
  4. Wave 4 :  Wave 4’s usually trend sideways.  They are a mechanism for the market to cope with continued price appreciation and build a base for 5th wave to come.  Lagging stocks at this point build their top and start moving down.  Only the breath of wave 3 was able to raise these stocks.  For most investors they start looking overvalued at this point.
  5. Wave 5 : Fifth waves in stocks are always less dynamic than third waves in terms of breadth. They usually display a slower maximum speed of price change as well. Look for lesser volume as a rule in a fifth wave as opposed to the third. Market dabblers sometimes call for “blowoffs” at the end of long trends, but the stock market has no history of reaching maximum acceleration at a peak. During fifth advancing waves, optimism runs extremely high, despite a narrowing of breadth. Nevertheless, market action does improve relative to prior corrective wave rallies. For example, the year-end rally in 1976 was unexciting in the Dow, but it was nevertheless a motive wave as opposed to the preceding corrective wave advances in April, July and September, which, by contrast, had even less influence on the secondary indexes and the cumulative advance-decline line. As a monument to the optimism that fifth waves can produce, the market forecasting services polled two weeks after the conclusion of that rally turned in the lowest percentage of “bears,” 4.5%, in the history of the recorded figures despite that fifth wave’s failure to make a new high!

Elliott wave degrees

The sub-cycles are referred to as “degrees”. The classification of a wave at any particular degree can vary, though practitioners generally agree on the standard order of degrees (approximate durations given):

  • Grand supercycle: multi-century
  • Super cycle: multi-decade (about 40–70 years) [ Colour Golden on my charts ]
  • Cycle: one year to several years (or even several decades under an Elliott Extension) [ Colour Green on my charts ]
  • Primary: a few months to a couple of years [ Colour Red on my charts ]
  • Intermediate: weeks to months [ Colour Blue on my charts ]
  • Minor: weeks [ Colour Pink on my charts, I do not track anything below this ]
  • Minute: days
  • Minuette: hours
  • Subminuette: minutes

Golden ratio

Golden ratio is 1.618.   A lot of things in this world use this ratio.  From the sunflower to sea shells to galaxies.

The law of large numbers (LNN)

The law of large numbers simply states that if an even happens many-many times, then its outcome will gravitate towards it’s theoretical mean.  Like rolling dice.  Roll it a few times and you average could be anywhere between 1 and 6.  But roll it a 1000 times and your average will be very-very close to 3.5, the theoretical mean.

Why the Law of Large Numbers (LLN) is important to stock markets is because we have millions of traders doing billions of transactions.  Overtime the average of their transactions start tracking to the mean.  LLN should always be considered in playing the odds in Lotto.  If you need further guidance, please feel free to reach me.

More information

I will start from SuperCycle in this post, in the previous chart (monthly log), the Super cycle is posted using Golden color. The last step (V) is posted on screen just for visibility however it’s assumed that it will be much-much higher up (some 20x higher than now)

Elliott waves leave a lot of room for interpretation and Elliotticians seems to have differing opinions due to that. I also look at macro trends 90 year chart with inflation adjustment to give me a clear view.

<a href=’http://www.macrotrends.net/2324/sp-500-historical-chart-data’>S&P 500 Index – 90 Year Historical Chart</a>

For an interesting read you can even goto http://www.safehaven.com/article/12280/welcome-to-super-cycle-wave-iv to get a view of Grand Super Cycle.

My understanding of wave count at this point

  • Grand super cycle: I don’t care for this one, it’s too large for my lifetime.
  • Super cycle: multi-decade (about 40–70 years) [ Colour Golden on my charts ]. I believe we are in wave 5 of this one. This means we will have very fast paced growth, almost vertical as is typical in wave 5’s.

For sub-degrees of the Super Cycle, let’s go into a weekly graph:

  • Cycle: one year to several years (or even several decades under an Elliott Extension) [ Colour Green on my charts ].  My research tells me that we are in wave 1 of this.  What this means is that at some point we will drop 38% to 61.8% retracement level.  Then we will move faster in a wave 3.  I also believe that such drop shall happen very soon.  Previous cycles as agreed upon based on evidence are:
    1932-1937 the first wave of Cycle degree
    1937-1942 the second wave of Cycle degree
    1942-1966 the third wave of Cycle degree
    1966-1974 the fourth wave of Cycle degree
    1974-2000 the fifth wave of Cycle degree
  • Primary: a few months to a couple of years [ Colour Red on my charts ].  As shown in weekly chart below, my calculation is we are in wave 3 of this degree.
  • Intermediate: weeks to months [ Colour Blue on my charts ]
  • Minor: weeks [ Colour Pink on my charts, I do not track anything below this ]

Here’s a zoomed in version of the same with parallel lines citing the expected terminating point for all 4 degrees and 1.618 Fibonacci level posted to indicate a possible extreme high.  Usually we find wave 5 extending to 1.5 (in yellow) which in SPX index means 2750.  There’s however a big catch in this scenario, which is that wave 5’s of 5’s usually are truncated because they run out of steam.

When do I expect it to roll over?

My guess is a month like September if we don’t go into an extended wave 5. Sometimes waves get extended because there is great deal of good news to propel the market higher. Why September?  Because at that point almost everyone is back into the market expecting something called the “Santa Claus Rally”.  See, the Market has 2 unwritten but very important rules:

  1. Market moves in a manner to impact maximum amount of damage to maximum number of people
  2. Bull markets don’t die of old age, they get butchered

So expect it to roll over when least expected and expect a significant catalyst to push it.  In a month or two, as I monitor the markets, I will try to understand if we are moving towards an extension in Wave 5 and post accordingly.  If we get an extension this year, then such fallout gets postponed to next year.

What should I do to safe guard my capital ?

  1. Work with your investment advisor to create a portfolio which is ideal for this stage of the market (a late bull market).  Make sure your investment advisor can help you understand the sector rotation model and help you pick the right stocks to be in your portfolio
  2. Use Trailing stops, Profit Targets and re-entry guidelines.  Again with the help of sector rotation model, pick the sectors to exit at this stage of the market. For right now I will be exiting Financials (XLF, WFC, BAC, JPM etc) and very soon will be exiting Technology (XLK, AAPL, FB, NVDA etc) and basic industry (XLI, CAT etc).  And will be looking at adding Energy, Utilities, Consumer non-cyclicals and Precious Metals. For stocks I will like to exit, I will put in Take Profit levels and Trailing stop orders.  This way if it goes high, I hit my Take Profit and I exit.  If it decides to go high and then fall, then I exit on my Trailing Stop loss.  I usually pick 10% as my Trailing stop loss level when I enter a trade so as to not loose more than 10% if it goes down and then after it’s gone up a bit, then I tighten it to 4-5% to lock in my profits.  As I get money exiting trades, I keep a list of others I want to enter.
  3. Meet with your financial planner on “Capital Preservation”. Run scenarios with him / her to assure that a 30-40% drop in market is not going to ruin your portfolio.
  4. Do not take on China debt. Assure all assets and funds owned by you are staying away from China debt.  Again your financial planner should help assure  this.
  5. Start hedging the portfolio a bit.  GDXJ, GDX, GLD and SPX puts are some ways to hedge.
  6. As a general rule of mine, I try to stay away from 3x ETFs and futures.  Exception is when I use them to hedge the portfolio or for very small time periods.  These 3x ETFs usually have large decay built into the product that destroys value over time.  And there’s a way to avoid it while getting the same leverage.  As an example, if you have a margin account, then instead of buying NUGT (3x gold miners ETF) you can add 3x quantity of GDX (gold miners ETF).  A margin account will allow you to buy 3 times of your capital in GDX but not NUGT since NUGT is already leveraged.  Your margin account will at this point charge interest (usually 4.5%) but GDX will give you dividends and NUGT will not. GDX will not decay while NUGT will.  Whether leveraging fits your investment strategy / goals is something you have to work with your financial planner on.

Spread the knowledge, spread the wealth and god bless us all with long, wealthy and meaningful lives.

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