For decades, October has been a down month that causes investors to wince. The 1987 crash happened in October, as did several major market lows before and after. Going into this fall, a very reliable cycle was calling for a bottom sometime in or around October 2006. The four-year cycle goes back decades, with significant troughs in 1974, 1982, 1998 and 2002.
Yet, somehow, against the odds and a roughly 50/50 bull-to-bear ratio in August, the Dow worked its way to an all-time high in October. Now, with the media hyping record highs and the Dow with a 12,000 handle, fewer and fewer investors are finding the will to fight the tape. The crowd around the exits is thinning, but is this really the beginning of another advance, or is this the beginning of the end?
In August, I predicted the S&P 500 would reach a target of 1360. At the time, most thought the top was already in, but my target was reached in the October rally. Now the index is consolidating around that area before its next big move. Many traders still see room to the upside because we’re still below the all-time highs for the S&P and Nasdaq. However, the NYSE, Russell, Dow Jones Composite, Valueline, Small and Midcap indexes and transports all have made new all-time highs. The NYSE index has been making record highs since 2004 (see “Topping out,” below).
Bearish analysts will label the new high in the Dow as ending a fifth wave advance, but that might not be the case. It might be a B wave from a larger correction since 2000. This would actually mean the rally from the 2002 low is the completion of the second part of a three (flat) or five-part correction (triangle). Either way, the next major move should be down, not up; and it’s approaching just as sentiment turns about as bullish as possible.
For the second time since the rally began in October of 2002, 1360 in the S&P 500 looks like a solid top. The first time was against the May top and a quick sell off ensued. Now, traders are too bullish to justify continued rallies without a decline. Jake Bernstein’s sentiment index, for example, has climbed to +90. Sentiment being a leading indicator, Bernstein’s advice is, “Wait for a timing trigger to sell, which could occur at any time now.”
While some bear projections of the S&Ps dropping to 500 or lower are far-fetched, the S&Ps could lose in excess of 30%. And what about the four-year cycle low? Analyst Jim Curry says the summer lows were not the four-year cycle low, as many now believe.
His statistics show that the real low can arrive early next year. He notes that it has occurred six times throughout the history of the cycle, with the average decline going into the following four-year bottom, which is 29%. Cycle analyst Peter Eliades is losing hope a four-year cycle low will hit but believes that market cycle master George Lindsay’s theory of bottom-to-bottom-to-top may be playing out. He says we are setting up for a significant top between now and the first quarter of 2007.
It’s important to remember that there is no confirmation of a top yet. It may come at the beginning of 2007 and several hundred Dow points higher. The problem, as always, is that the market can stay irrational longer than you can stay solvent, so simply shorting a stock index is not a viable strategy.
Instead, an investor can start to trim some of his holdings to buy them back at a discount.
A market speculator can buy out-of-the-money S&P put options that expire next year. Because the S&Ps have the look of a wedge at the moment, if it breaks, the sell off will be fast. Because there isn't much of a bearish premium in them and the fact that the volatility will explode — those put options will increase dramatically. The reason you can buy out-of-the-money puts is because the target for this wedge would be a couple of hundred points lower. Between buying them out-of-the-money, while at all-time highs, they might be giving them away.
Dominick Mazza is a technical analyst and full-time trader. He hosts a trading forum at www.tradingthecharts.com.