Monday, July 25, 2016

A Pause in the Rally Across All Capitalizations

For the entire month of July, we've been treated to extremely encouraging news in the face of the first major stock market rally we've experienced in well over a year.  For over a week, both the Dow Jones Industrials and the S&P 500 posted new all-time highs day after day.  Now that we're well into Q2 earnings season, however, the markets have turned flat and the exuberance is starting to subside.  Let's take a look at the anatomy of the rally separated by large-cap, mid-cap, and small-cap stocks.

Daily Chart of Small, Mid, Large Cap Indexes for July, 2016
These three charts show the month of July in the S&P 600 Small Cap Index ($SML), the S&P 400 Mid Cap Index ($MID), and the S&P 500 Large Cap Index ($SPX).  For those not familiar with the capitalizations, a Small Cap stock is considered one with under $2 Billion in market capitalization, a Mid Cap stock has between $2 Billion and $10 Billion in market capitalization, and a Large Cap stock has over $10 Billion in market capitalization.

At first glance, it appears that all three indexes benefited from the rally.  Each of them started their rally immediately following the Brexit sell-off in late June, and each of them have plateaued over the last two weeks.

From an Elliott Wave perspective, we have completed three very obvious waves in all three indexes.  Wave 1 lasted 4 days in each, Wave 2 lasted 2 days, and Wave 3 lasted 4 days in $SML, 5 days in $MID, and 6 days in $SPX.  From that point to the present, each index has traded flat.

Of the three indexes, though, in only $SML was Wave 3 longer than Wave 1.  Under Elliott Wave theory, we know that Wave 3 cannot be the shortest of the impulse waves.  This means that, assuming this is a true 5-wave impulse sequence, only the Small Cap stocks remain unconstrained to the upside.  Both the Mid Caps and Large Caps, however, are faced with a ceiling, which is the actual height of Wave 3 beginning at the bottom of Wave 4 when that wave completes.  As it stands now, the Large Caps have an upward limit of around 2250 and the Mid Caps around 1615.  We'll need to keep these potential limits in mind once the uptrend resumes and we plan exit strategies for long positions.

All this, of course, assumes that we are in a 5-wave impulse, and not a continuation of the correction that's been ongoing for over a year.  So far, the pattern has not violated any impulse rules.  In fact, it's conforming to them rather nicely.  Wave 2 retraced between 38.2% and 50% of Wave 1 in all 3 indexes, Wave 4 has not (yet) violated the territory of Wave 1, and we're experiencing well-defined alternation between Waves 2 and 4.  As long as Wave 5 doesn't exceed the length of Wave 3 in the Mid and Large Caps, the impulse pattern will be valid.

The caveat, of course, is that we're in the middle of earnings season, and anything can happen here.  We also have a presidential election coming up, and that should add a bit of volatility into the mix as the summer draws to a close.  What could easily invalidate the entire impulse pattern would be a price decline that creates overlap with prior waves, signalling a consolidation pattern, not an impulse pattern.  I would be very concerned if we dropped below the high set on June 8, causing overlap with the prior A-B-C corrective wave pattern, and I would consider the impulse pattern definitively invalidated if we drop below the high set on June 23, just prior to the Brexit vote.  Some purists may argue that the pattern's valid unless we dip into the Wave 1 high in the current sequence, however when analyzing Elliott Waves I find it important to consider the pattern or patterns that completed as we enter the current one.  Continuation patterns can be confusing since they can take so many different forms, and for those of us that change strategies based on whether or not a market is trending, knowing where we are in the cycle is extremely important.

As to the current situation, we have clearly been in a flat corrective pattern for the last two weeks, and the most obvious wave count structure would place this corrective pattern in Wave 4.  Take a look at it yourself, and plan your strategies accordingly.  Remember to include the weekly and hourly charts in your analysis if you're a short-term trader using the daily chart for your primary analysis.

Happy Trading.

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