Today I’d like firstly to answer a question from Jon Bailey. Jon asked why I wrote in my blog of Nov 3 : “It would be very bearish if the market breaks below 839 without reaching 1044 to 1018″.

This idea comes from an inference from Market Profile ideas. Sideways markets rotate high-to-low-to-high-to-low etc. An indication that the rotation is about to come to an end is when the market fails to achieve at least the 78.6% retracement and then reverses. To understand why I say 78.6%, read the Nature of Trends.

On November 3rd, the market was below the 21.4% (reciprocal of 78.6%) retracement level. A turn down from there would suggest a possible failure of the sideways market that would lead to a downside breakout. (See Chart 1).

11-05-2008-sp-_d-sw.jpg

Chart 1 3-d swing S&P

It was a variation of this idea that enabled me to call the May 2008 reaction high. At the time, I was unsure if the market was forming an Irregular Ray Wave 4th (one more high to come) or had topped.

When the market created a Doji bar on May 19 and followed it with two bear bars down, that threw the probabilities in favour of a topping pattern rather than a Wave 4. Chart 2 shows the Doji. Note that the failure occurred around the 50% to 67% retracement levels - the ideal zone for failures.

11-05-2008-sp-18d-2-sw.jpg

Chart 2 S&P 18-D

Secondly, I’d like to muse on the election results. Obama won. We now have to see whether the Democrats will win 60 seats in the Senate to prevent any Republican filibuster attempts. If the Democrats do win the 60 Senate seats, the question will be how they will respond to a stagflation situation. Will they resort to even greater use of the ‘printing press’ than Bush, Bernanke and Paulson? If so, I believe that will guarantee an eventual deflation.

For those that have missed my reasons for saying this:

  • The rescue attempts since Bear Stearns has increased the M3 to a peak of 17%.
  • In the past 3 months, M3 has fallen to 14% but we have yet to see the impact of 1.3 or so trillion that has to be spent on ‘bailouts’.
  • This increase in the M3 will see a reflection in the inflation - probably next year.
  • At that point, the FED has to choose between the threat of hyperinflation and raising rates in a fragile US economy.
  • The raising of rates will cause a second wave of sub-prime ‘emergencies’.
  • The FED response to this second round of crisis will determine if we have a severe recession or deflation.
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