Revised Outlook – March 11, 2015

The selloff this week has altered my outlook for the U.S. stock market in the coming months. I am now expecting wide-range sideways movement for the rest of the spring with a final drop of 10-20% in the late-summer.

In my post on Feb. 12, 2015, I discussed breakouts from triangle patterns on the NASDAQ-100 (NDX), and Dow Transports (DJ-20). However, the upside following the breakouts was less that I anticipated, and some bearish retracements have occurred.

NDX triangle breakout failure

The NDX has reentered the price territory of the triangle which I feel has bearish implications.

The DJ-20 has also fallen deeply into the price territory of its triangle:

DJ-20 triangle breakout failure

Many analysts are saying that a stronger U.S. dollar and falling oil prices are putting downward pressure on the stock market. However, I think that both of those factors should be bullish rather than bearish. A weak dollar is bullish for the economy (and thus stocks) shortly after a recession in which there is still risk of deflation. A weak dollar can boost exports and stimulate the economy. However, it appears that, over the past year, the recovery from the Great Recession has finally solidified, with consistent job creation over 200,000 payrolls per month, and GDP growth at an annual rate greater than 2% for the past three quarters. Both the headline (U3) unemployment rate, and the more comprehensive U6 unemployment rate (which takes the labor force and unsatisfied part-time workers into account), have been falling.

Thus, at this point in the economic cycle, the greatest risk is INflation, not DEflation. What we don’t want is for inflation to creep up, causing the Fed to raise interest rates aggressively. Sharp rate hikes would probably interrupt the economic recovery. If the Fed raises rates moderately in response to an accelerating economy, that is a vote of confidence in the economy and should be viewed bullishly. A rising dollar, falling oil, and falling gold are all signs that inflation is not about to surge, and thus, signs that the Fed can raise rates at a moderate pace.

I now think the markets have been in a corrective phase ever since December. However, the bullish economic factors described above have probably turned what could have been a sharp downturn into a sideways period.

Here is my current Elliott Wave count for the Dow Jones Industrial Average:

Dow 2011-2015

I have primary waves labeled in blue. Bull markets typically unfold in five primary waves. Waves 1, 3, and 5 are advancing, while Waves 2 and 4 are declining or sideways. It appears that Wave 4 is underway now.

Another pattern which I have discussed before is the Ascending Middle Section. I think that an Ascending Middle Section took place on the Dow during 2014:

Dow middle section 2014

The Middle Section theory expects that after Point J, the subsequent decline to will last for a duration equal to the duration between Point E and Point J. In our case, E-J was April-December 2014, a duration of 8 months. Counting 8 months from December 2014 predicts a low in August 2015. From that low (the 2nd Point A), the Middle Section predicts a rally lasting for a duration equal to the time between Point E and the Point A low. In our case, that would be April 2014-August 2015, a duration of 16 months. Counting 16 months from August 2015 puts us at December 2016, which could be the final high of the bull market.

The idealized schematic of the Middle Section shows a return to Point D following Point J. In our case, that would be a drop of about 16% on the Dow. I am not sure if the final drop will be that bad given that the correction has been sideways so far, but I would keep that target in mind in case we get some news shocks later this year.