Why is this pullback in the markets more significant than any other in the past nine months?  There is a negative divergence which set up the turn in the McClellan oscillator – higher prices, but lower market breadth.  This is exactly the reverse of the positive divergence which preceded the market bottom in March 2009.

The market is now at a critical juncture.  Internals suggest that the intermediate term defensive / capital preservation team is now on the field.  A head and shoulders pattern (rounded top) is now visible on most major indicies.  Today’s price action will most likely confirm this setup on an impulse move.

Markets have now lifted for the past nine weeks.  Beneath the surface, however, there are signals that structural shift has occurred in the overall market breadth.  The McClellan oscillator is very close to signalling a trend change in the summation index.  This was the same signal that was present and confirmed the early March “V”-spike bottom.

Back on November 26, 2008 I posted a weekly chart of the S&P 500 showing the Elliott wave count.  At that time, a PTI (profit taking index) used to measure the strength of the decline suggested that we would revisit the lows at a future juncture.  Well, here we are retesting the November spike lows.

The markets are at a critical juncture, since a trend termination often leads to a rip-roaring move in the opposite direction as either too many bulls or bears are caught on the wrong side of the price action.  This is what happens when a 5-wave count completes.  We already witnessed this phenomenon following the November lows, and are very close to another cycle of whipsaw action.  Based on the previous weekly count, I have now updated the daily chart with wave (4) highs and now the final countdown is in progress to the wave 5 of (5) to complete the downtrend since the 2007 highs.

Looking at a more finer granularity, the hourly chart is suggesting that wave 3 on the daily may be in place.  If so, we can expect a rather quick lift back into the mid- to high-700′s before the final retest of lows.  At that juncture, a rally lasting more than a few days will be possible.  Shorting the pops becomes an ever-more-dangerous trading stance and becomes now more of a game of looking for good entry points on long positions.

What type of signals do we look for to guide our trading stance?  The final fifth wave is one which will be marked by divergences in price action versus momentum and breadth indicators.  Some of the popular measures are the advance-decline ratio, the p&f bullish percent, or even the McClellan Oscillator shown below.