We expected the U.S. stock market to rally after the dip in late January. Years ago, we set our minimum target for the top of wave 3 off the 2009 lows at 3,011 points on the S&P 500 Index

SPX, -0.13%

with the ideal target being 3,225. And, over the past few months, the market has been teasing us with both potentials, and not tipping its hand.

This past week, with the breakdown below 2,880, I think the market is suggesting that we are now much closer to the top of wave 3. In fact, it seems that wave (iii) in green has topped, and we are now within wave (iv) of that ending diagonal.

During the past week, I also provided the following analysis about the potential in this green wave (iii):

“A typical wave (iii) in an ending diagonal will target the 1.236-1.382 extensions of waves (i) and (ii). In our case, that is the 2,935-2,970SPX region … the target for the wave (v) would be the 1.618-1.764 region (3,011-3,045), which is right in line with the long-term minimum target we have for this wave 3 off the 2009 lows.”

As long as the market does not rally in impulsive fashion toward 2,920 points in the coming week (meaning a 5-wave structure following our Fibonacci Pinball outline), then I am going to view any rally as a b-wave, which will be pointing us down to our lower target box for wave (iv) in the coming weeks.

Normally, I would expect us to drop down to the trend channel presented on the 60-minute chart in a 4th wave. However, remember that most ending diagonals see wave (iv) overlap into wave (i) territory. Wave (i) completed at 2,791. So, ideally, we should see a drop just below that level if this is going to turn into a standard ending diagonal.

But this is where trying to trade for the last segment of an ending diagonal gets very tricky. Even though the ideal target is 3,011-3,040 for this ending diagonal, sometimes they do not reach their ultimate conclusion. Moreover, sometimes they even top where one would expect only wave (iii) to top, and many times they even see a strong spike through their standard targets. In other words, when dealing with ending diagonals, you have to understand you are in a treacherous market environment, which provides significant volatility in both directions.

To add to the treacherous nature of the environment, when an ending diagonal completes, the reversal is quite strong. In fact, we usually see the market drop quite quickly back to the point of origin of the ending diagonal. In our case, that is the 2,500-2,600 region, and that would likely only be the a-wave of wave 4, as shown on the daily chart.

So, as we move into a much more likely ending diagonal scenario, please recognize that risks have increased significantly on the long side. The only thing that could resurrect the more bullish perspective to 3,225 for me would be an impulsive rally over 2,990. Barring that, I am going to treat the current structure for wave (5) was being an ending diagonal.

In summary, as long as any rally remains corrective in nature in the coming week, I am looking for the market to drop down to at least the 2,840 region for wave (iv), and ideally as deep as the 2,790 region. My alternative count can even allow for a push higher to the 2,950-70 region for a more extended wave (iii), but I think attempting to trade for that potential carries very high risk. It would now take an impulsive break out over 2,990 at this point in time to make me consider the 3,225 target for 2019. Lastly, unless we see a sustained break down below 2,770, I am still looking for another rally into year end toward the 3,011 region to complete wave (v) of (5) of V of 3 off the 2009 lows.

This brings me back to the warning I have been posting the last month or two. We are now approaching the top to wave 3 off the 2009 lows. That means that when this completes, potentially as early as the end of this year, we will likely begin a 20%-30% correction, which could drop us down as deep as the 2,100 region. So please consider the risk inherent in the market over the next few months.

See detailed charts illustrating the wave counts on the S&P 500.

Avi Gilburt is a widely followed Elliott Wave technical analyst and founder of ElliottWaveTrader.net, a live trading room featuring intraday market analysis on U.S. indices, stocks, precious metals, energy, forex, and more, along with an interactive member-analyst forum and detailed library of Elliott Wave education.

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