The Elliot Wave Crossroads

Are we there yet?  I want to include one last comment about last Thursday’s blog which I forgot to include, which supports the idea that the markets are at a crossroads, comes from Elliott Wave Analysis. The configuration of the stock market charts, from the perspective of Elliott Wave analysis, (according to the folks atElliott Wave International), is that the stock market pattern to date, is that of a market which is in a primary down-trend. 

This form of analysis was discovered by a RN Elliott in the 1930s, and has been popularized by Robert Prechter, and his Elliott Wave International (EWI) service. The main pattern for Elliott Wave analysis is a 5 wave pattern, which in the case of a bear market, as I describe below, consists of alternating down and up waves, (3 down and 2 up). I will use the sell-off from October of 2007 to March of 2009 to show the labels, see attached and the description below:


Wave 1: down from Oct 2007 to March 2008

Wave 2: up from March 2008 to May 2008

Wave 3: down from May 2008 to November 2008

Wave 4: up from November 2008 to January 2009

Wave 5: down from January 2009 to March 2009 - 


which ends all of big wave I down. 


The most significant other rule you must apply to the analysis is that Wave 1 and Wave 4 cannot overlap. Accordingly, when a wave 3 is underway, it will plunge through the previous low (or high for a rally) in a quick, and impulsive fashion. In stocks, the third wave is usually the most powerful, while in commodities, the most powerful wave is often the 5th wave. Waves in the direction of the trend are often a distinct 5 wave pattern, as the attached graph shows. Unfortunately, there are a multitude of patterns which corrective waves can take, and even if you have one completed corrective pattern, there are numerous situations where 2 or 3 corrective patterns string themselves together, extending the timing of that corrective pattern. In other words, it is often difficult to determine when one is transitioning from a corrective time frame to an impulsive one. One hint that a new impulsive period is starting is that the smaller moves are 5 wave patterns in the direction of the trend.


This brings us to the current configuration of the market. Since the March 2009 low, the S&P has been tracing out a corrective (upward pattern). The folks at EWI believe that the beginning of wave 3 started in April, as the sell-off from April to June was swift and sported a smaller 5 wave pattern, to make little wave 1 of wave 3. Accordingly, we are in the final stages of little wave 2, and about to begin little wave 3 of wave 3 of the overall bear market. And since wave 3s are the most dramatic and impulsive in stocks, what is supposed to follow will make the 2008 sell off look like a  warm-up act. In the past, you have heard me say that I am expecting a dramatic sell-off during which the market will drop more than 13% in 8 trading hours, which represents the maximum downside velocity of the sell-off during October of 2008. And this is predicated on the idea that this will occur during wave 3, of 3 of 3, the period of maximum velocity.


While one is waiting for this dramatic crash, it is very important to manage risk and preserve capital. In fact, as much money can be made by positioning yourself to be long the risk trade during these corrective periods.


While today’s blog is about the Elliott Wave, I will suggest to you that the patterns I am reporting on is also consistent with my macro view that we are marching closer to a dramatic down trade in risk assets. The focus of risk asset sell-off in the 2007 to 2009 bear market was predicated on a collapse in the US mortgage market, and the distribution of those losses through the global financial system. The process of wealth destruction and asset/credit de-leveraging continues to exact a toll on the health and prospects for our economy. Problems with sovereign debt finances in the spring acted as a catalyst for the start of wave 3. What will be the catalyst for the start of wave 3 of 3 of 3? I have speculated on some possible scenarios in past blogs, but the waves really do not care about the scenario which kicks them off, just the fact that the waves follow recurring patterns. And based on the sizes of the potential problems which exist, if the un-easy balance in global trade and finances tips over, then the following reaction in the stock market has the potential to fulfill the very bearish implications of wave 3 of 3 of 3.


One other comment about such a bearish scenario. Over the course of the last hundred years, there were 5 times, during very bad bear markets, when the P/E (price earnings) ratio dropped to single digits, ranging from 5 to 9. If you apply a P/E ratio of 7 to an earning value of $70, that projects an S&P value of 490, which is well below the March 2009 low of 666. And if there is some event which tips us into a recession, a low P/E ratio, and a drop in S&P earnings to at least $70 a share is a no-brainer.


The other alternative is that the patterns since April comprise more of a corrective pattern, and the correction, which is now 18 months old, could have more legs, and might extend above the April high in the low 1200s. For me this is an alternate view, and not my primary forecast. Nonetheless, one needs to be on the look-out for outcomes which take an alternative path.


* Conclusion: we could very well be on the cusp of a major and dramatic sell-off according to this way of looking at the markets. It is not a guarantee, but such an outcome has a pretty good chance of working out (bearishly), and is consistent with the fundamental work I put out in this piece every day.