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Before presenting this analysis, some background and a few clarifications are necessary. Elliott Wave analysis is controversial in many ways. I believe, the controversy relates to the long term and extremely bearish views by those popular analysts who use the Elliott Wave principle as their primary forecasting tool. Additionally, so much of the principle and its explanation deal with corrections against the larger trend and the nature of these corrections tend to be difficult to characterize, trade, and predict. Therefore, although forming a large part of the discussion of Elliott Wave principle, corrections have the least practical value compared to major 5-wave trends. The portion of the Elliott Wave principle dealing with 5-wave advances (or declines) is of significant practical value as a long-term forecasting tool. Of the 5 waves in a typical 5 wave advance (or decline), there are three waves in the direction of the major trend, and two corrections against the major trend. In their sequence, waves 1, 3 and 5 are in the direction of the trend, while waves 2 and 4 are in the opposite direction. The 5 wave patterns or “motive” waves in the direction of the trend tend to be easy to recognize and interpret. The rules are that wave 2 ALWAYS retraces less than 100% of wave 1. In addition, wave 3 ALWAYS travels beyond the end of wave 1. In price terms, WAVE 3 is often the longest and NEVER the shortest among waves 1, 3 and 5. While the corrective waves 2 and 4, against the major trend are complicated to evaluate individually, waves 1, 3 and 5 each ALWAYS can be broken down into 5 sub waves and are therefore easier to evaluate than waves 2 and 4. The five wave patterns of waves 1, 3, and 5 may ONLY be of two types – they are either “impulse” waves or “diagonal triangles.” Each of these simplified 5-wave patterns are illustrated below. The geometric differences between the impulse and diagonal patterns are that the impulse pattern tends to form a parallel channel line, whereas the diagonal forms a converging channel line. In addition, whereas wave 4 never enters the “territory” or wave 1 in an impulse, it does so in a diagonal.
Within the diagonal pattern, an ending diagonal is a special case that is important. Quoting relevant sentences from Frost and Prechter, “An ending diagonal is a special type of wave that occurs primarily in the fifth wave position at times when the preceding move has gone “too far too fast”, as Elliott put it….In all cases, they are found at the termination points of larger patterns, indicating exhaustion of the larger movement…” “Ending diagonals take a wedge shape within two converging lines. Each subwave, including waves 1, 3 and 5 subdivides into a “three,” which is otherwise a corrective wave phenomenon, producing an overall count of 3-3-3-3-3….” “…the fifth wave of a diagonal triangle often ends in a “throw-over,” i.e., a brief break of the trendline connecting the end points of waves one and three…” “Fifth wave extensions, truncated fifths and diagonal triangles all imply the same thing: dramatic reversal ahead…” (Emphasis added) Below is a long-term weekly technical chart of one of the market leading indices, the S&P mid-cap index ($MID). The long-term trends are labeled according to my interpretation of Elliott Wave. Overall, we see the last three waves (waves 3, 4, and 5) of the 5 wave bull market in mid caps, which began in 1982 (waves 1 and 2 are not shown) and was followed by a correction that occurred between mid-2000 until late 2002. Note that wave 3 is typical of a 3rd wave in a 5-wave advance. It is the longest wave and pullbacks are of relatively short term magnitude and minor duration. As is also typical in third waves, it ends with momentum (14 week RSI in this case) at a high point. As can be seen clearly in the chart, wave 5 didn’t trigger the end of the bull market in mid cap stocks. It only triggered a complex correction (labeled a, b, c in the chart), before the bull market resumed with an additional 5-wave advance, beginning in March of 2003. In this 5-wave advance, note how wave 2 doesn’t correct all of wave 1. Note that as with wave 3, wave 3’s pullbacks are also of minor magnitude and short duration. Also similar, wave 3 terminates with strong momentum. As can be seen from the chart below, the S&P 400 Mid Cap Index is now in the 5th wave of a 5-wave advance.
A look at a shorter term weekly chart (from Jan 2003 to the present) provides insight into the nature of the current 5-wave advance.
The current motive wave appears to be that of an ending diagonal. Note how each of the sub waves including waves 1, 3 and 5 subdivide into 3 sub waves, thereby yielding a pattern of 3-3-3-3-3, as described above. (These sub waves are each labeled “a”, “b”, and “c”, in the chart above.) Wave 4 enters the territory of wave 1 as occurs in diagonals, while not in 5-wave impulse patterns. While it is questionable whether the trendlines form the required wedge in the case of the S&P mid caps, as shown below, a similar examination of the similar-behaving Russell 2000 small cap index leaves no such doubt. This analysis suggests we are in the 5th wave of the suspected diagonal, and if so a dramatic reversal may occur soon.
While the current (UP) trend in the leading indices deserve the benefit of the doubt, the formation of the potential ending diagonal deserves attention. This is because as with “extended fifth waves,” and “truncated fifths,” diagonal triangles imply “dramatic reversal ahead”! The “dramatic reversal” would be confirmed with a decisive break of the lower support trendline. Similarly, this analysis would be proven to be incorrect if the S&P mid cap index were to break above the upper trendline of the proposed diagonal and then use this former resistance line as technical support. However, as described by Frost and Prechter, there is the potential for a “throw over” to occur whereby the upper resistance line is broken for a short period of time before a dramatic reversal occurs. It is the fundamental absurdities occurring in the stock market such as recent Wall Street Google price targets that lead me to suspect that a dramatic reversal would be preceded by a “throw over” of the upper resistance line of the diagonal. Finally, since we are on the topic of the black magic that is Elliott Wave, below is presented the long-term chart of the Gold Bugs Index ($HUI). After having broken out of a trading range (labeled as an a, b, c, correction), I believe that we are in the third wave (wave III) of a bull market in gold stocks. And as with the correction of a couple of weeks ago, as with any wave III, pullbacks are likely to be of relatively short duration and minor magnitude.
Today’s Market Stocks finished mixed today while Google was up 1.3% on better than average volume. If Google achieves the price target recently assigned by a gaggle of Wall Street analysts, it will rank 4th in market capitalization among the 30 Dow Jones Industrial stocks…that is, if Google were part of the Dow Jones Industrials. Google surpassed IBM in market capitalization recently. While it is no use arguing with the market when managing money and investments, it is worth noting such things to understand the overall roadmap of the market. Once the extreme optimism that is driving the stock market subsides, valuation will matter once again. It’s a crowded theater and someone may yell “fire.” Worse yet, a real fire may occur. Smell the smoke that is the flat yield curve, the rising precious metals, and commodity prices? Favorable jobs economic data says nothing of the large number of jobs that are occurring in the Wal-Marts of the world and those tied directly to the unsustainable real estate market. As pointed out by an economist on Bloomberg Radio today, many of the new jobs are in restaurants. There’s such a “disconnect” between actual economic conditions and the stock market, that it somehow seems appropriate that we would get a “throw over” prior to the dramatic reversal that is suggested by the diagonal proposed above. But until there is a change of trend, this is all just conversation. Keep it business because “it’s business, not personal.” Today’s action saw its leadership coming from those sectors sporting high valuations and high long-term risk, including technology, semiconductors, biotechnology, and internet stocks. Laggardship came from transportation stocks while metals, the oil complex and commodity stocks took a long overdue pullback. The small cap stock that I recommended to my uncle a couple of weeks ago, Mannkind (MNKD), was up 12% today on three times average daily volume (no news). Retail was a mixed bag, with fashion hits and misses being greeted by disproportionate moves in daily stock price. The action in this sector typifies how the speculators are trying to game the market for short term gains. More stuff of a potential throw over. In spite of recent bullish action in many of these stocks, the intermediate term charts of many of these companies are still damaged. Nordstrom produced an IBD high volume breakout to a 52-week high. More stuff of a potential throw over. The homebuilders were up over 2% today, and it appears that the fix is in that the fed will do what it has to do to keep the housing market afloat. That is, if they can. (It might eventually fall of its own weight.) Many of the homebuilding charts appear to have gotten healthy over the last few months. There also was an IBD breakout for Beazer Homes (BZH) today. It is what it is and it's business, not personal. The 10-year note interest rate has been trending down for almost 2 months now. This will also help to maintain the “healthy” housing market. Have a great evening. Martin Goldberg
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