My last take on Elliott wave theory (named after R.N. Elliott) as a blueprint about how bull and bear trends begin, develop and end. Using wave analysis can lead to some profitable trades and avoid some costly mistakes.
While this article can be read as a 'stand alone' piece, to get a full overview of wave analysis, I suggest reading
Wave Patterns in Trends, part 1 and Wave Patterns in Trends, part 2 ahead of this last piece.
This concluding part of my series on Elliott Wave (EW) analysis of market trends finishes with how wave theory differs in defining long-term trends relative to Dow theory, how to use wave analysis along with OTHER technical analysis tools and also describes some general wave characteristics in terms of the attitudes held by investors, traders and the 'public'.
I don't spend a lot of time working out all kinds of wave 'counts' for the indexes; i.e., interpretations of ALL market moves in terms of a theoretical future for how the trend 'should' unfold according to EW theory. When I see what I think is an 'obvious' wave pattern, I use it to help guide trading decisions, but don't rely on just EW analysis.
My first chart was seen in part 2 of my wave analysis in trends series and shows how the upcoming market trend might unfold, basis the Nasdaq 100 (NDX) weekly chart. What it looked like to me was that there would be a pullback from the very strong 'wave 3' that ended early this month (with the 11/5 top). You'll note that a top was projected with the help of a very overbought readings on the RSI and MACD.
The hypothetical end of the (small) 'wave 4' pullback is not spelled out as to price level. Price targets can't always be guessed at with EW theory. Whenever/wherever this current correction ends, I project another 'wave 5' advance that would conclude both the smaller and larger 'wave 5'; i.e., waves of a smaller and larger degree. The below chart reflects prices as of the 11/10 close :
As reflected by the weekly NDX chart seen next, updated through tonight's (11/17) close, my outline of how the trend MIGHT develop, is coinciding with how NDX is performing. Time will tell as to how accurate my wave interpretation on this subject matches market realities. So far, as they say, so good but with much more to come!
Longer-term trend definition in Elliott Wave (EW) analysis is different than the way that a primary bull market is defined in using a Dow theory interpretation.
In the historical chart below, taken from my book (Essential Technical Analysis), up wave 1 could be considered a 'primary' bull market, corrective wave 2, a primary bear market and up wave 3, a primary bull market in terms of Dow theory. In terms of an EW interpretation, the entire sequence of wave 1 to wave 5 was a major bull market sequence.
The entire sequence of the correction that follows wave 5 seen above, consisting of the large moves labeled A-B-C at the end points for those waves, is all part and parcel of a major bear market trend and can go on for many years. The up move of the down-up-down (A-B-C)bear market pattern would be considered part of a bear market; wave B would be a 'bear market rally', even though a year long and reflecting a big percentage rebound.
Elliott defined different degrees of bull and bear markets by different terms than Dow's primary bull or bear markets. R.N. Elliott related the type of bull or bear market to smaller or larger 'degrees' of bull or bear market waves and used 'cycle' to describe some of them; e.g., a supercycle.
EMPLOYING WAVE ANALYSIS ALONG WITH OTHER TECHNICAL TOOLS:
Using the same IBM monthly chart as the first one above, Iâ€™ve added a bit more explanation or text below. OK, it gets more complicated with a detailed breakdown of the wave pattern!:
My next chart shows a WEEKLY time frame for just part of the years shown above. In this chart the interpretation made was that corrective wave 2 (consisting of an a-b-c or down-up-down pattern) might have run its course. At such a juncture, good use can be made of the next smaller time frame (weekly in this case) and then refined still some more with a daily chart, to arrive at an entry decision:
For purposes of timing trade entry it's valuable to use other technical analysis 'signals' such as a bullish moving average and oscillator crossover and/or a breakout above the dominant down trendline:
We can often have higher confidence in the technical indicators such as the ones seen above when there is also a fairly 'clear cut' or well-defined wave pattern. Having confidence in your trading decision is very important early in a trend. It is the hardest to sit tight in the EARLY stages of a new trend, as the business and economic news, for the most part, rarely 'supports' the side of the market chosen.
If I expect that a corrective a-b-c bearish move has ended, I have a reasonable expectation that the next move is an impulse wave higher that will take an index or stock well above where it went on the highest top of the prior correction.
As Dow said, early in any major bull market up swing there is little bullish enthusiasm. In fact, the public is decidedly UN-enthusiastic about the market after a significant decline. Of course, it is not enough to be early, as prices could always be heading into a multiyear sideways pattern; e.g., gold/silver for most of the 80's and 90's and in stocks, for much of the 60's and 70's.
However, if trade entry is made early in an emerging trend that doesn't carry all that far and with a suitable exit strategy, most of what move there is can be captured. With the interest in stocks of recent decades it seems less likely that equities will again be in the doldrums for years to come. But, never say never either!
GENERAL WAVE CHARACTERISTICS:
R.N. Elliott, like Dow, saw that there is progression of human emotions in the marketplace from pessimism to optimism and back again. (Elliott lived not long after Dow's career and influence.) Bullish to bearish, bearish to bullish patterns tend to repeat in a cyclical fashion such that the characteristics and price pattern of the predictable part of the 'cycle' we are in can be recognized.
Impulse waves or the 3 up moves of waves 1 through 5 that make up a typical bull market behave differently than the 2 corrective downside moves; i.e., waves 2 and 4. Such 'impulse waves' have different characteristics than the bear market trends that follow bull markets, identified as waves A, B and C.
In fact, all the wave patterns from 1 through 5, and A through C have their characteristic 'flavor' or personality as highlighted in the charts that follow my explanations of them.
1. (Up) Wave 1: Many of these first waves are part of a basing process, so the corrective next wave (2) that follows, will often retrace much if not all of wave 1. This explains a double bottom in EW terms. If wave 1 follows a 'big base' pattern, its rise can be far stronger than the norm.
2. (Down) Wave 2: With this corrective pattern, prices often retrace much of the first advance or wave 1. This corrective wave pattern will often produce bullish divergences as prices, a key average or indicators don't decline as much as prior lows.
3. (Up) Wave 3 or the second impulse wave (of 3): Third waves are typically powerful advances that make 'believers' out of most investors and traders. (This is where bullish sentiment gets extreme.) Third waves typically consist of a very strong and often very prolonged, advance. This wave will see broad participation by most or all stock sectors.
4. (Down) Wave 4: The fourth wave is the second corrective downswing or pullback. If wave 2, also a corrective pullback, was relatively simple and short-lived, this declining wave will tend to be more complex and prolonged according to Elliott's rule of 'alternation'. Stocks that lagged the advance in wave 3, will dip the most and start to build tops.
5. (Up) Wave 5: A fifth wave advance will typically be less powerful and prolonged than the preceding (up) wave 3. Sometimes a wave 5 advance will EXTEND an advance considerably, in both time and price, relative to wave 3; especially so, if the third wave was relatively short-lived and did not carry prices as far as would be typical of the middle advance in the 1-5 bull sequence. If so, wave 5 may look more like wave 1. If wave 1 was a good-sized advance, then this final (wave 5) rally may be also. Advancing wave 5 completes a bull market trend.
A-B-C (or smaller degree a-b-c) CORRECTIONS:
(Down) Wave "A":
This is the first decline of a bear market trend. As in the 2000 Top and subsequent initial decline for the Nasdaq market, investors tend to be convinced that this down move will be a short-lived decline. This wave is characterized, in terms of the psychology of investors, by continued faith in a longer-term â€œbuy and holdâ€ philosophy.
(Up) Wave "B":
This is a rebound phase that typically sees less volume and fewer stocks rebounding strongly. Being a move contrary (up) to the trend established in the Wave A decline, B waves typically have three parts, also highlighted on the chart as a smaller 'a-b-c' correction, but this pattern BEGINS with a rally and therefore usually follows an UP-down-UP sequence. This is a reverse start and finish of the a-b-c (DOWN-up-DOWN) waves of waves 2 and 4 of a bull market.
B wave rebounds may carry to as high as the levels previously achieved by the market, but technical and volume indicators will tend not to confirm as much internal strength as previously. A double top, relative to the top of wave 5 is a possibility with B waves. It is during this rebound that 'non-confirmations' occur with the two Dow averages and/or in key bellwether stocks, with related market indexes or key sectors.
(Down) Wave "C":
This decline, in the reverse direction but with similar intensity to wave 3 advances, will often be of longer duration and carry prices significantly lower than the first sell off; a fibonacci relationship to the first A wave decline might carry 1.38, 1.5 or 1.62 times farther than the first downswing.
In a typical C wave decline there are often FEW sectors that offer much 'shelter' to investors given such a major and broad decline. Fear and gloom tends to build. At the bottom of this move, investor sentiment has become very bearish and, as discussed by Dow, the public doesn't want to own equities, no longer maintain much interest in the market and are in fact disillusioned with it.
Any correction (to an uptrend) will tend to break down into a smaller a-b-c declining wave pattern:
SUMMARY OF ELLIOTT WAVE THEORY:
As with the theories of Charles Dow, the Elliott wave principles cannot be 'proven' according to any statistical proofs that I know of. There are too many variables and interpretations to facilitate this effort.
Unlike Dow's simple rule that holds that the averages must 'confirm' each other to maintain trend validity, Elliott wave analysis can be complex and an unfolding price pattern can be open to differing wave interpretations, even though alternative wave forecasts seem to each be in accord with EW principles.
And, like Dow's 'non-confirmation' of one Average versus the other, understanding of the wave pattern may occur only AFTER a formation completes itself and too late to take defensive or appropriate trading action. That said, in its simplest terms and used only when a wave pattern is well-defined and seemingly 'obvious', Elliottâ€™s rules of market behavior can suggest some very profitable trading and investment opportunities. And to the avoidance of key mistakes, like staying fully invested in the market long past the end of a bull market.
Use of Elliott wave principles has given me a useful identifier for the structure of trends and how to recognize the unfolding pattern of a bull or bear market; of special interest is to know the nature and timing of wave 3 or Wave C power moves.
Cycles are trends that have a repetitive sequence, depending on the type of cycle. Because the markets tend to repeat similar patterns in a similar sequence, recognition of the current point in this sequence will often have predictive and hence, profitable, value.
GOOD TRADING SUCCESS!