MAILBAG QUESTION:

"...you say in recent market analysis that the current decline may be near over. everyone else or many i guess many say that our stocks will continue to get hammered as long as theres more negative news out of europe or elsewhere in the world. slow down in china is another worry I think. What makes you confident that you can predict by technical methods you describe?"

MY RESPONSE:

Well, I wouldn't say I'm thoroughly CONFIDENT. At least I'm waiting to see if the major indexes don't sell off somewhat further. This may or may not happen as we could be 'at or near a low' already as I titled my recent (Saturday, May 26) Index Wrap. I don't think that 'somewhat' further is all that much, although the S&P 500 might fall yet to around 1260 and the Nasdaq Composite to around 2700 or the low-2700 area. Nevertheless, there's one aspect to technical analysis that says a common corrective pattern may have completed. This aspect involves market 'wave' patterns described by RN Elliott. I'll go into that a little but not as much as I've done in some prior Trader's Corner articles.

I wrote a fairly comprehensive BASIC guide to wave analysis back in late-2010, which is in our Trader's Corner archive. Go to part 1 HERE; part 2 by clicking HERE and my 3rd completing article HERE.

'Wave' analysis relates to Elliott Wave patterns and predictions which is a subset or separate field of what we would call 'technical analysis'. This theory is named for an astute stock market observer, RN Elliott, who was the originator of these theories back in the 1920's and 30's. If you want the long study, go to The Major Works of R.N. Elliott, edited by Robert Precter to Bob Precter's own book, Elliott Wave Principle. These are relatively short books and are quite an interesting read. The HARD part is interpreting ALL market moves by estimating their wave structures. I would say that for the average trader, figuring every 'wave' could drive you crazy.

Bob Prechter is someone I knew from New York/Wall Street days and was President for a time of the New York based Market Technicians Associate or MTA. He and I both toiled form Merrill Lynch for a time also. He's a good guy but totally looks at all markets from a wave perspective. I don't do that but I do find certain wave patterns to be highly predictive. For example, that major uptrends in the market or in individual stocks will tend to have 3 advancing moves or (major) 'waves' and that the second big up leg will be the 'power' move and carry the farthest. When you see this unfolding you bet the ranch on it. Well, not the ranch, heaven forbid, but you can go in heavier than usual as long as you haven't raided your kids' college fund or the like.

Another wave pattern concept relating to bear markets OR to bearish corrections within an overall primary bull market, that in my experience is true for how things often unfold is the concept of how an a-b-c (or, down-up-down) market correction will play out. Bob Prechter sees the Elliott Wave Principle as the best tool for identifying market turns as they are approaching. But, and here's the grain of salt, even he says that: "Elliott is not the perfect formulation, since the stock market is part of life and no formula can enclose it or give complete expression to it."

CORRECTIVE 'WAVE' PATTERNS

According to wave theory corrections always have 3 waves or components. The first component seen after an advance is a corrective pull back or downswing, labeled the 'a' wave. After a very strong and prolonged move, this downside correction may not carry all that far and won't typically be viewed as a significant change in the dominant trend.

There's a recovery rally after this first decline, labeled the 'b' wave. After this rally runs its course, there's another decline labeled the 'c' wave and this may or may not carry farther than the first decline; sometimes this decline carries significantly further than the first sell off.

Small letters 'a,b,c' designate downside corrections within an overall up trend. Big cap 'A-B-C' labels designate major BEAR MARKETS such as is seen in the 2007-2009 bear market.

CORRECTIONS TAKE 3 FORMS ACCORDING TO WAVE THEORY

#1 is the a-b-c flat correction, where the second decline ('c') is approximately equal to the first downswing 'a'. In fact all 3 component 'legs' (the a, the b AND the c) tend to be equal. In recent years and decades, the more common pattern to a-b-c corrections is NOT the flat variety, as the market has grown more volatile. I had to search a bit to find a stock that has the 'FLAT' a-b-c pattern.

#2 type of an a-b-c downside correction is the so-called 'ZIG-ZAG' pattern, where the zag is significantly greater than the zig! A zig-zag a-b-c correction occurs when the second down leg ('c') not only carries farther than the first decline, but tends toward being a Fibonacci 1.38, 1.5, 1.618 or even 2.0 times greater than the initial 'a' decline. This (zig-zag) pattern is the most common I've seen over the years and most common of all I've seen is where the second decline was 1.5 to 1.6 times greater than the first.

Fibonacci percentage retracements of .38, .5 and .618 (call it 62%) of the prior move are common. 38% are shallow corrective pullbacks, 50% fairly 'normal', especially in stocks and .618 or 62% are not uncommon but not so much in strong uptrends. A retracement of ALL of a prior move is a 100% retracement; if the decline stops there it's a double bottom .

If, in the highlighted daily Nasdaq Composite (COMP) chart seen below, COMP went on to retrace 62% (to 2705) of its prior advance, the 'c' down leg would be 2.0 times greater than the initial 'a' wave decline and would also then be considered part of the Fibonacci numerical sequence.

As to chart 'types' that we can use, specifically a bar or Candle chart which show intraday highs and lows (although, 'shadow' highs/lows with candle charts) versus a close-only line chart, BOTH have validity and I often look at both. A line chart will of course take out the big intraday spikes that we see from time to time on standard bar charts.

Based on use of a close-only daily chart for the S&P 500 (SPX), the 'c' down leg is to date, 1.55 times the initial 'a' leg decline. If SPX were to retrace a Fibonacci 62% of its prior advance, the 'c' downleg would be double (2.07) that of the first decline on a Closing basis. Stay tuned on the final outcome, but I lean to the view as I said earlier this (long) weekend, that we could be 'at or near a bottom'. I don't fear Europe contagion but it may be the soft spot I have for most things European, even though the Euro currency made Spain and Greece more expensive!

I mentioned THREE types of corrective a-b-c wave patterns. The third is called a 'triangle' and is not common, so I omit a hard to find example here.


GOOD TRADING SUCCESS!