With a few interruptions, the market has been rallying for more than five years. That’s why the sideways start to 2014 has some investors wondering: Has the momentum begun to fade?
To answer this question, you can look to one of the primary trend analysis tools in technical analysis: Elliott wave. A current analysis of the S&P 500® Index using Elliott wave suggests that stocks might decline after hitting all-time highs, but there could also be a silver lining.
What is Elliott wave?
Elliott wave is among the foundational principles of modern technical analysis. Created by Ralph Nelson Elliott in the 1930s, Elliott wave forecasts market trends by identifying patterns and extremes in investor psychology, and examining market highs and lows. See the diagonal blue lines near the price action in the graph below to get a sense of what Elliott waves looks like on a chart.
This chart illustrates a simple 5-wave structure. Note that these lines were automatically drawn by Fidelity’s Active Trader Pro® software. The waves are represented by the blue diagonal lines. Wave 1 lasts roughly from July 2012 to September 2012, wave 2 from September 2012 to November 2012, and so on.
How to do Elliott wave analysis
Riding the wave
A wave can be motive (with the trend) or corrective (interrupting the trend). In the image above, waves 1, 3, and 5 are motive, and waves 2 and 4 are corrective.
Wave 1 volume is typically greater than wave 2 volume. For an uptrend, the movement of wave 2 should not retrace more than 61.8% of wave 1.
Wave 3 is usually the largest and most powerful wave, typically climbing by a ratio of 1.618:1 versus wave 1.
Wave 4 usually retraces less than 38.2% of wave 3 and should never breach wave 1. Wave 5 volume is typically lower than wave 3.
The purpose of using Elliott wave is to identify trends and spot potential reversal points. For active investors, spotting these trends can help you trade with or against the market’s momentum and manage risk. Keys to using Elliott wave include identifying start and end points of waves, corrective patterns, and minor degree subdivisions (“subwaves” within larger waves).
While there is no exact science to identifying the beginning, end, and length of individual waves, there are set principles that guide identifying wave formation (see sidebar). Many trading platforms, including Active Trader Pro®, can help you identify waves.
What Elliott wave indicates now
Until you have some experience identifying and applying Elliott wave analysis, consider the work of experienced users like Ching Tan, a veteran technical analyst at Fidelity.
When looking at a weekly chart of the new bull market that began in March 2009, Tan suggests that there is the possibility for a correction near the all-time highs on the S&P 500, based on Elliott wave. He points to a price level around 1,902.17 (the S&P closed at 1,911 on May 27, 2014) as a key level to watch because it is potentially a high for the current wave we may be in. See his full analysis below (for advanced, experienced users of Elliott wave).
Ching Tan applying Elliott wave to the S&P 500
“Elliott wave theory is one of the most flexible and subjective technical analysis tools. Two analysts can label waves on a price chart differently. Yet, even though the exact labeling of waves can differ, the forecasted future price moves often point in the same direction, and that is where the Elliott wave theory can add value.
“Based on my analysis, Wave I in the weekly chart below covers the period between the March 6, 2009, trough and the April 30, 2010, peak. The low to high range for the period covers 553.01 points. Wave I can further subdivide into five smaller-degree waves as marked on the chart below.
“Identifying wave II in this pattern is a little tricky. At first glance, you might think this wave covers the period between the April 30, 2010, peak and the July 2, 2010, correction bottom. However, this assumption is violated by subsequent waves. Between the July 2, 2010, low and May 6, 2011, high, the price range is 359.67. This is supposedly followed, after wave III, by the corrective wave IV that lasted into the October 7, 2011, week bottom, which is then followed by the wave V rally that developed into the week of September 14, 2012. This wave V covers 399.74 points.
“In this scenario, wave III would be the shortest among waves one, three, and five, yet that violates a key Elliott wave principle. Thus, we must reexamine wave II. Instead of labeling the single corrective phase between April 30, 2010, and July 2, 2010, we treat the complex price path between April 30, 2010, and October 7, 2011, as wave II. This wave II is a running flat (a type of wave pattern where wave B ends significantly beyond the beginning of wave A, however, wave C does not reach the price where wave A ends) of an A-B-C corrective wave (an Elliott wave pattern that can follow a standard 5-wave move) in which wave B exceeds the beginning of wave A.
“Wave III begins at the October 7, 2011, week low. We can easily see five smaller-degree waves lasting into the September 14, 2012, peak, which covers the 399.74 points just mentioned. However, this cannot be the complete wave III because, after the shallow wave IV would complete, wave V would extend 558.82 points. This still leaves wave III as the shortest wave, which again is an Elliott wave rule violation.
“Therefore, the 399.74-point price moves between the October 7, 2011, week low and the September 14, 2012, high appear to constitute subwave 1 of wave III, which is followed by the wave 2 within wave III that ended in the week of the November 16, 2012 low. What we are witnessing now could be subwave 3 of wave III, which covers 558.82 points so far.
Where are we now?
The golden tool
In addition to wave structure, one of the primary tools used within Elliott wave analysis is the Fibonacci series. Key Fibonacci ratios for Elliott wave are 23.6%, 38.2%, 50%, 61.8% and 100%. These ratios can be applied to previous waves to forecast future price targets. The mathematically inclined may recognize 61.8% as the golden mean. This number is of particular importance in Elliott wave analysis.
“Now comes a critical question as we assess the current market: Has subwave 3 of wave III ended and a corrective subwave 4 of wave III already begun, or will subwave 3 of wave III continue to go higher? One way we can generate ideas is by using Fibonacci ratios (see sidebar).
“We already know that subwave 1 of wave III covered 399.74 points and, so far, subwave 3 of wave III exceeded the length of subwave 1. A conservative estimate of subwave 3 would be 1.382 times that of the wave 1, which spans 552.44 points. Adding that to the subwave 2 low of 1,343.35 results in the target of wave 3 being 1,895.79.
“Interestingly enough, this is only about 6 points shy of the all-time intraday high of 1,902.17 that was achieved recently. This tells us, from an Elliott wave perspective, that the market may be risking a correction at this price. Therefore, it will be worth closely monitoring the price action in the near future. On the other hand, if the market continues to rally past this price level, we will have to adjust the targets of subwave 3 to 1.50 or 1.618 times that of subwave 1, which will give us an approximate price range of 1,943 to 1,990.
“We have to keep in mind that, if the subwave 4 correction has already started, or starts later, a subwave 5 rally would follow in order to complete wave 3. This would then be followed by a wave 4 correction and wave 5 rally (to complete a full 5-way structure). This could mean that the current bull market that began in March 2009 might be far from over.
“In addition, if we apply the alternation rule to wave 2 and a possible wave 4, because wave 2 is a relatively sharp correction of 131.16 points, the expected wave 4 could be a relatively shallow flat (another type of wave) with a less than 131.16-point decline. This would imply that the S&P 500 Index would be unlikely to decline below 1,771 before it starts a wave 5 rally. The result would be a test of at least the recent all-time high, and possibly new highs.”
While this type of analysis may seem complex, once you understand the basic guidelines and get some experience looking at the market in waves, Elliott wave can be a powerful tool that may be able to help you trade with the momentum and spot changes in trends.
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