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MARKET UPDATE


Elliott Waves And The S&P 100

10/26/04 04:35:52 PM PST
by David Penn

Once again, it pays to err on the side of excess when counting the waves.

Recently, I was reading the Paul Tudor Jones interview in Jack Schwager's excellent Market Wizards. Jones has a unique trading style, one that tends not to correlate with that of other hedge fund money managers. I suspect this is largely because Jones enjoyed picking tops and bottoms, while the majority of traders prefer variations on trend trading.

In any event, Jones has also expressed an appreciation for Elliott wave theory. Calling Robert Prechter "the champion," Jones in the Schwager interview underscores how integrating Elliott wave theories into his trading approach has helped him capitalize on superior risk/reward scenarios. Combing the high-mindedness of Elliott wave theory with a trader's embrace of cold, cruel reality ("Don't be too concerned about where you got into a position," Jones advises. "The only relevant question is whether you are bullish or bearish on the position that day"), I never cease to enjoy reading and rereading his conversation with Schwager.

As you might imagine, I found myself turning to Jones as I was busily revising my wave count for the Standard & Poor's 100 or $OEX in the wake of the surprisingly strong early October rally (Figure 1). I had suspected a strong move to the upside around this time (see my "From Flat To Zigzag," Traders. com Advantage). However, I initially believed that this upmove was part of a larger move downward (that is, a (ii) inside a larger [iii] that began with the mid-September highs) instead of what it now appears to be: the third and last leg of a larger wave ii correction. (Square brackets denote wave labels that are circled in charts.)

Figure 1: When the initial wave [ii] top (here marked as "(a)") was exceeded in early October, the review of the wave count led to a larger wave [ii] that topped in October (instead of in September). Still, the wave [ii] top was only slightly higher than anticipated.

This may sound more complicated than it really is. After posting a wave [i] low in mid-August, the $OEX has made a strong rally into mid-September, a roughly 50% correction toward the end of September, and most recently a rally back up to test the mid-September highs: three market moves.

At first I thought that the first of these market moves was enough to form a wave [ii] in response to the wave [i]. Thus, I posited a wave [ii] top near mid-September, and considered the subsequent decline (the second of the market moves mentioned) to be the beginning of a massive, third-wave decline (that is, [iii]).

When the third of the market moves developed, I suspected that it was merely a response to the previous decline — a smaller wave (ii). As such, I used the rule of alternation to warn that a sharp countertrend rally was likely (see again "From Flat To Zigzag,"). Nevertheless, because I believed that this was a smaller (ii) in response to the previous, smaller (i), I did not suspect that the move would take out the September highs.

In the $OEX, the third move did not. Nor did it in the Dow Jones industrials. But both the Nasdaq and the S&P 500 (both broader and more representative than the $OEX or $INDU) did see a third move that took out the September highs. This led me to believe that the third move could not be merely a smaller (ii) and that, instead, wave [ii] must have not been completed with the mid-September "top."

The easiest way to fix the wave count, then, was to make wave [ii] larger. The first one-two of a new downward third wave increasingly appeared to be the second and third (b and c) waves of a larger wave [ii] than I had originally thought. Specifically, given the dimensions of this "new" wave [ii] — a long a wave, a short b wave, and

a final c wave that doesn't extend beyond the top of the long a wave — I suspected that wave [ii] would turn out to be a "running zigzag." Such patterns are in the "unorthodox" camp (or modern, as the Elliott wave analysts at ELWAVE Prognosis Software Development call them). But I do think that such unorthodox patterns can be helpful ways to apply a consistent wave count that does not violate the basic rules of the Elliott wave theory.

By classifying wave [ii] as a running zigzag, I was also able to get a better sense of where wave [ii] might really top. Knowing that running zigzags feature c waves that do not move beyond the end of the a wave, I posited that by multiplying the amplitude of the a wave by 0.618 and adding that amount to the b wave low, I might get a reasonable approximation of where the c wave of wave [ii] might end. That computation — 30 x 0.618 = 18.54 and 530 + 18.54 — provided an upside target of about 548.54, approximately $0.90 off the current wave ii peak from October 6.

In the case of the other averages (the S&P 500, the Nasdaq), a more orthodox zigzag interpretation likely suffices. But to deal with the exceptional situation of the third corrective wave not setting a new high, as is so far the case with the $OEX, the running zigzag is the pattern that fits best. Should the $OEX reverse and take out the September high, then the orthodox zigzag interpretation could apply.

One of the observations I've had about Elliott wave theory is that when a wave count appears to be inaccurate, the first thing to try is to go large. Be willing to consider extensions, or even nontraditional forms like running corrections, before deciding that a particular price pattern will not yield to a wave count.

The waves right now

Read in concert with my most recent Elliott wave-themed article, "Election 2004: A Tale Of Two Tops" (Working Money), the current argument underscores the notion that the broader market is in a topping phase. I say this even as I have argued repeatedly that the series of lower highs and lower lows since January 2004 means that we are in a bear market, regardless of what perma-bullish commentators elect to allege.

In the $OEX or S&P 100, this couldn't be more pronounced: Not a single rally this year has succeeded in taking out a previous significant high in the S&P 100. The S&P 500, by comparison, did manage to take out an intermediate high with its October rally. But the failure to sustain those levels was a strong intimation that the path of least resistance remained a downward one.

With two sets of first and second waves now apparently completed with the October highs (1 and 2; [i] and [ii] of 3), what follows should be straightforward: A massive, powerful, destructive third-wave decline. Think of the summer and autumn of 2001 and multiply that by an order of magnitude. Recall that, per Elliott wave analysis, the previous wave [1] decline was the bear market from the spring of 2002 until late in the autumn of 2002. A wave [3] decline that is significantly stronger and significantly more destructive than that wave [1] (which began with the end of the Taliban regime in Afghanistan and ended with — among other things — the passage of a war resolution against Iraq in the US Congress) is something all serious investors and traders need be wary of.

After talking with a colleague about "Election 2004: A Tale Of Two Tops," I realized that I should perhaps have included the 1980 election as another instance of a US Presidential election being held under the auspices of a completed first and second wave. Of course, the crucial difference between the first and second waves in 2000 and 2004 and the first and second waves in 1980 was that the former pair occurred as the broader market was moving downward (using March 2000 and January 2004, respectively, as the peaks from which the declines emerged). In 1980, however, the broader markets were moving upward from the secular bear market low in 1974. While the election in 2000 and the election in 1980 were quite different in terms of the vote counts (the former was close, the latter an electoral landslide), both elections did result in losses for the incumbent's party.

Looking forward, the next major test will be the August lows in the $OEX. Insofar as the August lows represented a wave [i] low (let's say of minute degree), which took out the low of the previous wave 1 of a higher degree (call it minor), I am expecting that the five-wave sequence that began with the October highs (a wave [ii] minute degree top) will likely complete itself somewhere below the August lows and form a wave (i) low of a lesser degree (minuette).

Some of this minutia and nomenclature may be of interest only to the most passionate of Elliott wave enthusiasts. But it does serve to provide signposts for all chart-reading traders and investors by which they can determine just how far along the path of this secular market we have already traveled — and how much farther we have to go.

David Penn may be reached at DPenn@Traders. com.

Suggested reading

ELWAVE User Manual, Prognosis Software Development.
Frost, A.J., and Robert Prechter Jr. [1985]. Elliott Wave Principle, New Classics Library.
Penn, David [2004]. "From Flat To Zigzag," Traders.com Advantage, October 5.
_____ [2004]. "Election 2004: A Tale Of Two Tops," Working Money, October 6.
Schwager, Jack [1993]. Market Wizards, Harper Business.

Chart courtesy Prophet Financial Systems

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Seattle, WA 98116
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E-mail address: DPenn@traders.com

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