Elliott Wave 2005

Never have these words been more true than when it comes to the current primary/cycle degree wave count of the Standard & Poor's 500 since late 2004. While I suspected that there were flaws with previous longer-term wave counts (and some of these flaws were recounted in the aforementioned October 2004 Working-Money.com article), I wanted to hold off from making such a large-scale reassessment. Now, at the beginning of the year, seems as good a time as any to present this reassessment.

First, I want to make a point about Elliott wave analysis in general. The fractal nature of Elliott wave theory, a quality that explains the unparalleled scalability of the wave principle from the shortest time frames to the longest, is a key component of using Elliott waves. As such, while there are a number of different ways for analysts to interpret and use Elliott wave methods, in my opinion any analysis that does not take into account the degree of waves under discussion is incomplete. It is easy enough to apply Elliott wave methods to any random five- or three-segmented market movement. But if the analysis does not go further and put any given five- or three-wave movement into a larger context, a great deal of the value of the analysis will be missing.

To this end, the wave count I am presenting concerns largely primary and cycle degree waves. Although, toward the end of this discussion, I will comment on the intermediate degree waves in particular that make up one-degree-larger primary waves, the focus — for purposes of this reassessment — should be on primary and cycle patterns.

On Primaries and cycles

The bull market that began in autumn 1974 and ended in spring 2000 was of cycle degree, specifically, a Cycle Five. By "five," Elliott wave theorists locate the 1974-2000 bull market in a continuum that extends not just back to the bear market bottom in 193 — 2a bear market bottom of SuperCycle degree — but to the bear market bottom of the late 18th century, a bottom of Grand Supercycle degree. The Supercycles within this Grand Supercycle wave are five, and consist of the advances between, roughly, 1790-1840, 1850-1929, and 1932-2000. Supercycle declines occurred between 1840 and 1850 (roughly) and between 1920 and 1932.

Looking at the most recent Supercycle from 1932 to 2000, we can see the fractal pattern of the waves at work again. Cycle One consisted of the advance from 1932 to 1937. Cycle Two consisted of the decline from 1937 to 1942. Cycle Three consisted of the advance from 1942 to 1966. Cycle Four consisted of the declines and sideways movement from 1966 to 1974.

From 1974 to 2000, this Cycle-degree bull market was composed of five smaller Primary waves. Three of these Primary waves represented bull markets. And two of these Primary waves represented bear markets. The three Primary bull markets during Cycle Five were 1974-77, 1980-87, and 1987-2000. The two Primary bear markets during Cycle Five were 1977-1980, and 1987.

Nothing is especially typical about this arrangement. The bull markets were, sequentially, three, seven, and 13 years long. The bear markets ranged from a three-year variety to a virtually instantaneous bear market as a result of the crash of 1987. And some of the most negative times in terms of social/investor mood occurred not at bear market bottoms in 1974 or 1987, but in the years afterward once things had already begun to improve (that is, 1982 and 1991).

This provides the backdrop for what has followed since the bull market/Cycle Five peak in 2000. For reasons too expansive to detail here, many Elliott wave theorists believed that the post-2000 bear market — not only a Supercycle bear market that would be comparable in magnitude to the 1932-2000 Supercycle bull market that preceeded it, but one of Grand Supercycle degree — would take the form of a contracting triangle. Such a triangle would be composed of five legs of increasingly shorter magnitude (Supercycles) bound by a set of converging trendlines. And each Supercycle would be broken down further into Cycle legs.

Moreover, the first leg down in that triangle, the Supercycle A wave — the one with the largest magnitude — would likely be a zigzag. As a zigzag, this leg down would be composed of three parts (A, B, C), the first and last legs being further subdivided into five parts, with the second (middle) leg being subdivided into three.

A New look at the old bear

For our purposes, we will focus on this Supercycle A zigzag leg first. Because so much of this leg has apparently played itself out — from the bear market from 2000 to 2002 to the 2002-05 bull marke — tit should be fairly easy to establish just where along the path that the current market — and the buyers and sellers slugging it out within it — are now.

"Should be fairly easy," I say, because what is key is locating just when the first leg of the zigzag (the wave A) ended. Initially, many observers believed that this first leg ended with what have been referred to the "September 11th lows" in autumn 2001. While I initially subscribed to this view, I have since found it wanting.

At this point, there are a number of reasons why this earlier interpretation is likely false. But suffice it to say that the bull market from 2002 to the first few days of 2005 has moved upward for too long and too great an extent for the September 11th lows to hold as the "A" wave low. Had this 2002-05 bull market not rallied above the highs of spring 2002, for example, then there might still be a chance that the September 11th lows were the bottom of the first leg of the three-wave zigzag.

As such, I think it is far more likely that the October 2002 lows represented the bottom of the first leg of the zigzag, making the first, bearish leg of the zigzag a spring 2000 to October 2002 affair. This would make the September 11th lows the bottom of the third leg in the five-part, "A" leg of the zigzag. As confusing as this might sound, consider Figure 1, which will likely be far more clear to those still a bit tossed and turned by the Elliott wave jargon.

Figure 1: Relocating the bottom of Cycle A to the October 2002 lows instead of the September 11th lows makes for a more consistent and hopefully more accurate wave count. Note how the current rally since the August 2004 lows is some 5% from the 61.8% retracement level at 1260.

There are a number of reasons for making the switch to a focus on October 2002 as the major, "A" wave low (incidentally, this makes March 2000 to October 2002 a Cycle A wave). Technically speaking, the trio of lows in August 2002, October 2002, and March 2003 — creating as they did a head and shoulders bottom or triple bottom — stand out as a clear bottoming pattern. The long lower shadows on all three of those bottoms (look at the weekly chart of the S&P 500) also strongly suggest a bottom. And finally, the powerful bull market that began shortly after that bottom has had both the intensity (technical as well as social) and duration of a bull market, not merely a "bounce" from an oversold condition.

Here, I can't resist throwing in some sentiment analysis of the October 2002 bottom. Bear markets end when news of conflict and anxiety seems at its peak. People in the mainstream feel powerless to stop those forces arrayed against them, and it is from this pervasive sense of powerlessness that marginal figures — from serial snipers to Chechen terrorists, both of which were murderously active during the October 2002 lows — often strike. In addition, it is often organized conflict (read: war) that helps "shock and awe" the mainstream back into a sense of mission. This is usually just as bull markets are getting started.

It is not without some truth that many quip that World War II got us out of the Great Depression. As political opponents of the recently reelected US commander-in-chief learned to their great frustration, war is among the most powerful tools for social mobilization in the history of humankind. The bull market that began in the autumn of 2002, was tested in spring 2003, and soared higher over the balance of that year, has been called the "war" rally for good reason.

Cycle B and the bulls

The bear market of 2004 was the source of some joy for Elliotticians, myself included. Still operating on the mistaken impression that the September 11th lows market the Cycle A wave bottom, the rally of 2003 roared higher toward a make-or-break point for that earlier wave count. Specifically, if the war rally of 2003 took out the spring 2002 high, then the earlier count would have been voided. Fortunately for those wedded to the earlier count, the war rally failed to reach this level and, by early 2004, had begun moving down — if not in earnest, then with significant conviction. This led many to suspect that the January 2004 peak might have represented the Cycle B peak — the peak of the three-legged, "middle move" within the larger zigzag I previously discussed.

But a funny thing happened on the way to financial Armageddon — or at least the Cycle C lows. Namely, stocks stopped going down and started going up. The market made a 2004 low in August and a higher low in October. While this action alone did not invalidate the previous wave count, it was the first sign that the market might be headed higher than many Elliotticians were anticipating at the time.

Nevertheless, as I have noted elsewhere for Traders.com Advantage, the technical clues were abundant (see my "Divergences And The Bush Bounce," November 9, 2004), suggesting that a significant bottom was developing in October 2004. The only question was — would the ensuing bounce take out the 2004 high?

Figure 2: The bull market that began in the October 2002 lows surprised many bearish observers with its strength throughout 2003, as well as with its resurgence late in 2004 — after months of lower lows and lower highs.

This question was answered in fairly short order, as the market in early November surpassed the 2004 highs and, by December, had surpassed the spring 2002 highs (Figure 2). This was the development that killed the old wave count and made a new, larger count necessary. Fortunately, a new count was possible because of the October 2002 lows, which became the new Cycle A wave bottom.

So what does that mean for the 2002-05 rally/bull market? By this new wave counting, the 2002-05 bull market is a Cycle B wave, the second, three-part, motion in the middle of the zigzag pattern. Its three-parts consist of an initial advance from October 2002 to January 2004, a decline from January 2004 to August 2004, and a resumption of the advance from August 2004. Just how much further the Cycle B wave will travel is the question at hand for Elliott wave theorists whose wave accounting is compatible with this outlook.

Zigzags and the 61.8% solution

If the Supercycle bear market is a triangle and the Cycle A bear market is a zigzag, can this information help us determine the likely extent of the Cycle B wave, the second and middle move in the three-part Cycle A, zigzag bear market?

For an answer to this question, let's first reflect on what a zigzag is and, having recalled that, see if the definition of the zigzag is not the most important factor in determining the likely magnitude of a Cycle B wave that may have already surpassed the expectations of many who spent most of 2002 firmly in the bear camp.

Here's an official introduction to the zigzag, provided by A.J. Frost and Robert Prechter in their book, Elliott Wave Principle:

A zigzag in a bull market is a simple three-wave pattern which subdivides into a 5-3-5 affair with the top of wave B noticeably lower than the start of wave A.

In their helpful manual accompanying the ELWAVE software product, the Prognosis developers make the following comments about zigzags:

A Zigzag is the most common corrective structure, which starts a sharp reversal. Often it looks like an impulse wave, because of the acceleration it shows. A zigzag can extend itself into a double or triple zigzag, although this is not very common, because it lacks alternation (the same two patterns follow each other). Notice that the zigzag can only be the first part of a corrective structure.

This is all helpful information, even if most of it was covered in the previous discussion. Reading more in Prognosis' manual, we discover that:

(Zigzags) are composed of 3 waves. Waves A and C are impulses, wave B is corrective. The B wave traces no more than 61.8% of A. The C wave must go beyond the end of A. The C wave normally is at least equal to A.

This is tremendously helpful. To go right to the heart of the matter, the B wave should not retrace more than 61.8% — a Fibonacci retracement level — of wave A. A 61.8% retracement of wave A — in this case, Cycle A — would require the S&P 500 to rise to approximately 1260. This is all the case should the Supercycle pattern currently tracing itself out turns out to be valid. Reaching 1260 would require the S&P 500 to rally another 60-odd points, or about 5%.

What if the S&P 500 reaches 1260 and continues moving higher? Such a development would undermine the zigzag argument presented here (although there are variations on the zigzag, such as ELWAVE's zigzag flat, that permit a B wave that retraces more than 61.8%), but because it would be a development that is more bullish than the current bullish outlook, most traders and investors would be little affected by an S&P 500 that doesn't stop at the zigzag cut-off point. If such an event did occur, then a run to the 1400-level makes a great deal of technical sense.

If the run from the 2004 bottom is equivalent to the run from the 2002 bottom, then traders and investors should consider slapping another 350-odd points from the August 2004 low. Such a maneuver provides a price target of approximately 1400.

Bulls and bears: who's waving goodbye?

Per this analysis, the market is in a very interesting situation. Hovering near 1200, the zigzag thesis allows for another 5% advance before the 61.8% retracement level for Cycle A (or, for that matter, the whole ride down from the spring 2000 highs to the autumn 2002 lows). And if this level is taken out by prices, a reasonable upside target afterwards would be in the 1400 area.

Either way, the near-term argument is bullish — at least, in the approach to the aforementioned levels. The great reversal into the beginning of the Cycle C wave, a market move that should be devastating by the time it is through, is no less a likelihood once these advances are concluded. But between now and then, Elliott wave-oriented traders and investors should content themselves with riding the "B (for 'bull') train" as long as it is chugging higher.

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

Suggested reading

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