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The Case for New Highs

06/30/06 03:38:53 PM PST
by David Penn

An alternative Elliott wave count suggests that the summer 2006 correction is a prelude to even higher stock prices.

Full disclosure: I completely missed the October 2005 bottom. Not only that, I wrote an article suggesting that the October 2005 lows were likely to lead to lower lows "before a truly tradable move to the upside materializes" ("About That Bottom," October 25, 2005; Advantage). My bearishness on the market had dissolved by the time I wrote an Elliott wave analysis of the Standard & Poor's 500 in November ("Broads, Wedges, And Waves," November 21, 2005; Advantage), when I suggested--with the S&P 500 at 1250--"(i)f anything, bulls will find themselves chasing the S&P 500 higher (as high as 1300 ...)." But I missed the bottom a month earlier, and there's no fading that.

So maybe my skepticism of the idea that the market topped in mid-May 2006 will be proven incorrect as well. At any rate, there are a few technical reasons and a few Elliott wave-based reasons that suggest that it is quite possible that the May/June 900-plus-point drop in the Dow Jones Industrial Average (DJIA) notwithstanding, the bulls still have more control over the market than the bears do.

Let's look at the technical case first. Since making a wave B bottom in the autumn of 2004, the S&P 500 has traveled in a fairly clear-cut trend channel as it has moved higher. The lower boundary of this trend channel is only a few points lower than the 50-week exponential moving average (EMA)--a fairly decent gauge of intermediate-term price movement. Prices penetrated this 50-week EMA to the downside on three occasions since the wave B bottom. The first was in the spring of 2005, setting up what I suspect was a wave (2) low. The second was in the autumn of 2005. This time, I suspect that the low was part of wave (3)'s b-wave low (each wave in the ending diagonal that is wave C is composed of three parts, a-b-c). The third break occurred just recently in the spring of 2006, and most likely represents a wave (4) low.

Again, what stands out is that while prices broke down below the 50-day EMA, they did not do so beneath the trend channel's lower boundary. Not to put too fine a point to it, this suggests that the breaks of the 50-day EMA should be noted, but perhaps not taken with too much gravity. This is supported by the candlestick patterns that developed during these tests of the 50-day EMA and the lower boundary of the trend channel. These patterns--long lower shadows or tails that reflect a lack of selling power at the session lows--are especially apparent during the October 2005 lows and the current mid-June 2006 lows. As much as these types of candlesticks mean on daily charts, their appearance on the weekly time frame is an especially noteworthy development, ostensibly warning traders and speculators from becoming too bearish at this moment.

FIGURE 1: S&P'S 500, WEEKLY. During the 2004-06 advance, the S&P 500 repeatedly found support at the lower boundary of a trend channel that extends from the 2004 lows. Note also the bullish "hammer" candlestick pattern on the most recent test of support.

Other interesting observations include those made by Barry Ritholtz of Ritholtz Research & Analytics that were published on his blog, The Big Picture ( These observations, made public in a post titled "RR&A Trading Call" from June 15, include a set of charts that note the "percentage of NYSE stocks over the 200-day moving average," put/call ratio, "Big NYSE Volume Spike on Sell-off," and the Investor's Intelligence bull/bear ratio. In their own different ways, each of these charts points to how stocks could have made a major low with the June declines. The first chart, for example, suggests that over the past few years (during wave C), each time the number of NYSE stocks has fallen below a certain level, that event has coincided with a significant occurrence (tradable low). Ritholtz's chart notes that the June correction was the fifth time this setup has occurred.

Other interesting observations include those made by Barry Ritholtz of Ritholtz Research & Analytics that were published on his blog, The Big Picture ( These observations, made public in a post titled "RR&A Trading Call" from June 15, include a set of charts that note the "percentage of NYSE stocks over the 200-day moving average," put/call ratio, "Big NYSE Volume Spike on Sell-off," and the Investor's Intelligence bull/bear ratio. In their own different ways, each of these charts points to how stocks could have made a major low with the June declines. The first chart, for example, suggests that over the past few years (during wave C), each time the number of NYSE stocks has fallen below a certain level, that event has coincided with a significant occurrence (tradable low). Ritholtz's chart notes that the June correction was the fifth time this setup has occurred.

Different speculators evaluate sentiment differently from others. But when extremes in sentiment appear, virtually all informed observers--traders, speculators, and investors--go contrarian. As R. Earl Hadady wrote in his book, Contrary Opinion:

A Contrary Opinion situation is said to exist when most of the traders are of one mind, either bearish or bullish ... Such a situation offers the potential for making extremely large profits. So many traders are bullish, or in a reverse case bearish, that there are not enough traders left to drive prices any further. Consequently, a very sharp reversal in prices is imminent. In a contrarian situation ... a position is taken that is opposite to that of the crowd.

Hadady is the creator of a sentiment study for the futures markets called Bullish Consensus. But his discussion of what contrarianism is and how it works is broadly applicable--especially to the stock market, where a number of sentiment-measuring tools have been developed specifically for the use of speculators looking to determine when the expectations of those participating in a given market have become either too greedy or too fearful.

One of the more common of these tools is the put/call ratio. The put/call ratio measures the relationship between bearish and bullish bets on the market. Generally speaking, when the number of bearish bets (puts) greatly exceeds the number of bullish bets (calls), contrarian speculators tend to see a bullish resolution to this imbalance insofar as the speculating community is believed to have become too fearful or too pessimistic. There are two principal put/call ratios that are most widely followed by speculators: the simple equity put/call ratio, which is based on individual trades, and the S&P 100 index put/call ratio, which tends to represent institutional and "professional" trading. Despite their differences, contrarian analysis of both put/call ratios is the same.

According to Barron's, equity put/call ratios in excess of 60/100 and index put/call ratios in excess of 125/100 are considered excessively pessimistic and, thus, bullish for the markets. The past few weeks (June 5-9 to June 12-16) have seen the equity put/call ratio remain at a steady, albeit pessimistic, level from 69/100 to 66/100. With regard to the index put/call ratio, a fairly dramatic increase in the index put/call ratio from 99/100 to 126/100 was seen. In both instances, the number of puts relative to calls was significant enough in the last week for both put/call ratios to elicit bullish speculation calls.

Another slightly more sophisticated sentiment gauge is the Rydex asset ratio. Rydex is the name of a family of unique mutual funds that include opportunities for speculators and investors to make bets both for and against the market by way of mutual funds. Speculators keep close watch on the ratio of assets in bullish or sector funds versus assets in bearish or money market funds to determine whether there is a significant imbalance between those making bullish bets and those making bearish ones. The calculation of the ratio is straightforward--principally because Rydex is one of the few mutual fund families that regularly discloses asset values for its funds. To calculate the Rydex asset ratio, add the assets in the money market and bear market funds and then divide that sum by the assets in the bull market funds and sector funds:

(Money market assets + Bear fund assets) / (Sector fund assets + Bull fund assets)

Rydex asset ratio analysis comes to us courtesy of the work of Carl Swenlin, who is president and founder of the market research website While Swenlin has said that his original Rydex asset ratio analysis has been improved upon by looking at what he calls cumulative cash flow (CCFL) instead of asset totals, his original analysis remains a staple of those looking to examine sentiment at its extremes. In either event, both the Rydex asset ratio and the Rydex cumulative cash flow ratio have pointed to levels of bearish sentiment that are at extremes in mid-June 2006. In a brief article for, Swenlin writes: "This is bullish for the stock market because short-covering bears are like rocket fuel for rallies."

The last sentiment indicator I want to reference is the American Association of Individual Investors (AAII) survey. This weekly survey has the AAII polling their members to find out whether they are bullish or bearish on the market. As you might imagine, this survey is most commonly used as a contrarian indicator. With apologies to the legions of individual investors who diligently do their homework and technical analysis, this is another group whose positions are believed to be best faded when they begin to approach any sort of consensus opinion. Of the various products from the AAII survey, the one most commonly used by contrarian speculators is the bull ratio, which is calculated as follows:

Bull ratio = % bulls / (% bulls + % bears)

Generally speaking, bull ratio levels above 70% are considered bearish ("too many bulls") while bull ratio levels below 30% are considered bullish ("too many bears"). Looking at the AAII figures from the past few weeks, we see that the bull percentage has fallen from 30.8% to 26.4%, while the bear percentage has risen from 50% to 55%. Based on that equation, we get the following "bull ratio":

Bull ratio = 26.4 / 26.4 + 55 = 26.4 / 81.4 = .32 or 32%

At 32% for the week ended as of Friday, June 16, we have a market that, while not strictly bullish, is certainly experiencing a major dearth of bulls. For comparison's sake, the bull ratio was 38% two weeks previous and 36.7% the week ended Friday, June 9. So while the bull ratio has not crossed the 30% threshold in the current downturn, it is clear that sentiment has been negative and getting worse of the past few weeks. While a particularly severe bear market can result in a bull ratio that slips beneath 30% and remains there for a significant period of time, the longer the bull ratio remains below 30%, the more powerful the rally will be when sentiment eventually does shift from fear.

Much of Elliott wave analysis is intricate--maddeningly so at times. But some of the tools it provides are straightforward enough that, when deployed alongside other technical tools and sentiment analysis, they can suggest which scenarios are more or less likely than others.

The bull market in the S&P 500 from the October 2002 lows has moved in three stages. As I wrote in Working Money ("Wave Count 2006," April 26, 2006), this bull market is a cyclical one inside a larger secular bear market. As a countertrend movement, I suggested that the cyclical bull market was taking the form of an ABC correction. The first wave of that correction, "A," lasted from October 2002 to March 2004. The second wave of that correction, "B," lasted from March 2004 to August 2004. We are currently late in the third and likely final wave of that correction, the "C" wave.

Why "late"? There are a number of ways of anticipating the length of an ABC correction, but most of the more common approaches see the third C wave as some multiple of the first A wave. In some instances, the C wave will be equal to the A wave. In others, the C wave will be double or some Fibonacci multiple of the A wave. While not necessarily precise to the last digit, these approaches can help point to scenarios that are more or less likely than others--including the possibility that the ABC correction that began in October 2002 is over and that a resumption of the secular bear market that began in 2000 is under way.

FIGURE 2: S&P 500, WEEKLY. The 2004-06 leg of the cyclical bull market represents the C wave of the ABC correction that began in the fall of 2002.

Wave A of the ABC correction is approximately 350 points (using 800 as an average of the October 2002 and March 2003 lows, and 1150 as the top in April 2004). If A equals C, then we would add 350 points to the low end of wave B for an upside projection of 1425. If A is half the size of C, then we would get an upside projection of 1775, creating a new all-time high. And if A is a Fibonacci 61.8% of C, then we would get an upside projection of 1291.30--a level that has already been breached.

What makes this interesting is how the subwaves of wave C seem to be shaping up. I argued recently that the C wave was taking the form of an ending triangle ("Wave Count 2006, Part 2," Working Money). Ending triangles have a five-wave internal structure, as do all motive waves (the other kind of motive wave, according to A.J. Frost and Robert Prechter, is the impulse wave). I've written about methods for projecting the end of motives waves before for Advantage and Working Money (especially the approach suggested by Robert Fischer in his book Fibonacci Applications And Strategies For Traders). This approach calls for multiplying the length of wave 1 by 1.618 and adding that product to the value at the top of wave 1. At the same time, he has traders multiply the length of wave 3 by 0.618 and add that product to the value at the top of wave 3. Doing this provides a range in which wave 5 is expected to end.

Applying Fischer's method to the C wave yields some interesting results. Wave 1 from October 2004 to December 2004 is 118 points; 118 x 1.618 gives us a rounded-up figure of 191. And 191 added to the value at the top of wave 1--a weekly closing high of 1212--gives us a lower range limit of 1403. Wave 3 from October 2004 to May 2006 is 232 points; 232 x 0.618 gives us a rounded-down figure of 143. And 143 added to the value at the top of wave 3--a weekly closing high of 1326--gives us an upper range limit of 1469. Averaging these two results together for an ideal or target peak of wave 5, we get 1436. Recall that our earlier estimate of the length of the C wave suggested a peak at 1425.

Just a month ago, it was common to hear stock market observers wonder aloud about the possibility of a market crash. In spite of some things I've suggested about contrarianism, talk of a crash does not necessarily forestall a crash. There were many people in the late summer of 1987 who suspected that the market's ascent at that time was problematic and that a crash would not have been a surprising consequence. Similarly, there were plenty of observers who believed, and wrote, in 2000 that the dotcom mania was indeed a mania and was likely to come to a tragic end. At the same time, however, contrarianism clearly has its place--and when market observers find it increasingly easy to discuss the possibility of a market cataclysm, it is often just another sign that the mood of the market has become too bitter and too fearful, and that a surprising move back to the upside may be more than likely.

This is another reason why it is often so helpful to look at market-moving factors in concert with one another rather than separately. Here, looking at "old school" technicals like support and resistance in trend channels, "new school" technicals like candlestick patterns, sentiment analysis, and some of the (relatively more) quantitative approaches to Elliott wave analysis by way of Fibonacci applications can be an especially helpful way of understanding exactly what is going on in the market at any given time--to say nothing of those instances where any (or all) of the factors are registering extreme or unusual levels.

FIGURE 3: DOW JONES INDUSTRIAL AVERAGE, WEEKLY. The 1973-74 cyclical bear market featured a powerful 14% bear market rally in the summer of 1973 that proved to be the last chance that investors would have to unload shares before the deluge.

I have no idea whether the S&P 500 will make new year-to-date, new cyclical-bull-market-to-date highs in the summer of 2006. I've suggested elsewhere that one of my favorite bear charts is of the 1973-74 correction. That correction--which led to the lows point of the secular bear market of 1966-82--featured a powerful countertrend rally in the summer of 1973 during which the Dow 30 rallied above previous resistance levels and appeared--at least at first--ready to test all-time highs set at the beginning of the year.

To recap that seminal market meltdown, recall that the DJIA hit an all-time weekly closing high early in January 1973 at about 1047. The DJIA then began correcting, slicing through potential support between 950 and 900 en route to a weekly closing low of about 863 in late August 1973. From here, the DJIA spent the next two months rallying strongly, tacking on 123 points or about 14% from late August to late October. That weekly closing high of 987 in October was the high water market, as the DJIA quite literally collapsed over the next 14 months, falling some 410 points or nearly 42% to a weekly closing low of about 577 in December 1974.

For comparison's sake, a 14% rally from the most recent weekly closing low of 10757 in the DJIA (week ended June 9, 2006) would represent a 1,525-point bounce and a new, all-time high. A similar move in the S&P 500 would take the $SPX from its most recent weekly closing low of 1251 to approximately 1,426. As it happened, the relatively prepubescent S&P 500 in 1973 experienced a milder bounce that summer just shy of 10%. A 10% bounce from the most recent weekly closing low would yield an S&P 500 of about 1,376.

David Penn may be reached at

ELWAVE User Manual, Prognosis Software Development.
Fischer, Robert [1993]. Fibonacci Applications And Strategies For Traders, John Wiley & Sons.
Frost, A.J., and Robert Prechter [1985]. Elliott Wave Principle, New Classics Library.
Hadady, R. Earl [2000]. Contrary Opinion, John Wiley & Sons.
Penn, David [2006]. "Wave Count 2006,", April 26.
_____. [2006]. "Wave Count 2006, Part 2,", May 30.
Ritholtz, Barry [2006]. "RR&A Trading Call," The Big Picture at, June 15.
Swenlin, Carl [2006]. "The bears have hardly budged," Trading, June 16.
‡Prophet Financial

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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