Has the 5th Wave of Elliott Wave Theory Come to an End ?

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“Let me start off with this disclaimer:  I am a neophyte when it comes to Elliott Wave theory so please forgive my rudimentary analysis and labeling especially to those that are far more sophisticated in EW analysis than I.  However, the point I want to make here is not so much about the technical analysis itself but the underlying “psychology” of the current cyclical bull market and the fact that this time “is not different.”

Recently, the media has been making many comparisons between the current rally and that of 1998. It has no doubt been a stellar rally during the first quarter of this year. In a recent research report David Rosenberg stated: “It seems so strange to draw comparisons to 1998, which was the infancy of the Internet revolution; a period of fiscal stability, 5% risk-free rates, sustained 4% real growth in the economy, strong housing markets, political stability, sub-5% unemployment, a stable and predictable central bank.”

Obviously none of those dynamics exist in today’s economic landscape. However, as I pondered his commentary I began looking at past bull market cycles compared to the recent 3-year advance, and a pattern begin to emerge. This led me to do some digging into my bag of technical analysis notes that I have collected over the years. I found this bit of discussion on the basic analysis of Elliott Wave Theory and the five waves of a cyclical bull market advance (I have annotated each wave on the chart).

Wave 1: Wave one is rarely obvious at its inception. When the first wave of a new bull market begins, the fundamental news is almost universally negative. The previous trend is considered still strongly in force. Fundamental analysts continue to revise their earnings estimates lower; the economy probably does not look strong. Sentiment surveys are decidedly bearish, put options are in vogue, and implied volatility in the options market is high. Volume might increase a bit as prices rise, but not by enough to alert many technical analysts.

Wave 2: Wave two corrects wave one, but can never extend beyond the starting point of wave one. Typically, the news is still bad. As prices retest the prior low, bearish sentiment quickly builds, and “the crowd” haughtily reminds all that the bear market is still deeply ensconced. Still, some positive signs appear for those who are looking: volume should be lower during wave two than during wave one, prices usually do not retrace more than 61.8% of the wave one gains, and prices should fall in a three wave pattern

Wave 3: Wave three is usually the largest and most powerful wave in a trend. The news is now positive and fundamental analysts start to raise earnings estimates. Prices rise quickly, corrections are short-lived and shallow. Anyone looking to “get in on a pullback” will likely miss the boat. As wave three starts, the news is probably still bearish, and most market players remain negative; but by wave three’s midpoint, “the crowd” will often join the new bullish trend. Wave three often extends wave one by a ratio of 1.618:1.

Wave 4: Wave four is typically clearly corrective. Prices may meander sideways for an extended period, and wave four typically retraces less than 38.2% of wave three. Volume is well below than that of wave three. This is a good place to buy a pull back if you understand the potential ahead for wave 5. Still, fourth waves are often frustrating because of their lack of progress in the larger trend.

Wave 5: Wave five is the final leg in the direction of the dominant trend. The news is almost universally positive and everyone is bullish. Unfortunately, this is when many average investors finally buy in, right before the top. Volume is often lower in wave five than in wave three, and many momentum indicators start to show divergences (prices reach a new high but the indicators do not reach a new peak). At the end of a major bull market, bears may very well be ridiculed (recall how forecasts for a top in the stock market during 2000 were received).

 

 

If any of this sounds familiar — it should. We have been here twice before in recent memory. In the second chart I have done some plotting of previous 5-wave cyclical bull markets. At the top of each cycle the belief was that everything could be sustained. Analysts were writing research about the cheapness of the indexes at current levels and how they would rise by another 100% or more. Economists predicted increasing economic prosperity. The media discussed why “this time is different”. Of course, the end result was that none of it was true. The subsequent declines retraced either most or the entire previous advance, leaving investors battered and broke in its wake.

 

 

The reality is that markets cannot travel in one direction indefinitely. The laws of physics do apply to the stock market, and for each action there is an equal and opposite reaction. In the case of the stock market the larger the advance during the bull market cycle (both in time and magnitude), the larger the correction process will be either is depth or duration. Of course, this simply isn’t a phenomenon that has been witnessed over the last 15 years of this current cycle. The chart is the inflation-adjusted price of the S&P 500 with a growth trend line. The blue area chart shows the amount of time and deviation the market spent above and below its long-term growth trend.

There are a couple of important points here:

• The market has ebbed and flowed between secular bull markets and bear markets since 1900. For each period of time that was spent above the long term growth trend, there was time spent below it.
• Currently the market has already spent a significant amount of time above the long term trend line beginning 1995 which indicates that the current secular bear market correction cycle still has further to run.

With the current push in the market being very much driven by expectations of continued liquidity injections, hopes of a European crisis resolution and economic recovery, there is little real strength in underlying data. The economy remains very weak and subject to external shocks, earnings are beginning to slow dramatically and profit margins for corporations and consumer budgets are under attack by rising commodity costs. The current environment is very reminiscent to what we have seen in prior Wave 5 advances:

• The news is almost universally positive and everyone is bullish.
• Many average investors finally buying in, right before the top.
• Volume is often lower
• Momentum indicators are showing divergences
• Bears are being ridiculed

While the markets could certainly advance further from here, there is no doubt the next major correction is coming; the only question is: “When?” That is an answer that we can only postulate on. However, what is most important is identifying the change in trend when it occurs and reduce portfolio risk accordingly. The current market environment does not have the benefit of the tailwinds that existed in 1998 as laid out by Rosenberg or the benefit of the mortgage equity extraction/credit boom of the 2004-2008 cycle. However, with our model currently on a “buy” signal since December, and portfolios subsequently almost fully allocated to their model weights, this current unabated rise in the market is more than a little uncomfortable.

With the risk/reward of being invested in the market now grossly out of favor, we are on the lookout for the changes in our indicators that will warrant reductions in equity exposure and increases in cash levels. That hasn’t occurred as of yet. However, as we saw last April, that change can come quickly. The good news is that, when the correction begins, we will have ample time to readjust portfolios accordingly. The next secular bull market is on its way. However, it will most likely require one more major market correction before we get there.”

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