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A look at the stock market through Wave Theory

If Wave Theory is watched by enough investors it can become a self fulfilling prophecy much like other indicators.
If Wave Theory is watched by enough investors it can become a self fulfilling prophecy much like other indicators.
Amatuer Investor

Usually Elliot Wave analysis leaves one with two possibilities or patterns. Unfortunately one is usually up for stocks and one is usually down. So many traders take Wave Theory with a grain salt. Then again one can look back historically and the relationship of the moves and match them to Wave theory. But less clear is matching Wave theory to a current scenario and then looking forward.

In a very real sense if enough traders are looking at wave theory then there is some, however large or small, measure of credibility. If enough traders and investors trade with this in mind it can be a self fulfilling prophecy just like with other indicators and moving averages. If enough people are watching them then prices may react to them. So whether you give wave theory great reverence or not, it can pay to be aware of it.

This latest current move is interesting because the next move according to wave theory should be down. In tis case one just can't tell when or how far. An explanation is as follows:

From a wave analysis perspective there was a pretty clear 5 wave move down from the high at 1371 in the S&P 500 which then bottomed at 1075. So under wave theory we have to be in a Wave 1 of a larger 5 Wave drop or "A" of a less severe "ABC" type correction. What follows is a comparison:

Chart 1

If the latest move down was wave 1 of a large 5 wave pattern, then the current rally would be a wave 2 of 5 bounce. So once the wave 2 of 5 bounce ends then wave 3 of 5 would develop followed by waves 4 and 5 to complete this pattern at some point most likely in 2013. So this also would most likely lead to an eventual retest of the March 2009 low as the entire move from late 2007 would evolve into a large "ABC" type corrective wave.

Chart 2

If we look at a historical chart of the S&P Composite using a log scale notice the longer term upward trend line (blue line) and the trend line connecting the 2002 and 2009 lows (green line) coincide in the mid 600's. Additionally notice the 61.8% retracement from the mid 1970's low to the late 2007 high also resides in the mid 600's. So from this perspective the mid 600’s has some major long term support.

Chart 3

The second pattern under wave theory would be that the move down from 1371 is evolving into a simple "ABC" correction, and that "A" bottomed at 1075 while the current move up is "B". Once "B" ends then "C" would occur most likely with a drop back to the 1000 to 936 range. The 1000 area is near the 50% Retracement area from 667 to 1371 and is where the S&P 500 held support at in July of 2010 (D) while 936 is the 61.8% Retrace from 667 to 1371. So if it was this pattern that was to play out then the previous low made in March of 2009 would never be retested.

Chart 4

An "ABC" type pattern did occur from the early 1930's through the early 1940's as the S&P Composite never did retest its prior low made in 1932 that was related to the big depression.

So what can be gleaned from this if one is not an avid Wave Theory follower? Well, first this current move up will end and the market will head lower. (That sounds like a safe 100% prediction); but we have resistance levels to help us with how high can it go before it drops, and we have the two wave theory scenarios which may signal how far down it may go. Even if only one can be right, if either. With this in mind if stock prices drop beyond the “ABC” corrective scenario we can look for a much far bigger fall.

Trade with a plan.

(For help on how to make a trading plan on this site)


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