Reading the S&P 500's Crashing Waves

by: Michael Shedlock October 10, 2008 | about stocks: SPY    
Michael Shedlock

Michael Shedlock

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In Elliott Wave terms the S&P 500 is in wave 3 of 3 down. I will attempt to explain this in terms those not familiar with Elliott Wave can understand. Here goes:

Wave 3's are long and strong and unrelenting. They can be in either direction. When wave 3 is headed up, everyone is waiting for a pullback to get in. That pullback never occurs.

When wave 3 is down everyone wants a rally to either get out or get short. Those rallies either occur intraday or they do not occur at all.

Wave 3 of 3 is where everything you do is right or everything you do is wrong, depending on whether you are long or short. Playing for countertrend moves is highly unlikely to be a winning move for anyone but the extremely nimble.

With that backdrop, here is a chart of the S&P 500 with the wave 3 of 3 "crash count" highlighted.

S&P 500 Weekly Chart



click on charts to enlarge

In Elliot Wave theory, "impulsive" waves trace out in patterns of 5 and corrective waves in patterns of 3. Note 5 clearly distinct waves down off the October 2007 high until the March 2008 bottom (the big red 1).

Wave 2 up, a corrective wave(the big red 2) peaked in May. When wave 2 ended, wave 3 began. In theory, wave 3 like wave 1 should subdivide into 5 clearly distinct waves. Indeed that is how it seems to be playing out.

Wave 3 of 3 Down

Wave 1 of 3 ended in July, Wave 2 of 3 ended August, and we are now in the unrelenting 3 of 3 down where every attempt to play for a bounce has been like "catching knives".

I have a small blue 3 labeled, but that is not final. We do not know where 3 of 3 down finishes. Here are the implications.

Given that we are in a 5 wave impulsive pattern, wave 3 of 3 has to end first before we can think about the 4 of 3 up. 4 of 3 up will be followed by 5 of 3 down. If this sounds complicated, just look at the chart above with waves (1 of 1, 2 of 1, 3 of 1, 4 of 1, 5 of 1) all distinctly visible with blue numbers, ending with a big red 1 down.

Wave 4 of 3 UP

Where to from here? Wave 4 of 3 up has not started yet. Technically I expected wave 4 of 3 to start at 960. However we blew right through that number to the downside.

I do not expect wave 4 of 3 up to be a strong up although it could be reasonably long (2-3 months) in duration. Here is the reason to NOT expect a big bounce:

Sentiment in a wave 2 up is often very strong as it is accompanied by big short covering rallies. In wave 2 up, people still believe “we are off to the races again”. No one is convinced the bull market is over. Indeed, I received more than a few taunts about the S&P only being down 10% for the year. Most had expectations that a new high would soon be forthcoming.

In wave 4 of 3 up, sentiment will be more of “suspicion” as opposed to “we are off to the races again”. Consider the big 3 of 3 down as the “recognition” phase where everyone finally realizes all is not OK.

If we continue heading south as it looks, the 960 target for 3 of 3 we blew past on the downside, could serve as huge overhead resistance in any corrective wave up.

Wave 5 of 3 Down

If the pattern plays out like it is setting up, wave 5 of 3 down will reverse all of the gains of 4 of 3 up and then some. Once wave 5 of 3 down ends, we can then put in a big red 3 on the chart.

See the chart below for how this may look.

Wave 4 Up

Wave 4 up will begin after 5 of 3 down finishes. Look for wave 4 up to be choppy and overlapping (ups and downs in seemingly random patterns). 4 up will be tough to play. It is best to avoid it unless you are extremely nimble.

Once again, "suspicion", as opposed to “we are off to the races again” will be the overriding sentiment.

Wave 5 Down

Wave 5 down will be the washout phase where everyone throws in the towel who is going to. Pessimism will reign supreme and many will swear off the stock market for good. Given that we blew straight past 960 without so much as a pause, the likelihood that wave 5 down blows right through the 2002 bottom is quite high.

Possible Pattern




Notice that in the grand overall scheme of thing we are likely in wave 3 of 3 of C down, clearly nasty stuff. The target of 600 is an estimate based on an approximate retrace of 62% of the peak of Wave B (.38 * 1576 = 599).

A 50% retrace would stop close to the 2002 bottom of 775-800. Unfortunately, we are running out of time for that to be a likely target. That is one of the implications of blowing past 960 without so much as a pause.

The Theory And The Man

I have taken a lot of flack for many years about Elliott Wave. Nonetheless, I think it is a valid tool. I tend to use E-Wave when the patterns are clear. However, E-Wave is not the be all or end all of anything. No tool is.

Here is a word of caution: If you are determined to find patterns of 3 and 5 you can easily find them, even when they are not really there. Much of this is subjective. However, if one just steps back without a goal of forcing patterns, the clear valid counts will scream right at you.

The charts above are screaming. Those are the charts you want to pay attention to.

Much of the maligning of E-Eave is on account of its founder, Robert Prechter. This is where it is important to separate the tool from the man. As many know, Prechter has been calling for a crash for decades. He has also called for gold to retest the lows near 250. Time and time again Prechter has given conditions in which he would proclaim a new bull market in gold. Time and time again he has failed to do so.

Prechter needs to come out and say "I was wrong about gold" and "I was hopelessly early on my crash call". Instead, his personal wave counts have frequently been convoluted. Many E-Wave practitioners do not pay attention to much of what he is saying.

However, that is a slam against the man, not a slam against the methodology.

Socioeconomic Theory

It is important to note that Prechter has led the way in aspects of socioeconomic theory such as attitudes change first and price follows. Prechter is correct and here is a prime example:

Think back to the Summer of 2005. People were camping out overnight hoping for the chance to buy a condo in Florida. Overnight sentiment changed. It was many months before there were significant price declines in housing. Yet, you still hear today ideas such as "consumer sentiment is down because house prices are down". Such statements are clearly backwards.

Home prices will not go up until sentiment changes, not the other way around.

Right now, people are still walking away from homes. That is one reason why liquidity measures by the Fed and Treasury are doomed to fail. More philosophically, You Cannot Patch a Busted Dam With Water.

The Fed and the Treasury could probably learn a lot from Elliott Prechter. There is almost no chance they will listen.

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This article has 15 comments:

  •  
    Oct 10 01:09 PM
    Very interesting and helpful.
    As far as declaring the bull market in gold, Prechter may yet be proven right. There is still an awful lot of deflation that may occur. The other commodities as well as mining shares are not confirming the current gold bull move. It also makes me a bit nervous to hear anecdotal evidence of physical gold unavailable to long lines of customers. There's your camping out for condos equivalent. Not that the guy in the street is always wrong - he's not. When silver hit $35 back in the day, there were enormous lines to sell the family sterling. Those folks were absolutely right. Go figure.
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  •  
    Oct 10 01:25 PM
    Knowing the wave patterns has always prejudiced the traders to expect and behave in conformance. So, do we believe that EW theory is descriptive or predictive? Frankly it seems to help me to avoid madness when I am despairing of the markets. But I would never admit that in public of course. Nice investors do not do EW.
    Reply | Link to Comment
  •  
    Oct 10 01:29 PM
    The wave count here is the most bearish possible. Other wave counts are possible. For example, it is possible this is an ABC from the top in Oct. (WXY from the prior top, we would be in wave Y, or another variation), and that we are mostly through it. In the ABC scenario, we would be in 3 of 3 of C of Y. Wave 4 would be a strong bounce, and in this case, Wave 5 might be considered a failure. A failure is when wave 5 does not go below the wave 3 lows. This occurs when the prior wave goes too far, too fast, and that certainly seems to be the case here.
    In 1987 for example, that is considered by most to be a 3-3-5 correction. In other words, the new high was part of a B wave correction (3 subwaves), and then the C wave was 5 waves down. However, the wave 3 low that was the crash, was never broken by wave 5. After that crash low, a triangle pattern is traced out, which is common for wave 4's. The wave 5 after that held well above the wave 3 lows, and you can see that wave 5 subdivided further into 5 waves.

    So, from an Elliott Wave perspective, the bear market probably isn't over even if we put in a good bottom here. But, from a price standpoint, that doesn't necessarily have to agree.
    Reply | Link to Comment
  •  
    Oct 10 02:59 PM
    Tuesday is the 10th of 12 full moons this year. Expect that to influence things too.

    "Combine Elliot Waves with full moons and you can't lose."

    Very famous saying, or at least it ought to be.

    Seriously, Elliot Waves are a good framework for placing yourself in the big picture market-behavior-wise. I just added the full moon stuff to throw the masses off the trail. ;-)
    Reply | Link to Comment
  •  
    Oct 10 03:56 PM
    There is another Theory that explains all this wreckage… When Uranus is perfectly aligned to Neptune (as happened on Monday October 6) the market will drop around 20% in value for the entire week, and on the fifth day, clueless “prophets” will try to scare people by forecasting a series of powerful waves that will destroy the world as we know it but that is a sign from the stars hinting the markets will recover most of the value lost during the next weeks! It’s totally explained by Nostradamus…
    Reply | Link to Comment
  •  
    Oct 10 04:34 PM
    Th only prophets I trust are Gary North, Ron Paul, Lew Rockwell and Jim Rodgers. And the ones in the Bible.
    Reply | Link to Comment
  •  
    Oct 10 04:55 PM
    E.W. WAY over-analyzes the situation, like trying to fit a polynomial curve to 5 data points.

    Simply look at any 25-yr chart and it is obvious that we have another 1000 points to go down on the DOW (100 points on the Russell 2000), before we get to any significant suppot level. We're at least 2 days away.

    And we may blow through support considering the relentless velocity of this market, because it MIGHT 'be different this time.' (In my humble opinion IT IS.)

    So stay in cash people, we're not there yet.
    Reply | Link to Comment
  •  
    Oct 10 09:16 PM
    Great article!!!
    Reply | Link to Comment
  •  
    Oct 11 05:11 AM
    Wave goodbye to your money
    Reply | Link to Comment
  •  
    Oct 11 01:05 PM
    I follow EWI and subscribe to their publications. I attemp to follow EW theory and wave count, though I am by far no expert and tend to get caught up in the never-ending show of governmental attempts to "fix" the "problem" and "instill confidence", as if the President can do such a thing by speaking every morning at 10:30. You can see how much confidence he "instills" by watching the market action as he and Paulson appear before the cameras. Same for Congress. I must apologize to myself for being human and allowing my own emotions to override my strategy from time to time. But who doesn't?

    Not only has the EWI Financial Forecast generally been right about the wave count (though it is by design backward looking) and the relationships about wave segments, it has damn sure saved my financial bacon in the stock market. Keep in mind that the waves of buying and selling are the psychological expressions of the mass public. The stock market is their mirror and at this time in history it is expressing fear and loathing of stocks, commodities, bonds (except treasuries) and flight to safety.

    The author of this article clearly explains the current status of the market and the wave count. He describes waves 4 and 5 and what they will likely lead to. However, he is not painting the entire picture. The 5th wave he is illustrating will not be the end of the c wave. We are currently in the 3rd Minute wave of Intermediate wave (3) of Primary wave 1 of Cycle wave c.

    This implies, if correct, that there are two more waves remaining of Intermediate wave (3), to be followed by Intermediate waves (4) and (5). Following those, next to come will be Primary waves 2-5, each with its own sub-sets of 5 Intermediate waves and each Intermediate wave with its own subset of 5 Minute waves.

    Once Primary wave 5 is complete, Cycle wave c will be over. By that time (several years), the stock market could be back to the levels of 1974, the previous Grand Supercycle wave IV. Somewhere in the vicinity of 400 on the Dow.

    Will it work out like this? Nobody knows, of course. But the unthinkable is happening around the world right now. Nobody would have predicted 40% off the market a year ago either. Nobody would have predicted the failure of virtually all the 100 year old investment banks, AIG, Freddie and Fannie and on and on.

    When GM, Ford, municipalities and states are declaring insolvency and the Federal government finally realizes that it does not have the power (brain or financial) to put it all back together again, we will be living in a much different world.

    Cash and short funds have been the best investment recently. Cash has beat everything else over the past 10 years. It is still king.

    Reply | Link to Comment
  •  
    Oct 11 01:10 PM
    Buy SSO and UYG right now. If it goes to $6, big deal. In six months it will $20. That's all that matters. No one ever got poor buying close to the bottom. The American economy will recover. That's why the dollar is strong. Because everyone on earth trusts the American economy. America has $20 trillion in reserved funds. I got in Friday, and if it goes down again this week, I'm doubling down. Am I trying to bolster the stocks? Of course not. I don't need to. I'm trying to share some of the greatest trades you will ever see.
    Reply | Link to Comment
  •  
    Oct 11 05:27 PM
    I hear a lot of Prechter bashing and most of it is timing related, not substance related. Prechter's book alerted me to the concept of manias and explained what a ponzi scheme the market is so I owe him a huge debt for this. At the same time he does try to treat EWT as a new religion or something and I think your views in that regard are far more balanced and correct.
    Reply | Link to Comment
  •  
    Oct 11 08:48 PM
    avenger: i think you have it right. this reminds me of my days playing the horses. there's always touts hanging around telling you what the races should look like based on the old programs they are carrying in their briefcases. each race looks like it might follow the pattern of some previous race and, in fact, they do. you just don't know which pattern they will follow. why? because something is always different. the jockey is different, the horse took a dump before the race, it rained last tuesday, there is a headwind, someone bumped someone else during the turn, someone got boxed in along the rail. my friends, i think it was shakespeare who said that "our fate lies not in our stars but in our hands." take hold of the reins. show the horse the whip and lean into the turn. you don't want to go home with money in your pocket.
    Reply | Link to Comment
  •  
    Oct 12 10:05 AM
    Good article captures the current frightening sentiment in the financial markets.
    Reply | Link to Comment
  •  
    Oct 27 01:09 PM
    The one mistake Mr. Shedlock is making with his EW analysis is discounting "the rule of alternation." Thus he stands to miss the biggest rally in years.

    The simple fact is this...

    The corrective wave currently unfolding from the Y2k top should be relatively more complex than the corrective wave that unfolded from Q4 1976 through Q3 1982. Thus, one should minimally expect an a-b-c-x-a-b-c form to unfold from the Y2k top.

    The first a-b-c formed from 2000-2003. Wave x topped last October. The second wave "a" is completing (taking a 3-3-5 "flat" form). The second wave "b" is due next and should result in the biggest rally since 2003.

    By way of the same "rule of alternation" expect a zig-zag (up) to form this second wave "b" since the Y2k top.

    It is entirely possible new, all-time record highs could be set during the formation of the coming wave ["b"] up. It's a fact the first wave "b" in the [potential] a-b-c-x-a-b-c unfolding since Y2k did NOT set a new, all-time record high. Thus, again by way of the "rule of alternation," one might anticipate the second wave "b" will do what the first wave "b" did not.

    First things first, though. We're still looking for the next "Vince Farrell bottom." Current intra-day lows should not be too greatly exceeded before this bottom is in. It could take some weeks, too. So, my advice is be patient and remain calm...
    Reply | Link to Comment
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