Here's what I think is going to happen (S&P 500 numbers. I'll cover numbers based on the DOW later in the article):
- The market will fall further in the coming days. Not further than 1174.14. Most likely to 1239.59.
- The market will then rally. It will at least get as high as 1344.07. The likely top will be 1344.55.
- The market will then enter a bear market. There is no way to measure how far it will go. My best guess is that it will end around 1050 for a loss of about 17% from here, or about 22% from the likely next peak.
Here's a picture:
Got your attention? Predictions to the penny? First let me state quite clearly that I am not an investment advisor and do not give investment advice. Make your own decisions! Okay let me explain how we get here.
Technical Analysis
My predictions (an awful word) are based on technical analysis. That is, by analyzing the price action of the stock market. This is opposed to fundamental analysis that makes prediction based on economic information. One finds analysts in either of these camps. The technical analysts are quite happy to take money from those who trust fundamentals.
To determine market direction I rely primarily on Elliott Wave analysis ("rules" that govern the movement of markets) and back this up with historical analysis (repeating patterns). Finally I cross reference multiple markets to look for correlation.
To determine specific price points I use Elliott Wave analysis, Fibonacci analysis and gap fill theory.
A Gentle Introduction to Elliott Wave
Terse books have been written about Elliott Wave theory. If you've never traded then you probably have never heard of the theory. It will sound like bunk. Many technical traders believe it is bunk. Most people who try using Elliott Wave fail. Most of them give up. The others don't make much money at it. There's the caveat. The thing is: it works.
The theory goes like this. Markets always go up in the long run. (Heard that before right? The catch is that they can go down for long periods of time, some hypothesizing as long as 400 years as in the dark ages). We all know markets go both up and down, so for markets to continually go up in the long run requires a basic mathematical function. Either (a) up waves are bigger than down waves or (b) there are more up waves than down waves. Elliott Wave theory incorporates a little of both.
The main part of the theory is what drives markets and is called the "motive wave". It looks like this:
There are 5 waves. Waves 1,3 and 5 are directional waves. Waves 2 and 4 are correctional waves. Since there are more directional than correctional then the market's movement is up. There are also a few rules. The 3rd wave must not be the shortest (in terms of price differential). The 4th wave must not enter the price zone of the 1st wave. The 2nd wave cannot go beneath the 1st wave. These rules ensure that a motive wave is completely directional.
Yes, this works. No-one told the market it has to do this but it does. It has always done this and Ellioticians have combed through hundreds of years of stock charts and not found exceptions (well, there is one known exception but it is quite rare).
The directional waves are themselves motive waves. If you dig into wave 3 you'll find it is a motive wave:
As you can see, note every directional wave looks as picture perfect as the first one I showed you. This is part of what makes the theory difficult for many. You have to be good at spotting waves and also good at making sure they don't break the rules. You can drill down like this right down to 1 minute charts and see the waves. Once you practice, you can even sit there and watch a ticker and see the price action moving in waves in the span of seconds.
Those are the rules. The implication from these rules that is most noteworthy and relevant to price prediction is that the directional wave can extend. You can see in this chart that we're forming another directional wave at the top of the chart and that these waves together will form a larger directional wave...or will they?
Correctional Waves
While there is only one type of directional wave there are three main categories of correctional waves. The art of Elliott Wave is really in parsing the correctional waves because they are ill behaved compared with the motive waves. The main thing about correctional waves is that instead of being 5 waves they are composed primarily of 3 waves. The main types are:
Flat:
Zig Zag:
Triangles (I had to go to the 2004 market to find an example) :
A flat is composed of 3 waves (A,B,C) that are 3, 3, and 5 waves respectively. A zig zag is 5/3/5 waves. A triangle is 5 waves that are all composed of 3 waves (3/3/3/3/3). Like motive waves, correctional waves can also extend and do so by adding an extra 3 wave in between. They can then attach together kind of like atoms in a molecule.
Those pictures are pretty straightforward but what about this one?
Yup, that's the current correction. Note that the B wave is higher than the last motive wave. This is actually fairly common and a key reason why many fail at wave counting. Note also that the third wave is a question. If it turns out to be a 5 wave then the whole thing is a flat, which probably means we head up. If it is a 3 wave then we definitely continue. The reason I said "likely" is because, as I stated earlier, a correction can extend. That's the thing about Elliott Wave. It is not really deterministic. It is semi-deterministic. It can tell you where you will go but not how you will get there.
Where Are We Now?
Back to our picture. I'm reasonably confident that the wave that is developing now has become a C wave. It requires a few more directional waves to complete, and it must go lower than it is. The price projection I gave was 1239.59. This is arrived at from Fibonacci analysis. Quite simply, market waves tend to be Fibonacci ratios of prior waves. In this picture:
I can multiply the length of wave 3 by .618 and it projects the price point that the correction will land at. I can also multiple the length of wave (i) by .618 and it projects the length of the as yet uncompleted wave (v). These two projections end up within a few pennies.
Likewise, the projected top of the theoretical final wave 5 (in red) is a .618 projection of wave 3.
We are very lucky with our current wave count because wave 1 happens to be larger than wave 3. Since the rule states that wave 3 cannot be the smallest, this means that wave 5 will have to be less than wave 3. That provides the theoretical roof. The other rule that wave 4 cannot penetrate wave 1 gives us the theoretical floor.
It is possible for the motive wave to expand. What I have labeled as wave 3 could become wave 1 of wave 3. It is highly unlikely in general but this is why I use historical analysis and cross market analysis to rule out such possibilities.
Back to the big picture though you might be asking, what about the final 5th wave? Shouldn't this be going way past that red five wave? In fact many, many people looking at Elliott Wave believe this. In order to recognize that this isn't the case we have to zoom out:
This is a chart of the S&P from 1982 until today. Most everyone has heard of the 20 year bull market but the picture is striking. It is also wonderful from an Elliott Wave perspective. The bull market is a 5 wave pattern. The exact location of the waves is somewhat debatable as there are always many theoretical wave counts in a long wave but any way you slice things, it is done. The red waves are (A) dot.com crash, (B) Real estate boom, (C) Financial panic, (D) Current Recover, (E) My predicted bear market. You'll note that each of these is 3 waves. Crucially, A/B/C are all 3 waves which means that this must be a triangle correction and therefore that D and E will exist and will be 3 waves. The other wonderful thing about triangles is that (excluding the possibility of extension) they always end in another up move.
Correlation With the Dollar
It is no secret that today's recovery is financed by a weak dollar. Criticism of the Federal Reserve's "money printing" is widespread (this blog included). What is not understood by most however is that this is not a recent phenomenon:
Looks familiar? A/B/C/D are all 3 waves. We are currently in the final 4th wave correction with a projected bottom 7 pennies lower than the previous bottom. It is the oscillation in the final purple triangle that is causing the volatility in the market. Those purple lines will trace out D and E triangles which will mark the bottom. The market will then recover during the 5th wave. Then finally, the dollar will soar (relatively, please consider the big picture still) for a wave E which will effect a bear stock market. After which the dollar will resume it's unceasing slide.
To show you how global markets are interconnected consider the following picture:
This is a recent chart of the Australian dollar. Note how it forms a triangle pattern. The bottom of the triangle is "support" and the top is "resistance". I stumbled on this a few days ago. The black bars indicate up days in the US stock market. The red bars indicate down days in the US stock market. One could watch the Australian dollar oscillate between these support/resistance zones and call the movement of the stock market. Of course this is really movement of the US dollar but the global dynamics created an amazing leading indicator.
The brown bars indicate days that are both up and down. This is logical since the width of the triangle at the apex is so small that the Aussie is bouncing intra-day. As the bounces on the currencies speed up, so do the swings in the US stock market. What is evident from this chart is that it cannot go on like this indefinitely! Somewhere between now and the apex it will have to break in one direction or the other. If we were futures traders we would be buying the Australian dollar. Which indeed is what the triangle indicates. People who are buying form the bottom bar (stable) and people who are selling form the top bar (less and less of them). Soon there will be no-one selling, at which point it will go through the roof (only to collapse later when all the recent buyers find no-one to sell to at the top!)
Note that currencies are a global market and the oscillations are continuous despite the fact that we only see the 9:30 - 4:00 action on this chart. The S&P is also 24 hours (traded on the Globex futures exchange) and much of the Elliott Wave occurs behind the scenes! This makes daily wave analysis quite difficult on the S&P. I have access to extended hours charts which helps but in a pinch one can always cross reference the individual charts of component stocks to make sure something wasn't missed.
Historical Evidence
Whew. You may have heard about the potential for a horrific end of days crash. This is prevalent in the Elliott Wave literature (the dark ages scenario). Thankfully, the triangle pattern ensures that we are heading up, not down. Of course there's nothing in Elliott Wave theory that states how far we must got up but for some comfort we can turn to some historical reference points:
Look familiar? Look at the numbers on the right of the chart to see how far we've come. This is the stock market from 1950-1980. Evident will be a 20 year five wave bull market (note quite as crystal clear as 1980-2000 but just as motive). So 1968 was a stock mania and crash. Instead of Internet stocks it was conglomerates. Just as nuts as our own dot.com fiasco. In 1970 we went off the gold standard which created a financial boom (and massive inflation). 1973-1974 was a financial panic, the infamous bear market. We then experienced a tepid recover into 1976. This was followed by a recession until 1980. If this pattern doesn't hit you over the head with a hammer then I don't know what will. Maybe this:
Stock mania. Currency devaluation. Financial Panic. Tepid Recovery. Recession. Not quite as easy to see but again the wave count is 3/3/3/3/3. Part of the problem here was the currency devaluation changed the scale of the dollar. Also World War II slowed down the first wave of the "tepid recovery". You might note the shape of the 1942 bottom and compare it with the shape of the 2009 bottom. Quite dramatic however is what you see when you zoom in on 1946:
The top of the market (to the right of the gap) is A/B/C. The wave patterns match our own market quite strikingly. Note the second test point of the correction is just a few points shy of the first correction just as I'm predicting for our own market.
Unfortunately history never repeats exactly. The top of this market was the lobe to the left of what appears to be the top. It is a slightly different wave count from our own and demonstrates how Elliott Wave can shape a market the same way using different patterns. I see this all the time when I see a stock going up and down with the market even though the market is in a directional wave while the stock is in a correctional wave! I believe this sort of thing could throw a lot of traders. They might look at the 1946 chart and sell their stocks way early. (Or go short, think they are wrong, and lose a lot of money in a so called "bull trap"). Of course the other possibility is that my own wave analysis is wrong. The nice thing about Elliott Wave is that you know when you're wrong relatively quickly and I would be sure to blog such an update.
How Far Down?
Elliott says nothing about the potential length of the E wave down. It could bottom out at the floor we found in 2009. It could go further. It could go just a few points. Again we look to the historical context for clues. Notice how both in 1946 and 1976 the market bottomed half way down (look on the 1929-1946 chart as the zoom is only showing the top half of that market). I believe that the point that the E wave finished represents the "mean" of the market. It is the pivot point that the market has oscillated around for a decade. There is a theory that the market prices trace out a bell curve over periods of time and I believe that this point would represent the mean on the bell curve.
However I have another useful tool for predicting the extent of long drops. Gap fill theory:
This is a chart of SPY. This is an ETF that tracks the S&P 500 and is the most widely traded security in the US market. It has been traded since 1993 and what you are looking at is a portion of the market around September of 1996. Gaps are spaces that are created in a chart when a stock opens higher than the previous days high price. A "gap fill" is when the market retreats to cover that open space. In this chart you'll see the blue arrows that indicate gaps that were left open but which the market back tracked to fill. This actually happens probably two or three times a week and represents very high probability trading! What is noteworthy however are the two black gaps. The market never back tracked to fill these gaps. They were left open. Gaps that are unfilled represent points in time when the market "takes off". Often they are good places to look for the start of powerful motive waves.
That lowest unfilled gap was at 67.73. Now take a look at this:
This is the lowest point of the 2009 market bottom. The low for the day? 67.1. Yes, the market reached back 16 years later to fill the gap. It's incredible and I challenge anyone to dismiss this as coincidence. There were in fact 3 gaps in that one motive wave 9/96 and 11/96 which means it was an incredible propulsion point. The market gained 20% in the next 6 months in a dramatic motive wave. No doubt this was related to widespread adoption of the Internet. Aside from those 3 gaps there were no unfilled gaps that the 2009 crash covered. It reached down specifically to fill those gaps.
Not to say that all gaps are filled. There is one more unfilled gap in the SPY at 46.57. No doubt some of those who were calling for the S&P to reach 400 (DOW 4000 or so) were looking at that gap. Quite possibly it does in fact represent some future low for the market in a dreadful time when this extended supercycle wave collapses. 2040? One can only imagine. The triangles however give us reasonable assurance that this is not where we're heading today though!
There are of course gaps that are unfilled going back even further in time. There is a gap in the DOW at 671.46 from January 1975. The 1980 bear market reached all the way down to 729 but didn't chase this gap. Surely there are also gaps going back to the 1920s. Whether these will be filled or not are a matter of conjecture. One will know if the market is heading there long before it gets there.
What is relevant today however are the most recent unfilled gaps. While there are gaps in the S&P index there are no gaps in the SPY below 98.09 and it is only a penny and the market clearly reached back for it. I think this is an aberration. The lowest unfilled gap therefore is at 105.98 on the SPY, roughly equivalent to 1053 on the S&P (multiply by 10). There are further gaps at 111.61 and 119.17. These gaps could be called "yawning". They are begging to be filled and the lowest unfilled gap is exactly at the same position that the 1976 and 1949 markets bounced.
1050 is therefore my prediction based on (a) the existence of the gap and (b) historical precedent of stopping at the mean.
How Long?
I do not have a good method for predicting time lines. I think any analyst who tells you "the market will be at X at the end of the year" should be tossed out the window (perhaps ironically, timing systems based on astronomical data are more accurate than analyst predictions!). The 1946 market collapsed in a panic while the 1976 market was a dreadful 2 year ordeal. I think some indication can be taken from the waves leading up to where we are. I believe the 1946 drop was hurried because the 1st wave dragged out. You'll recall that the first wave of the 1946 rebound was essentially put on ice by World War II. The market moved very quickly at the end of the war as if it were making up for lost time.
The 1974-1976 market took two years to rebound, just a few months shy of our own rebound. However, the stock mania and financial panic played out much more quickly than our own. I suspect our correction will go quickly but probably not develop into a panic. My best guess is a year. Timing is one of the ways in which news and political decisions can affect the market. The other way is amplitude (noting how much higher the 1970s financial boom was compared with it's stock mania due I believe to the currency devaluation). Also affecting both the 1970s and 1930s markets were the horrific combination of currency devaluation and price controls. These completely uneconomic political solutions probably caused these corrective periods to last much longer than necessary and possibly increased the amplitudes.
Unfortunately the only way to really know is to watch the wave count as it unfolds and/or make gut decisions. (Or take up Gann analysis and start charting the planets).
The Aftermath
Again one can look to historical context for a clue as to what comes after the bear decline. In both 1948 and 1978 we slipped into 2 year recessions. The stock market did a little better in 1978 than it did in 1948 but both were highly volatile. The 1970s market also must be put in the context of inflation. While the market gained 10%-27% depending (literally) on which day you measure, purchasing power was being eroded at 10% annually. Unfortunately the aftermath is a market where there is no place to hide. One can't even short the market. Likely the next 3-4 years will be a very difficult period which is why I think it is so important for people to preserve their investments right now!
The Dow
One of the problems for most average investors is that they judge the stock market based on the dow jones average rather than the S&P. Very few people are invested in the dow jones average. Most passive stock funds are based on the S&P and most active funds are somewhere in between. The averages can be misleading:
The top picture is the S&P chart for 1964-1980 while the bottom is the Dow. Note the difference in amplitude where the arrows are. Note how the tepid recover went much higher on the Dow than the S&P. Finally note how the S&P was moving upward during the 78-80 recession while the Dow stood still. This is reflective of the difference in the indexes. The Dow Jones Industrial Average is designed to reflect the economic vitality of the country. I think it does a fairly good job. It is a much better indicator of how well the economy is running and how people feel about the economy, notably it is much more indicative of the recessionary periods. However it is much worse at representing stock prices unless one is actually buying the Dow component stocks!
My advice is to understand specifically where your assets are and track that index rather than the Dow, and if one wants to track the general state of the stock market then the S&P is the true benchmark.
Trading It
Traders incorporate what they call "money management" into their trading. This is essentially a mechanism to not lose all your money. Like pacing yourself with small bets in Vegas. A basic money management scheme says the following: never risk more than 3%-5% of your capital on any one trade.
That doesn't mean don't invest all your capital. It means don't risk all your capital. A trader will place a trade and have a target for taking profits. They will also have what is called a stop loss. That is the point at which they recognize that they've made a bad trade and get out. Such money management is critical because traders are placing trades several times a day, week, month or even minute. If they lost more than 3% on any trade then they would be set back immeasurably (as are many hedge funds who don't or can't implement stop loss because of their size or the complexity of the products they trade).
Amazingly, the average investor does the exact worse thing that a trader can do. They put *all of their capital* into one trade without any target or stop loss! A trader incorporating this strategy will be out of business in short order. An investor with a 401k on the other hand might end up out of business after two decades! (Recall 13 years for that gap fill).
What I've provided here now is a target. The target is 1344.07 on the S&P. Once you get there: set your stop loss at that point. I'm not an advisor but if I was, at that point I would tell you: GET OUT! However if you're diligent then you can attempt to ride it higher. Just don't ride it any lower.
Meanwhile, what if I'm wrong? How low will you let things get before you decide to bale out? Did you consider baling out at any time during the 2007-2009 crash? Tough questions that traders must face every single day. Unfortunately most investors defer the question and accept the "stocks go up in the long run" argument.
The most basic thing to do of course is to sell your stocks at or near the top. Cash is better than a loss. The loss from the top will be somewhere on the order of 20-25%. Importantly, all asset classes will suffer. Bonds will suffer. Commodities will suffer. Even gold will likely suffer (I still need to do a wave count but logically if the dollar is getting stronger then the gold bug argument evaporates). Since markets are global there will be no foreign market or currency in which you can hide. The dollar will be king. Cash will be king.
There are two potential trading strategies then. The first is to buy treasuries. They should behave inversely to the stock market. This means that they will go down for a few weeks while the market rallies. Then they will go up during the bear market. Then they will go down again during the ensuing recession. Therefore buying treasuries is extremely sensitive to timing. You'll earn 4% while you own them but missing the timing by just a few weeks could eat up that yield through price loss. The best bet for treasuries (if you're not counting waves) is to buy them when you are definitely in the slide and then exit before the end of the slide.
When considering treasuries it's worth thinking about inflation during the 1970s. We think of it as a high inflation period, and it was, but the bear crash from 1976-1978 represented the only period during the 1970s when inflation retreated. It still ran at 6% but it declined. The price of oil also went down during this period. It was inbetween the embargoes (which of course didn't cause the price spikes but probably exacerbated them).
The other possibility is to go short. While many view short trades as inherently risky I would argue the opposite. When money management is brought into the picture then short trading is less risky than going long. Consider this. How often does a market drop 20% in the course of a few days? A few times in our lifetime for sure. Now, how often does a market rise 20% in the course of a few days? Never. For prudent investors, shorting is a way to earn money when the market goes down and these days can be accomplished quite easily by purchasing inverse ETFs. Unfortunately 401ks will be unlikely to have this option so you'll be stuck in cash.
For people who would consider shorting one can consider the different indexes, individual stocks, commodities, currencies, etc. Everything will go down. It is just a question of degree. The Nasdaq will drop about 5% more than the S&P. The Russell 2000 will likely drop a few points more than the Nasdaq even. The Dow will probably drop about the same as the S&P although the top is different and I haven't done a wave count. Apple might drop 30%. We'll have to see how high it climbs first.
Conclusion
I will post updates as my wave count continues. The wave count through this correction has been very complicated as you can see from this image:
It's an extremely difficult wave count which might be encountered on a daily chart maybe once or twice a decade. As it turns out though, such a chart shows up daily on at least one asset class on a one minute intraday chart. So day trading, or at least following intraday activity, really is the practice one needs to do effective long term charting. With such a crazy chart though it is quite easy to be wrong and I spend about an hour each day revisiting and cross referencing with other charts, retracement levels and indicators.
The little question 5/3/5 or 5 count was answered today. It was indeed a 5/3/5 zig zag yesterday which means we're still heading down. I am a bit puzzled as to how it will play out because there are still two waves down remaining and not much space between here and the projected Fibonacci level. I fear this means that the chart will continue to be extremely complex but I will keep at it knowing that in the imminent future it will crystallize and provide a tremendous investment advantage.
Pregnant wives? How many do you have?!
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