The Elliott Wave Theory is one of the most popular tools of technical analysis. Applying it in the current market scenario gives an interesting long-term perspective
In the 1930s, Ralph Elliott attained public fame because he had accurately explained the Wall Street crash of 1929 and subsequent stock market moves in a series of articles. His theory was that stock markets, and many other cyclical phenomena move in waves with patterns that repeat themselves. Hence future moves can be predicted in terms of both time, direction and amplitude.
The Elliott Wave Theory has become one of the most popular tools of technical analysis. One of its advantages is that although it predates chaos theory, it can be applied across any timeframe whatsoever since this is a fractal system. Each pattern of waves forms a subset of a larger pattern of waves which in turn forms another subset of yet larger pattern of waves. Elliott himself classified eight time-frames ranging from the sub-minuette to the grand super cycle -- a range from minutes to centuries.
The pattern usually repeats itself after 5 upwaves followed by three downwaves. Each wave can be decomposed into smaller waves. Each wave in a pattern- 1, 2, 3, 4 & 5 should possess certain characteristics. While 1, 3, and 5 will move in the direction of the long term trend, 2 and 4 will be corrections. A five-wave advance is always followed by a three wave correction or downtrend.
Generally, nomenclature of a wave-system and sub-system is defined by using upper and lower case. That is a,b,c,d,e will refer to sub-waves inside a pattern of ABCDE. Advances or moves in the direction of the prevailing trend are also referred to as Impulse Waves while declines are called corrections. Waves are considered failures when they do not exceed the value or timespan of the previous wave in the same direction.
The degree of movement and time periods can also be mapped. Mostly waves tend to move in harmonic ratio to other waves in the pattern. That is, advances and declines tend to conform to Fibonacci ratios - which are respective multiples and sub-multiples of 1.618 and 0.618 etc. Sometimes the formation of specific formations such as triangles can also be predicted by the theory. This piece is an attempt to judge the future market direction using Elliott Wave Theory. It is a follow-up to a previous article on the subject in Smart Investor on July 7, 1997.
The market appears to be in the intervening downtrend according to this theory. This downtrend started in August 1997. If the current wave pattern is a failure it would take between 8-27 months - ie last beyond April 1998. It would also bottom above Sensex values of 2966 points. If however the current wave isnt a failure, it may conclude by April 1998 between levels of 2713-2966 points. In any case, the good news is that following conclusion of this current wave, the market would be poised for another uptrend.
In an attempt to place the market action in a long term perspective, the author has also considered super-cycles which involve the use of RBI Shares Index going back some 52 years. This may seem of only academic interest -- but there are investors with very long term perspectives who may like to know the general market direction until at least the year 2001.
The Wave Forecasting
The Sensex has more or less behaved in the manner projected on the basis of Elliott Wave Theory. In July 1997, this writer had given a detailed wave count from Sep94 (when the market peaked at a Sensex value of 4643 points) onwards. Those projections are reproduced in the Sensex chart.
One should recapitulate what was said in that earlier article. The Sep94 top was taken to be a cycle degree top and treated as such. From that point, a cycle degree correction or dowmove is on. Within this corrective phase, the A-wave (downwards) was taken to be the movement between Sep94 (4643 points) to May95 when the Sensex temporarily bottomed at 2966 points. The entire phase from the May95 2966 bottom onwards was treated as B-wave (upwards) which was projected to take the shape of an Expanding Triangle. The Expanding Triangle finished at 4605 on 6th Aug97 and we are now in the C-wave downwards.
Within this B-wave Expanding Triangle, E was exactly 3 times of A, value-wise as well as time-wise. (In Expanding Triangles, it is usual to have a ratio between A and E). As an additional observation, it is noted that the magnitude of the Expanding Triangle (2966 to 4605) also happens to be exactly 0.618 of the earlier rise from 1980 to 4643, value-wise, and 1.618 timewise. These are Fib-onacci ratios which fit the general theory.
From Aug97 (4605) onwards, the C-Wave of the larger degree has, therefore, started. We are also experiencing the usual C-wave symptoms. The political situation has been shaky, the rupee has made a new low against the Dollar, the economy is not doing well; all these fundamentals confirm the technical reading of a C-wave. More symptoms would follow as the C-wave unfolds further in downward direction.
The Exception Rule
The internal construction of E (within the larger B-wave Expanding Triangle) has thrown-up an interesting observation for the students of Wave Theory. Within the E, the first corrective was a Zig-zag from 2713 to 4029. This was followed by an x wave Triangle from 4029 to 3659 (upto 29th May97). The second corrective after x is a 3-3-5 Flat, within which the b-wave (triangle) is not more than 0.618 of a-wave. This breaks an essential rule that b-wave of a Flat should be at least 0.618 of a-wave. According to Glenn Neely, this can happen only under unusual conditions or at important market turning points. Expanding Triangle has been listed out as an unusual condition by him. Further, since after this Expanding Triangle a larger degree C-wave bear phase is to start, it would also be termed as an important market turning point. (For more details, see the Exception Rule in Neelys book Mastering Elliiott Wave). The breaking of an essential rule, is therefore, in order in these circumstances.
The C-wave
As already discussed, we are now in the larger C-wave downwards. According to rules developed by Neely, a C-wave following an Expanding Triangle would have minimal power, and is likely to be a failure wave, i.e. ending above 2966 in case of Sensex. If C-wave happens to be a failure, then it will not be the shortest wave time-wise (out of A, B & C). It has to, therefore, continue for minimum 8 months in order not to be the shortest. Remember, the A-wave was of 8 months (Sep94 to May95) and B-wave Expanding Triangle was of 27 months (May95 to Aug97).
In rare situations, however, the C-wave may not be a failure and may retrace the Expanding Triangle completely. If it goes below 2713, then time-wise it has to be longer than the time period of E, which is again 8 months. Thus, the only situation that warrants the C-wave taking less than 8 months would be when the C-wave ends between 2966 and 2713.
To consume more time without doing much price damage, such C-wave would take the shape of a Terminal. Originally called Diagonal Triangle by Elliott, this pattern has been renamed by Glenn Neely as terminal as it comes as a move which terminates a move of one larger degree. Here, this C-wave is going to terminate the entire corrective A-B-C of more than 3 years, which started at 4643 in Sep94.
What is a Terminal Impulse?
It has 3-3-3-3-3 internal construction (as against the usual Impulse construction of 5-3-5-3-5), but comes at an impulse position of either 5th wave or C wave. In a Terminal Impulse, the 1st wave overlaps the 4th, which is otherwise not allowed in normal Impulses. A Terminal would also have a thrust implication after it is completed. The move after the Terminal would retrace the whole Terminal within 50% of the time taken by the Terminal. The move out of such Terminal would, therefore, be very fast. It would be interesting to see the further Sensex movements with this perspective.
What next after this C-Wave?
The Expanding Triangle formations are most common during very large Complex Correctives. Complex Correctives are the correctives which involve x waves.
The entire corrective so far, from Sep94 (4643) onwards, may only be the first standard corrective of the larger degree corrective count. What follows after the current C-wave, would, therefore, be a large x, after which another standard corrective would occur. Large x wave is greater than the preceeding standard corrective, against Small x which is not more than 0.618 of preceeding corrective.
Thus, once the ongoing C-wave finishes, the forthcoming large x wave would take Sensex to new heights in the next 1 to 2 years, after which its time for another corrective. The entire formation from Sep94 onwards would thus be A-B-C- x-A-B-C and may cover a period of about 7 years (counted from Sep94).
Super-cycles
This corrective phase of about 7 years from Sep94 onwards would be a cycle degree correction to the rise that ensued for about 12 years from Apr83 to Sep94.
Since Sensex data is unavailable, the RBI Shares Index is taken from 1946, to clearly spell out the Super-Cycle degree count of the Indian market. This count is a revised one after applying Neely concepts.
The Super-Cycle degree Wave-1 finished in the Jul46 (one year before independence). From here till April83 there was a perfectly channelled sideways movement, which I am labelling as Wave-2 of the Super-Cycle degree (covering 37 years). From April 83 to September 94 one can see 5 clear waves, which Im labelling as 1st of the Super-Cycle degree Wave-3. And from Sep94 onwards, for a period of about 7 years, well be in the 2nd of the Super-Cycle degree Wave-3.
The Mimicking
Neely has given importance to mimicking, wherein the smaller degree waves mimic the behavior of larger degree waves. For example, Cycle degree 2nd of Super-Cycle degree Wave-3 may mimic the Super-Cycle degree Wave-2. So far, in the last 3 years, the current Cycle degree corrective (which started in Sep94 and is labelled as 2nd of the Super-Cycle degree Wave-3) has mimicked the pattern of the first 16 years of the larger Super-Cycle degree Wave-2 from 1946.
Please see the RBI chart and compare the period from Jul46 to Dec65 of RBI Shares Index, with the period from Sep94 onwards of Sensex. The similarity of the pattern is apparent. If the current phase (2nd of Wave-3) continues to mimic the Super-Cycle Wave-2, then we can foresee the entire scenario unfolding the same way as Super-Cycle Wave-2 unfolded between Jul46 to Apr83.
Once the ongoing Cycle degree 2nd is finished, the 3rd of the Super-Cycle degree Wave-3 would open. It would be the most dynamic phase for the Indian economy, and therefore, for the stock market. Thus, the coming century should open with explosive action in the stock market.
