Surfing the Dow Jones Waves

Since September, the Dow Jones industrial average has gained 15% as the bulls rushed out to snap up stocks at bargain prices. The magical 10,000 level is within sight and perma-bulls are already calling the next bull run, confident that the bottom has been reached two months ago. But Elliot Waves are telling a different story, warning that we may see a retest of the recent stock market lows. For those not familiar with the Elliot Wave theory, here is a brief summary.

The Wave Principle was discovered by R.N. Elliot almost 70 years ago. By studying crowd behaviour with stock market data as his main tool, he found evidence of repeating patterns, leading him to believe that there is order in the apparent chaotic stock market movements. Elliot identified 13 different repetitive waves according to which the stock market develops. He then refined his theory and set up a few guidelines for predicting stock market action based on his Wave Principle.

The Wave Principle holds that a complete market cycle consists of an impulsive phase and a corrective phase. The impulsive phase can further be refined into a 5 wave structure, while the corrective phase has a 3 wave structure, as shown in Fig. 1.

Fig. 1 : Basic wave modes

The impulsive phase drives the market in the primary direction, while the corrective phase is a countertrend interruption. A complete cycle thus consists of 8 waves. Each "up" wave of the impulsive phase can further be refined into a 5 wave impulsive sequence while each "down" wave can be refined into a 3 wave corrective sequence. The reverse is true for the corrective phase, i.e. each "down" wave is made up of 5 smaller waves and each "up" wave consists of 3 smaller waves. This is shown in Fig. 2.

Fig. 2 : Refinement of the wave structure

Those familiar with the Fibonacci sequence 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, … will immediately notice these numbers in the wave structure. The reader is encouraged to draw his/her own wave structures and to refine it even more in order to find more Fibonacci numbers. Looking at this sequence of numbers, one finds that the ratio between any two adjacent numbers approaches approximately 0.618 to 1 or 1.618 to 1. This ratio is known as the golden ratio and is found throughout nature.

Before we apply the basics to the Dow Jones, mention must be made of a few rules. Looking at the impulsive phase, wave 2 never retraces more than 100% of wave 1, while wave 4 never retraces more than 100% of wave 3. Also, wave 3 is often the longest of waves 1, 3 and 5, while wave 4 never overlaps wave 1. Sometimes, we find a situation where the fifth wave does not move beyond the third wave, especially when the third wave has been very strong. This is called a failed fifth wave. Applying the golden ratio to the Wave Principle, Elliot also found that wave 4 often travels 61.8% of the distance between the start of wave 1 and the end of wave 3. Let us know apply this basic knowledge to the Dow Jones in Fig. 3.

Fig. 3 : Applying Elliot Waves to the Dow Jones

As we are currently in a bear market, the primary trend, or impulsive phase, is down. In Fig. 3 we can clearly see the first four waves of the 5 wave structure. While most investors are eagerly awaiting the crossing of the 10,000 level, there is a more important level to watch, namely 10122. That was the end of the first wave. If Elliot Wave theory holds, the current wave 4 should not exceed this level. We can thus deduce from this that the Dow Jones may be running out of steam and that the next leg down, the fifth wave, is just around the corner. The question is, how far will wave 5 travel ? There is a possibility that we may see a failed fifth wave, as wave 3 was particularly strong. This will confirm the belief of many investors and perma-bulls that the bottom was indeed reached at the end of wave 3. If we apply the 61.8% rule to wave 5, we find that this wave could come close to the September low of 8062. The calculation is as follows: the distance between the start of wave 1 (11350) and the end of wave 3 (8062) is 3288. 61.8% of 3288 is 2032. Subtracting 2032 from the end of wave 1 (10122) gives 8090, a tad above the September low. This represents a 17% drop from current levels, enough to send the bulls running for the hills !

Charl Marais

December 1, 2001

[email protected]