From Flat To Zigzag

10/05/04 02:41:35 PM

by David Penn

How the rule of alternation warned bears of a sharp reversal near the end of September.

Security: $OEX
Position: N/A

In my notes, sometime during trading on September 30, I wrote:

"If ii was a flat, will iv be a zigzag?"

By "ii," I was referring to the bullish correction in the $OEX near the middle of September, when the August rally that had lifted stocks for a month finally began to appear as though it were over. I use the term "bullish correction" because it was on September 10 that the August rally peaked, and the downtrend that has characterized the market since January is best looked at as an intermediate bear market -- at least for now. As I wrote in a recent piece for Working-Money.com ("Election 2004: A Tale Of Two Tops"), since January the broader market has consistently traced out a pattern of lower highs and lower lows. That is a downtrend. And when that downtrend has lasted for nine months, it is not just a downtrend, it is a bear market.

The "iv" I was anticipating back on September 30 is the sharp, post-Presidential debate rally that took off first thing Friday morning. I suspected that a sharp move to the upside was around the corner, one that would take the $OEX to the 543-539 level before running out of steam. How did I arrive at this conclusion?

Figure 1: The sideways correction early in the downtrend is followed by a sharp correction late in the trend � an example of the rule of alternation.

Graphic provided by: Prophet Financial Systems, Inc..

As the hourly chart of the $OEX points out, there was a true bottom that developed at about 531. I say "true bottom" because that low not only was made on an hourly "hammering man" candlestick (which in and of itself suggests a bullish reversal when it develops at the end of a downtrend), but also because of the clear positive stochastic divergence that developed. Not all bottoms form such candlesticks or positive stochastic divergences. But when these phenomena occur, they do greatly increase the likelihood that the suspected bottom is a "true bottom."

So that's how we get the pivot. How do we get the upside price target? The rule of alternation, which is derived from Elliott wave theory, suggests that corrections of the same degree tend to alternate between relatively sideways or "flat" corrections and relatively sharp or "zigzag" corrections. While there are other correction patterns (such as triangles), the point is that if one type of correction is observed early in a given trend, look for the next correction to be of the other type. If the first correction is relatively mild and sideways, then look for the subsequent correction to be sharper and relatively more volatile.

That said, when the $OEX broke down moving to mid-September, then moved sideways before resuming its downtrend through the balance of the month, I began to suspect that when the sharp declines subsided, the inevitable correction would likely be a sharp move upward. When the true bottom at 531 was established, the $OEX rallied about 5.5 points to 536.5 in the first leg of the wave iv correction, then slipped about three points to 533.5 by the final day of the month. This "slip" was the second or "b" wave of the iv correction.

In zigzag corrections, the third leg or "c" wave is at least as long as the "a" wave. In this context, that meant that the "c" wave would be at least 5.5 points and, given that the "b" wave ended at 533.5, suggested a minimum upside of about 539. Given the anticipated sharpness of the wave iv correction, I also considered what a "c" wave might look like if instead of being equal to the "a" wave, it was 1.618 times the length of the "a" wave -- 1.618 being a standard Fibonacci multiple (as are 2.618 and 3.618, and so forth). This calculation (5.5 x 1.618, with the product added to the "b" wave low at 533.5) provided an upside target of 542.40.

As I write this, the $OEX is struggling to move higher than 542.40. Should it do so, and threaten the September highs, then there is an alternate possibility that rather than being a fourth wave, the current rally is a second wave, with the September declines being a wave one. One argument in favor of this interpretation is that zigzags tend to show up more often in second waves than in fourth waves -- although zigzags can and do appear in fourth waves. In the event the October 1st rally is a wave two, then a serious challenge of the September highs north of 548 is virtually mandatory. This second-instead-of-fourth thesis is also supported by action in the $SPX, where the October 1st rally has taken out the September highs on an intraday basis, at least.

However, if the $OEX does find resistance at current levels, that development would go a long way toward dismissing the "inexplicable" bullishness of the first day of October in favor of the more traditional market turns to the downside that Octobers have so often provided in the past.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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From Flat To Zigzag

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