A Fourth Wave Correction?

06/25/07 03:13:03 PM

by David Penn

Bears once again look to overplay their hand during a summer correction.

Security: $SPX
Position: N/A

Listening to bears in recent days, I've learned that the market in general and the Standard & Poor's 500 in specific can do one of two things: either correct sharply or bounce weakly.

That's good to know. You would think that in the wake of the spring correction in 2007, which was similarly heralded as a doom-delivery device, bears would be somewhat chastened about referring to corrections as "important market tops."

I was recently reminded of an important point about markets after reading an article by Tim Wood of Cycles News and Views. If an advancing market does not take out a previous secondary low point, then the uptrend in the market should be considered intact. This means that in the absence of such a lower low, talk of "important tops" is almost always premature. While it may pain those who did not take profits on the way up to see their gains melt away while waiting for an advancing market to take out a previous secondary low point, that is the reality of trending markets.

I suspect the current sideways, choppy action in the S&P 500 — which has brought out the bears in numbers not seen since March — is merely the second correction in the bull market that began this spring near 1380. Using Elliott wave terminology, I see the June correction as likely a fourth wave, lateral correction (in contrast to the short, sharp correction of late March) that will lead to higher prices over the next few months.

FIGURE 1: STANDARD & POOR'S 500, 120-MINUTE. A fourth-wave correction low in the first half of March led to this advance over the balance of the spring and into the summer. It appears as if the market has slipped into another fourth-wave correction — albeit of one degree smaller — en route to a fifth-wave peak somewhere near 1,600.

Graphic provided by: Prophet Financial, Inc.

If this correction is in fact a fourth wave, then we can begin to make projections of a likely fifth-wave top, where an important market top is perhaps likely to develop. I will use the same methodology that helped me anticipate the "important market top" in February (see my "Fifth Of A Fifth," Working-Money.com, February 28, 2007; and "The Case For New Highs," Working-Money.com, June 30, 2006).

This fourth-wave correction call is based on a larger wave 4 bottom in mid-March (the spring 2007 correction). From there we move into a wave 1 top by late March near 1440, with a wave 2 bottom at the end of the month near 1415. A strong, robust wave 3 sent the S&P 500 higher over the balance of both April and May, leading to what I believe is a wave 3 top in earliest June at about 1540. The market since then has moved largely sideways, diving down toward 1490, then bouncing higher to test the 1540 level before retreating once again.

What would invalidate the wave 4 correction call? If the S&P 500 were to fall and close below the 1440 level, which represents the high of wave 1, then the wave 4 correction would have fallen too far and force a rethinking of the wave pattern.

Many bears are keying on the 1475 level as key support. While taking out the 1475 level to the downside would make for a deeper correction, as long as 1440 holds, then the possibility that the correction is a fourth-wave correction that will precede a fifth-wave advance remains a strong one.

On the other hand, if the market is moving through a fourth-wave correction, what sort of upside might a subsequent fifth-wave bring? With a bottom at 1370, a wave 1 top at 1440 and a wave 3 top at 1540, we get a range of 1,553 to 1,645 as a likely location for a wave 5 top. Averaging the high and low of the range gives us a target of about 1,599 as a place to look for the market to reach before resting.

David Penn

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

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