Bull Or Bear?

05/16/08 11:49:39 AM

by Alan R. Northam

Is the market rally off the mid-March low a bear market rally or the resumption of the bull market trend? The unbreakable rules of the Elliott wave theory can be used to answer this question.

Security: $SPX
Position: N/A

A camp of market technicians believes the the market decline from last October was nothing more than a bull market correction. They also believe that the correction is now over and the bull market is now starting to resume. To analyze this viewpoint, I have chosen to use the rules and guidelines of the Elliott wave theory.

R.N. Elliott came up with a set of rules for defining a trending market. He determined that a market trends in its major direction in five nonoverlapping waves. Wave 1 moves in the direction of the major trend and in itself subdivides into five smaller nonoverlapping waves. Wave 2 is a corrective wave that moves against the direction of the major trend and subdivides into three waves. Wave 3 is another wave that moves in the direction of the major trend and subdivides into five smaller nonoverlapping waves. Wave 4 is a corrective wave that moves against the major trend. The final wave 5 also moves in the direction of the major trend and subdivides into five nonoverlapping waves.

Under the premise that the market decline from the high last October is nothing more than a bull market correction, then mid-March marks the ending of that correction. It then follows that the rally from mid-March to the present day is part of a much larger bull market. In Figure 1, I have shown the daily price movement of the Standard & Poor's 500 since mid-March. This figure shows that from mid-March to the present day, the market has indeed been moving higher and looks to be the resumption of a bull market trend. Let's look at Elliott's rules for a trending market to see if it obeys Elliott's rules that cannot be violated.

FIGURE 1: $SPX, DAILY. This daily price chart of the S&P 500 shows overlapping waves.

Graphic provided by: StockCharts.com.

Ralph Nelson Elliott came up with 11 rules for identifying a trending market that cannot be violated. Of those 11 rules, there is one rule that is being violated in the market advance since mid March. This rule states that the price peak of wave 1 cannot be overlapped by the price minimum of wave 4. In Figure 1, I have idenified four sets of waves numbered 1 through 4 and have idenified each number set by a different color. For example, the green set of numbers 1 through 4 show that the price peak of wave 1, idenified by the green number 1, is overlapped by the price minimum of wave 4, identified by the green number 4. Of the five-colored number sets shown, never is there a case where wave 1 is not overlapped by its corresponding colored wave 4. Therefore, Elliott's rule that wave 1 cannot be overlapped by wave 4 is being violated. Elliott's rules for a complex corrective wave structures, on the other hand, does allow for overlapping waves.

In conclusion, the market rally from mid-March to the current date violates Elliott's unbreakable rule for a trending market that states the wave 1 cannot be overlapped by wave 4. This violation indicates that the current market advance cannot be the resumption of a bull market trend or the beginning of a new bull market trend. On the other hand, Elliott's rules does allow for overlapping waves in complex corrective market structures. Thus, the market advance from the mid-March market low has the look of a market correction and not that of an upward trending market. And since market corrections move in the opposite direction of the major trend, we can state with a high level of confidence that the upward market movement from mid-March is nothing more than a corrective rally in an ongoing bear market trend.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.