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Wave Counts and the S&P's Next Leg Down

09/24/02 03:17:53 PM
by David Penn

Do the declines of the first half of September augur even steeper declines before month's end?

Security:   SPX, ESU2
Position:   N/A

To rephrase the famous quote from King Louis XIV's Madame de Pompadour, "Apres le deuxieme, le deluge?"

In other words, after putting in a bottom in July that represented a Wave 1 decline, and then rallying to a Wave 2 peak, is there anything that will stop the S&P 500 from dropping once again, breaking down beneath the July lows?

The current drop in the S&P 500 is suggestive of a Wave 3 decline that should critically test the July lows at the bottom of Wave 1.
Graphic provided by: TradeStation.
It is hard to fade evidence that the rally that began with the July lows (the "corporate crooks" lows, as I referred to them in my Advantage article "Elliott Wave and August advances") has ended and is now turning into a major decline. From the July lows to the highs near the end of August, the S&P 500 appreciated some 24%. To put this advance in perspective, compare it with other advances in the bear market that began with the March 2000 market top. The Wave 2 rally from April 2000 to August 2000 represented a 14% gain in the S&P 500, the Wave 4 rally from March 2001 to May 2001 saw a gain of 23% and the Wave A rally from September 2001 to December 2001 provided the S&P 500 with a 25% gain.

Combined with the severity of the declines of September, this record of bear market rallies seems almost unequivocal in terms of the bearish implications for the S&P 500 at this time. To those who had been longing for a summer rally, the unfortunate news is, not only did we have one (July-August), but also the S&P 500 appears prepared to retrace all of that rally in little over a month. I had suggested in more recent pieces that until the S&P 500 declined to the 840 area, there was sufficient reason to believe that the rally might remain intact. While that still appears to be a reasonable assertion, prudence suggests that traders and investors be extremely careful in trying to fade four consecutive down weeks in the S&P 500.

Part of the evidence for this renewed caution comes from the intermediate head and shoulders top that developed over the month of August and into September. This intermediate top formation, with its peak on August 22nd at 966 and support at about 870 (based on the September e-mini S&P 500), suggests that the current correction in the S&P 500 could reach as low as 775 before pausing. Interestingly enough, 775 is also quite close to the year-to-date low in the S&P 500 of 770 (again, as measured by September e-mini futures).

Having considered the extent of bear market rallies since March 2000, it is only reasonable to consider the extent of the declines. The hope, of course, is that this information may provide some guide as to how far a Wave 3 decline might take the S&P 500 going into the fall of 2002. The first decline, from the peak in March 2000 to April 2000 was only about 14%. But the subsequent declines were much more robust: the Wave 3 decline from April 2000 to March 2001 was 29%, the Wave 5 decline from the summer of 2001 to September 2001 saw the S&P 500 lose 28%, and the Wave 1 decline in the late spring and summer of 2002 represented a drop of about 34%. Thus, the major declines in this bear market have averaged a drop of about 26%. If we take 26% from the peak at the top of Wave 2, then we get 713, about 8% below the July lows.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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