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Homebuilders Headed South

06/13/08 09:37:17 AM
by Alan R. Northam

The SPDR S&P Homebuilders Index has completed its corrective wave pattern, signaling that this index of homebuilders is now headed south.

Security:   XHB
Position:   N/A

Figure 1 shows the daily price chart of the SPDR S&P Homebuilders Index (XHB). In this chart, note that XHB made a major bull market top in February 2007. Since then, XHB has been trading in the downward direction. Note that from February 2007 to January 2008, XHB moved lower in five waves, waves 1, 2, 3, 4, and 5 (see blue numbers on chart). These five waves then form wave (1) of a larger five-wave move to the downside (see red number (1)). This is the fractal nature of waves, where waves 1, 3, and 5 subdivide into five subwaves. If we were to look closer at the wave structure of wave 1 down, which ended at the end of March 2007, we could identify five smaller subwaves within wave 1. We could also identify five subwaves within waves 3 and 5 by looking more closely at their wave structures.

FIGURE 1: XHB, DAILY. Here's the Elliott wave count.
Graphic provided by:
Waves 2 and 4 of a five-wave structure are corrective waves. These corrective waves form differently from waves 1, 3, and 5. Wave 2 normally forms as a three-wave zigzag structure and is labeled waves A, B, and C, but can evolve into other corrective wave patterns as well. Wave 4 usually forms in a corrective wave pattern that is different from wave 2. So if wave 2 forms as an A, B, C zigzag, then we can expect wave 4 to form a different corrective wave pattern. Despite these differences, what these two waves have in common is that they are both corrective waves that move in the opposite direction as waves 1, 3, and 5 and are not to be confused with the start of a new trend in the opposite direction. In looking at our chart, we can see that from January 2008 until the end of March 2008, XHB has been trading against the main trend in a corrective manner and has formed an a, b, c zigzag corrective pattern. Another characteristic of zigzags is that they normally stay within channel lines as indicated on the chart. Sometimes the end of wave c can occur at the channel line, sometimes it can break above the channel line before ending, and sometimes wave c can end at the midpoint of the channel. This is what has happened with XHB. XHB ended its a, b, c zigzag corrective wave pattern, with wave c ending at the midchannel line. Since then, XHB has moved lower and broken down below the lower zigzag channel line, signaling that the corrective wave move is over. One thing Elliottitians look for as verification that zigzag patterns are complete is for the market to move below the price minimum of wave b. I have identified this price level with a horizontal support line labeled S. As we can see from the chart, XHB has now closed below this support level, verifying that the market correction is now complete.

With wave (2) complete, wave (3) down is now headed south. Wave (3) should unfold as a five-wave structure due to the fractal nature of waves. Therefore, we can expect wave (3) down to unfold as five subwaves, waves (i), (ii), (iii), (iv), and (v). Waves (i), (iii), and (v) will trend in the downward direction and waves (ii) and (iv) will be small corrective waves. Once completed, wave (3) down should be at a price level much lower than the price minimum of wave (1). When will we know that wave (3) down is complete? When the subwaves of wave (3) count five.

One of the characteristics of third waves is that they travel the furthest distance in the shortest amount of time, indicating that momentum is at its greatest. Therefore, one way at trying to identify when wave (3) down should end is by watching a momentum indicator such as the average directional movement index (ADX). By monitoring ADX, we can watch for it to rise to a peak and then start to turn back down. The peak in ADX is a measure of maximum momentum, and once it turns back down, it is an indication that momentum is starting to slow down. When momentum starts to slow down, that means that the move in wave (3) down is drawing to an end and will end when momentum has fully run its course. Other momentum indicators can also be used, so use the momentum indicator of your choice.

In conclusion, once wave (3) down is complete, expect a corrective wave (4) to follow, and once corrective wave (4) is complete, the final wave (5) down will begin. Once wave (5) down is complete, then expect the market to retrace a large percentage of the complete move down from the market top. XHB is headed south, so enjoy the ride.

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 or by visiting his website at You can also follow him on Twitter @TradersClassrm.

Garland, Tx
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