A Time for Correction...

It has been a long time since I have posted my market comments in either a public forum or on a non-professional basis. Nevertheless, I have found the recent market behavior to be wonderfully compelling, and could not not resist the urge to discuss it. Please forgive me if I do not include a number of charts to illustrate my points in this particular post.

The market just got through completing a really beautiful top. We had these nice, widespread oscillator divergences on the daily and weekly charts. We had a remarkably clear, expanded wave count. We had a well-defined trend channel and trendlines that acted as support and resistance. We even rallied up to proportional levels relative to the October 2005 to May 2006 rally. Finally, the market broke down convincingly with the sell-off of last week. It was really an exciting example of how predicably the market can behave.

So what next? I think the most important thing to remember after a long rally like the one we saw from July 2006 until last week is that extended waves promise that there is more to come in the same direction. In other words, the high set last week will probably not be significantly challenged for a few months, but that powerful, extended rally cannot serve as the end of the longer-term rally. I think the oscillators on the monthly charts also support this assertion. We are not seeing the beginning of a new bear market. We are seeing the beginning of a corrective period that will last a minimum of six weeks and perhaps as long as nineteen weeks.

Let us go back to the rally from October 2005 to May 2006. We rallied from 1168.42 to 1326.53 on the S&P 500. This took place over a period of 29 weeks. I should note that I consider 29 to be a significant number in time cycle analysis. We then saw a corrective wave from May to July of 2006. Depending on how you look at it, this correction retraced either 107.24 or 101.77 points of the October to May rally over an eleven week period. This was roughly a two-thirds price retracement that occurred over 38% of the time. I do not think that this proportionality should be overlooked.

That was when we began our last rally. This rally took us from 1224.76 in July to our recent high of 1461.57 on the S&P 500. This gave us a total wave length of 237.81 points. The time cycle for our most recent rally? It took place over a period of 30 weeks. Interestingly enough, the price movement of the July 2006 to February 2007 rally is 1.5 times the length of the rally from October 2005 to May 2006, while the time periods for the two rallies are practically the same.

In order to predict what will happen next, we need to understand the principle of alternation in Elliott Wave Theory. This principle tells us that the two corrective waves within a larger rally will alternate. One will be deep and one will be flat. One will be short and one will be long. If you recall, the correction from May to July of 2006 retraced over 62% of the price in 38% of the time. This suggests that our current correction will retrace 38% or 50% of the price in 50% or 62% of the time. A 38% retracement of the July 2006 to February 2007 rally will take the S&P 500 to 1370.73, which we almost reached on March 5. A 50% retracement would take the index to 1342.67. If the market retraces below the May 2006 high of 1326.53, then that would support the assertion that a larger degree correction is taking place. A 62% retracement would take us below this level, but that level would be 1314.60.

From a time cycle perspective, a 62% time period of a 29 week rally would give us an 18 week correction. This would suggest that the current correction will last into June. I think that is a significant time period. If we count the weeks since the beginning of the rally in October 2005, we find that the top set at the end of February was 70 weeks into the time cycle. If we see a correction for 18 weeks that would put us right around 89 weeks into the time cycle, which is significant because it is a Fibonacci number. We must also be mindful that the next significant number in terms of time will be at 76 weeks. This is why I suggest that our current correction will last between 6 and 19 weeks.

We are near significant lows. We have a potentially prolonged period of time in which we might expect the markets to correct. What does this suggest in terms of pattern? I think the obvious answer is that we can expect the market to form some sort of flat corrective pattern or a triangle. It would be characteristic of a triangle formation to occur as the fourth wave in a larger formation, so that does not at all seem unreasonable. At the same time, I would also caution investors to be wary of a possible expanded flat formation that might eventually takes us temporarily above our recent highs on rapid movement but weak momentum. In any event, I would expect to see either a three-wave or five-wave sideways formation bounce the markets between 1340 and 1460 on the S&P 500 over the next four or five months.

Traders will find opportunity to make money off the shorter-term movements within this corrective pattern. My personal preference is to simply buy the market at significant support levels in expectation of profiting over the longer term. I say this because of my original assertion. The writings of R. N. Elliott suggest that an extended wave like that seen from July 2006 to February 2007 is typically not the final wave of the larger movement. There must be some sort of final movement up on increasing public exuberance, declining momentum, and weak volume. My personal belief is that this final, exhaustive rally will conclude 34 to 56 weeks after the highs of February 2007, and will happen as the S&P 500 rallies to somewhere between 1500 and 1550.

Best of luck,

Eldinril