Thoughts for Sunday, July 15...

There is a technique for wave counting that uses the Relative Strength Indicator (RSI) to assist with the identification of waves in a motive formation. The theory is that the Relative Strength Indicator peaks at Wave 3, or, in an extended formation, Wave 3 of 3. It is then followed by an RSI divergence as Wave 5 unfolds to new highs in prices without corresponding highs in RSI.

If we use this technique to characterize the rally up from March 2003, then we find an initial wave up from March 2003 that ended in December 2004. As the chart below suggests, the RSI peaked with a price peak in February 2004. This was followed by a three-wave flat corrective pattern, and a final surge higher from July to December 2004. As the S&P 500 rallied to new price highs at the end of 2004, we saw a divergence on the RSI that failed to confirm the new highs. True to form, this was followed by a ten-month corrective pattern that left prices a approximately the same level as they were in December 2004.

We saw a similar situation beginning to set up this year. As the chart above illustrates, the Relative Strength Indicator (RSI) peaked with the highs in February. We then saw a divergence on the RSI as it failed to make new highs with the rally into the end of May. All of this agreed with the many other indicators that suggested some sort of top was in order. Ultimately, equity prices are determined by the balance and imbalance between buyers and sellers in the market place, and not the tools that technical analysts use to predict future trends.

This was made abundantly clear as the S&P 500 and the Relative Strength Indicator both rallied to new highs. This suggests that the wave up from July 2006 is extending. Moreover, since this is the third wave up of the rally that began in March 2003, we might expect the RSI to rally to a peak above that made in February 2004. We can assume that the price of the S&P 500 will continue to rise with it. It is also possible that we will have another wave, after the one that began this week, in which the RSI diverges from even further price highs.