Thoughts for Sunday, November 25, 2007...

We discussed another technique last spring that suggested we were near the end of the rally and the beginning of a corrective period. This technique couples the practice of wave counting from the Elliott Wave Principle with the Relative Strength Indicator developed by Welles Wilder. This technique proved its usefulness on multiple occasions over the years. 2007 has been no different.

If we look at the chart below, we can see that the Relative Strength Index (RSI) tends to peak during the formation of Wave 3. We can see examples of this with the highs set in March 2004 and with the highs set in February 2007. As prices rally to new highs during the formation of Wave 5, we tend to see the RSI fail to confirm these new highs by reaching new highs of its own. That is, a divergence forms between price and relative strength. It was just such a divergence that formed as the S&P 500 rallied to new highs through July of this year, and suggested a corrective period was near.

The Relative Strength Indicator provided further indication of future market direction during the rally into October, as the chart below suggests. The S&P 500 approached and exceeded the highs set in July, but the RSI failed to confirm. Not only did the RSI fail to rally to new highs along with the underlying price, it failed to get anywhere close to the trend-line formed by the peaks of February and July. This suggests that even though S&P 500 rallied to new price highs, the underlying strength of the move suggested that this move was corrective in nature.

This leads us to our characterization of the corrective wave that began in July. One possible corrective formation found in the Elliott Wave Principle is known as a flat. To quote Frost and Prechter, a flat formation "tends to occur when the larger trend is strong, so it virtually always precedes or follows an extension" (Frost, A.J. and Prechter, R.R.. "The Elliott Wave Principle." 20th Anniversary ed.: p 45.). There are few who would dispute the strength of the rally over the past few years.

R.N. Elliott actually described multiple types of flat formations in his original book on the subject. Frost and Prechter focused primarily on the variety that forms a 3-3-5 formation. If we look below at a weekly line chart of the wave formations since the July highs, we can see an initial, simple thrust down to form Wave A. The rally up into the October high could arguably be described as a seven wave formation higher. This would give us a complex Wave B. Since the highs set in early October, the market has declined in five waves to form Wave C. This provides us with the 3-3-5 formation consistent with a flat formation. It also suggests that we are currently in the final wave down of Wave C.

Once again, we can look to the RSI for an indication of what to expect from future price behavior. Even as the S&P 500 continues to decline on the weekly chart, the corresponding RSI has failed to reach equivalent new lows. This suggests that the RSI is failing to confirm these new lows and a divergence is forming. It also supports the notion that we are at or near the end of this decline, as the wave count proposed above also suggests.

Thoughts for Tuesday, November 20...

This is not going to be an extensive post, but I did want to make folks aware of something. As of today, the 50-week simple moving average for the S&P 500 stands at 1472.94. The S&P 500 index, itself, closed at 1433.27. That places the index about 2.7% below the 50-week moving average. If we go back to 2004, then we will see that this has not been a bad place to think about entering the market.

I do not think the downtrend is over. I can actually envision two or three scenarios where we make a final thrust down to around 1400, or roughly 5% below the 50-week moving average. Nevertheless, those investors who pride themselves on buying the dips would not be unreasonable to begin looking for opportunities to do so at these levels.

Thoughts for Sunday, November 18, 2007...

The market action of the S&P 500 really supported some of my recent comments. One point in particular that I would like to revisit is the significance of the 50-week simple moving average. This moving average has provided significant support for the upward trending of the S&P 500 for the past few years. We have not had a penetration of more than three percent of this line since 2003, until August 16 of this year. Of course, that penetration was only intra-day.

We can see from this chart that the recent downward movement penetrated this trend-line during the week ending November 9. This past week the S&P 500 rallied briefly above the 50-week moving average, but failed to finish the week above it. This is not necessarily an ominous sign, but it does suggest that a certain amount of weakness remains in the market. Further evidence of this weakness can be found by looking at a shorter-term trend-line on the daily chart.

You can see from this chart the relationship of the S&P 500 to its 10-day simple moving average. The low was set on Monday, and you can see that things had gotten very oversold relative to this moving average. The rally on Tuesday was very strong. It was a 2% increase over the previous day's close. Nevertheless, that did not get us back to the ten-day moving average. We gapped up above this resistance on Wednesday, but were unable to close above it. This is also consistent with my belief that a fair amount of weakness remains in this market.

I will say that the strength of the upward move on Tuesday makes me suspect that we will see a second test on the 10-day moving average before heading lower. That said, I remain of the opinion that the S&P 500 has some additional downward movement ahead of it. This could easily take us down to test the 1400 level before resuming our longer-term bull market.

Thoughts for Sunday, November 11...

I have spoken recently about the importance of trend channels and of the tendency of the market to travel within two parallel lines. We have spoken about it primarily in terms of the trend channel that formed with the rally off the July 2006 lows. We might also find an excellent example of this from trend that began all the way back in March 2003.

We can see from this parallel channel how the highs of May, June, and July kissed along the upper trend-line of this channel, as well as the high of October. We can also see how the lows of August approached the lower trend-line across the 2003 and 2006 lows. I find it interesting to note that if the S&P 500 were to return to test the lower trend-line again, then it would find itself around the 1400 area. I do not find it a coincidence that we find significance in this same number from a variety of perspectives.

Thoughts for Thursday, November 8...

There was some rather volatile price action on the S&P 500 today. The market declined throughout most of the morning, and reached a low of 1451.01 around 1:15 in the afternoon. From that point, the index began an almost thirty point rally to reach a late day high of 1479.45, before settling down into a closing price of 1474.21.

I recount all of this because it illustrates the recurrent importance of a particular source of support for the S&P 500. I refer to the 50-week Simple Moving Average, which is illustrated on the chart below. If you look back as far as 2004, you can see that this price level has provided an excellent source of support for at least five sell-offs. It is not as though the markets turn on a dime when they hit this moving average, but the S&P 500 has yet to penetrate more than two or three percent below it (with the one exception of August 16, 2007).

I mention this point today, because the 50-week moving average of the S&P 500 Index currently lies at 1471.66. This means that today's trading saw about a one and one-half percent penetration of this moving average before rallying to close above it. In case you are wondering, a three percent penetration of the 50-week simple moving average at its current levels would take the S&P 500 down to around 1427.55. A penetration as severe as the one seen on August 16 would take the S&P 500 to 1405.08. My point being that we do find ourselves testing some very significant, time-tested support. At the same time, it would not be out of the question to see a fifty to seventy-five point penetration of this moving average before the markets finally turn up.

Thoughts for November 7, 2007...

One issue that I discussed on more than one occasion last spring was the concept of a throw-over. One of the underlying principles of Elliott Wave Theory is that markets tend to trend within a parallel channel. A throw-over occurs when price break above a previously established channel. We experienced just such a situation when the S&P 500 rallied above the upper trend-line of a channel that began forming in late 2005 or early 2006. You can see from the chart below that prices continued to rally above this upper trend-line until finally breaking down in July.

Throw-overs are important to recognize because they are almost always followed by an equal and opposite movement below the lower extreme of the trend-channel. We saw an example of such a reaction when the S&P500 declined below the lower trend-line of this same trend channel at the beginning of August. You can see this principle illustrated in the chart below. I find it interesting to note that this index continued to make a series of higher lows throughout much of the period that it remained below the lower trend channel.

We saw a subsequent example of the importance of the trend channel concept when the S&P 500 broke back above the lower trend channel in September. If you look at the chart below, you will see that this rally took this index back to the upper trend channel. It tested the resistance of this trend-line once, failed, and then fell back again to the lower trend-line.

One reason why I revisit this point tonight is to illustrate the significance of the breakdown on Wednesday, November 7. As the chart below illustrates, the S&P 500 fell down to the lower trend-line, bounced off of its resistance, and eventually penetrated below it. This whole scenario supports my belief that we did indeed see the beginning of a significant corrective pattern in May or July of this year. We completed the first wave down in August, formed the second wave into October, and have since been working on the third and final wave of this formation.

Thoughts for November 6, 2007...

Most of this past spring, I talked about the need for a longer-term corrective pattern that would take us into the fall. It is my belief that we have been in this corrective phase for the last six months, if we use a monthly closing price chart. My guess is that we have completed the first two waves of a three wave pattern. October began the third wave of this formation.

Over the next few weeks, I plan to revisit some of my comments from this past spring, and discuss how many of them played out. Many of these same concepts will be important as we consider the future movement of the U. S. equity markets. These include the throw-over of the trend channel that we saw from May to July, the divergences of momentum oscillators that took place through much of this same time, and other technical tools that have provided meaningful information as things have unfolded.

I hope that you will find the discussion useful.