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.
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