Jul 14, 2011

Next market wave

Despite recent sharp drop markets realized significant gains last 2 and a half years. After severe 2008 decline stocks (in S&P500) gained 19.67% in 2009 and 12.78% in 2010 and 4.95% year-to-date. However signs of fading recovery strength have lowered expectations and put stock prices under pressure last days. In addition rising debt problems in Europe clouded the summer investor mood. Those fundamental factors determine general market direction but markets are people driven system and thus human behavioral patterns exist.
Elliot wave theory
R.N. Elliott's essay, "The Basis of the Wave Principle"
Most widespread method for counting cycles is Elliot wave principle. In theory Elliot wave principle is based on collective investor psychology or crowd psychology. According to that in bull market each cycle consist of two stages - one 5-wave positive move – dominant trend and 3-stage corrective trend. Within the first move waves 1, 3, 5 are positive and 2, 4 retracing.

Using this principle in practice gives us power to predict coming bull markets or corrections but only in case we are sure that our counting is correct. Sometimes is hard to imagine that markets follow certain pattern because market trend is determined by independent not necessary repeated events. Here dominant is crowd psychology and chart proves it.
s&p500 chart analysis
S&P 500 Expected to Pull Back
Chart source: stockcharts.com, Chart analysis: investink.net
If Elliot wave theory is applied to the latest trend started with march 2009 bottom we can follow tree completely formed waves up to current moment. The first one from dominant trend (labeled with blue square) is consisted of 5 subwaves as described in theory. Second corrective wave started April and finished august 2010. Third, which again is formed from 5 subwaves, marked its top May 2011. How
can we be sure this is the end of third wave? Pattern formed from recent market move has appeared to be classical head and shoulders - trend reversal formation (for more details see latest S&P Technical Outlook). If theory is correct again we are at the end of 3rd wave which should be followed by 4th corrective. Closer look at fundamental factors proves that might be the case for summer months. European dept crisis pushed world markets under great pressure. Moody’s raises pressure for US debt deal,  China’s growth is slowing and speculations for hard landing are rising. Those factors rise risk in the system and as consequence we see new gold price record and high market volatility. Should market confirm its down trend with lower highs and lower lows next support for S&P500 is 1175, completing 4th wave.

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