Planet Yelnick

Stacked Against US!

Wave pattern looks like a stacking of 1 down - 2 up at smaller and smaller degrees. This usually sets up a serious decline, as happened last Sept after a series of 1s and 2s. The big 1 - 2 is the first drop off the 2000 highs to Sep00, followed by a reversal most of the way back to Mar01; the second is the drop after 9/11, followed by a reversal to Mar02, where the Dow got to over 10600, just 1000 pts below to the top; the next 1 - 2 was the drop into Oct02 and the reversal which appears to have ended a week or so ago on Jun17. Following a 1 - 2 is the 3, and we have a boatload of 3s lined up.

In wave count, we have set up the 3 of the (3) of the [3]. Is the big one about to hit? Not quite. As this 3 of 3 unfolds, it will first do a subwave [i] down and a [ii] back; the little 1 - 2s of the past week are within this wave [i] down. The big one comes after. Enjoy the summer!

Plunge Protection Team & Moral Risk

Continuing from the commentary yesterday, what is the implication of the Fed pumping the market? There was much discussion in the '80s during the bailout of the S&L crisis of moral risk for debt, the risk that if the cavalry comes in at the last minute to bail out poor banking practices, the bankers will learn to lend in an even more risky fashion. Similarly, when the Plunge Protection Team was first speculated upon after the LTCM bailout in '98, there was concern it might create a moral risk in equities, especially with derivatives. (LTCM had become very highly leveraged with clever derivatives and was caught over-invested in the wrong side of the Asian Flu crisis.)

How would moral risk manifest itself with equities? Why, with a mania, of course. Rampant speculation, corruption, inversion of normal values. We would be shocked, shocked! that gambling is going on.

Zoran likes to say that bear markets are not caused by blind economic forces but by this type of corruption which leads to lack of confidence in markets. Until the bad behavior is purged, the bear rages. This view is well supported historically, where periods of speculative excess are always accompanied by an inversion of the values of hard work, savings, integrity into the vices of speculation, gambling, quick money. I suppose it should be no surprise how State lotteries and Indian casinos have flourished, and legalized gambling has spread from Nevada to riverboats, resorts, and communities scattered throughout the country. The LA Times has recently done an expose of how lobbyists are hiring relatives of Senators to get special access. This has happened before, but with a vague taint. Now it appears to be rampant, and without shame. And so on. The crisis continues.

If the PPT is continuing to pump right now, it should be no surprise again that P/E ratios are at nose-bleed levels, speculation is rampant, and the manic psychology has re-emerged. The moral risk is revealed in all its glory. Time for more dot-com IPOs!

Plunge Protection Team & Wave Count

One can explain the current market market situation through Fed actions, as follows.

In 1998 after the Asian Flu and the LTCM debacle, the Fed pumped liquidity into major US banks. Whether this was through the rumored Plunge Protection Team to intervene in equity markets is still unknown. Normally the lag from the Fed pumping liquidity to economic impact on Main Street is 18 months +/- 6 months, but it was clear in 1987 after the crash and again clear in 1998 after a mini-crash that Wall Street responds to Fed liquidity much more quickly.

As an aside, this should not be overly surprising. The whole bull market from 1982 could be defined as a Currency Market, meaning it has been driven by changes in currency value (US Dollar) and the corresponding change in asset values. With worldwide assets in the $100T range, a 10% change in asset value creates $10T of impact, about the size of US GDP; hence changes in the global balance sheet can overwhelm changes in incomes. When Volcker broke the back of US inflation, suddenly financial assets were woefully undervalued. The surprising part is how long it took for equity markets to adjust to the new reality! A major reason for this slowness is that financial pundits mostly watch for income changes (earnings, for example) and ignore the larger swings in asset values. The crash in 87 occurred after the US changed from a strong Dollar to a weak Dollar policy, when otherwise there was no apparent cause in the income side of the economy. The pundits were at loss to predict it, let alone explain it at the time it happened. It just took a while for the significance of the policy change to sink in.

The Fed pumped further liquidity in in 1999 to prepare for Y2K. When Y2K turned out not to be "Y2K", in early 2000 the Fed tightened and the markets plunged. After 9/11, markets again fell in a mini-crash, and the Fed once again reacted promptly to pump in liquidity. Markets ran up, the Fed eased off, and we had the deep plunge into last July and October, in effect continuing the downward trend after an interruption. It is important to note that the interruption was not sustained, as the pump-priming was not sustained. The Fed appears to be priming the pump once again, ostensibly to pre-empt deflation.

In summary, two runups to respond to mini-crashes (Asian Flu and 9/11), and two runups to pre-empt an unknown (Y2K and deflation). Each of these runups created an bullish psychology. It is hard to argue with the Fed's moves after the mini-crashes, let alone the big crash in 87. But one should seriously question the Fed's attempts to pre-empt uncertain future events, since the resulting runups both led to manic levels of bullishness - in 99 and now. Rather than pre-empt a problem, the Y2K intervention may have helped cause a crash-like drop in the Nasdaq. The current deflation intervention has yet to unwind, but the more it builds up, the more it may be setting up a massive fall, especially once the pump-priming ends, as the major trend remains downwards.

Could the psychology which led the Fed to pre-empt be one and the same with the Wave Count? According to Zoran, normally manic moments only occur at the end of a wave 3 up or in a wave 2 of a downtrend. The preferred count is that we are in such a wave 2, and it is soon to end. But the implications of the alternative count are stunning: the blow-off peak in 2000 was the end of wave 3, and we have been correcting in a wave 4, which is over, either last October or at the recent March low. We have now begun a final wave 5 up of the Currency Bull since 1982. In other words, the mania is not yet over! And wave 5 could crest the 2000 peak. And end just as badly.

Brain experts now follow the money

From JP Morgan's daily newsletter, investigations which could substantiate the tie between emotional-driven financial decisions and stock movements, the foundation for Elliott Wave theory:

Neuroscience may soon shed light on all sorts of economic behavior,
The New York Times reported yesterday. Researchers are busy scanning
the brains of people as they make economic decisions, barter,
compete, cooperate, defect, punish, engage in auctions, gamble, and
calculate their next economic moves. They are finding that chemicals
in the brain drive behavior, and that these behaviors aren't always
rational.

Neuroscientists are also using economic games to explore brain
activity. It is possible to trace circuits in the brain that are
activated when people anticipate making or losing money, decide to
trust a stranger, or punish freeloaders in a game of sharing public
goods. It is also possible to calculate how much emotion goes into
evaluating the worth of economic activities and to study the neural
underpinnings of bargaining.

Editor's comment: Microeconomics has, at its core, the notion that
individuals can rationally calculate their own best interests when
making decisions. Now neuroscience is delving more deeply into the
chemical underpinnings of our decision-making. We may buy a stock,
not because of the company's business prospects, but.because it
generates dopamine flows in our brains, In the end, brain chemistry
may be one reason that tech stocks trade at higher multiples than
more staid industrial companies.

Most of us still cling to the notion that we are rational, and by
extension, that the markets that we trade in are rational. But what
if we aren't completely rational and our brains are wired to
interact to the emotions of others? Then the econometric model
builders will have to account for more than resource factor prices -
- they will have to add the chemistry of crowd psychology.

Elliott Waverers

Even the toughest ewavers are beginning to look for a bull count. But not Prechter! He sent out a report to put it all in perspective. Of course, he also missed the bull run from 1994 - 2000, so convinced he was the top was in. But his current view is worth contemplating. In effect, he pleads guilty of crying Bear! too often. By being so ready to call the end of wave 2 and missing it so many times, he has lost credibility with the ewave community. Yet, this bear market rally has not yet invalidated the bearish wave 2 count.

The problem begins with Prechter having counted the recent move as a smaller degree wave [ii] correcting the Dec02-Mar03 wave [i] drop, rather than a larger wave 2 correcting the Mar02-Oct02 drop. This led him to predict the end prematurely, as the normal wave retracement levels were based on a smaller range (1800 pts rather than 3500 pts). While we have greatly exceeded the *normal* 61.8% retracement of a wave 2 of the smaller range, we are still below a 61.8% retracement of the larger range. The previous two wave 2's of this bear, wave [2] right after the peak and wave (2) from Sep01 to the Mar02 interim high, both retraced 78.6%. If this wave 2 behaves the same, it will continue up over the summer to just under Dow10K.

Many technical indicators suggest the top truly is in. As Yelnick recommended last time this occurred (a month ago), prudence says wait and see how the next few weeks develop. One scenario is for a wave [i] down followed by yet another wave [ii] back in a summer rally. Plenty of time to pick a short position. If Prechter proves to be right, we will have stacked up a series of waves 1 and 2 preparing for the dramatic 3 of 3. The longer this stacks up, the deeper the subsequent drop.

Prodding the Bears

You gotta love this rally. Step by step it turns bears into bulls, or sheep. Yet a pullback is due.

This last few weeks is a classic wave extension, which tend to go 1.618 the first leg. Usually this happens in a wave 3 or 5 of an impulse, or in a wave C of an ABC correction. Extensions reflect the momentum players jumping on the trend; in this cases, bulls frothing at the mouth. Today in several indices this wave C hit 1.618 times wave A.

Wavespeak reports that the S&P has the best pattern to watch. The upside target to watch is SP1018 - if we break it, the current wave is a 3 and we would see a pullback in 4 and final highs in a wave 5 that could go fairly high. The downside target to watch is SP990. If we continue down and then rally, but fail to break 990, this downturn wil be counted as a five-way impulse and will go lower.

Dow Joins the Party

By cresting Dow9043 intraday, the Dow joins the S&P and Nasdaq, which both exceeded their Dec highs a few days ago. The last ewave holdout, Prechter's STU, has now moved to the Yelnick count. The count in all market indexes is now wave 2 from the Oct lows. And this is behaving exactly like a wave 2 should - drawing everyone including the uber bears into the view that the bull is back. When the last few bears fall, the market will turn. Make no mistake, this rally will be retraced downwards.

The pattern in the Dow today included a triangle followed by a thrust upwards, which normally is a topping pattern. Consequently, it seems likely that after a bit more upside, we end wave 2 and begin wave 3 down. The strength of the current rally, however, suggests we might see a wave 5 extension in this wave C and a longer run up. Key areas to watch are Dow9345 and SP1018, the 61.8% retracements of the full down move into October. Key timing to watch is June 20, the next turn window.

Elliott Wave Basics

The Yelnick thread has new members, so I thought it worthwhile to give a brief intro to ewaves. A better tutorial is available for free at Club EWI.

Ellliott developed his theory in the 30s. Prechter picked it up in the 70s and made a killing calling the 1982-87 period correctly. (Typical wave 1, many people were skeptical of the bull.) Then, Prechter called the top multiple times in the 90s and his cachet faded - until the real top in 2000. Now Prechter is back!

The Elliott religion has split into several sects, the most popular being Neely, whose work is being improved on by Zoran Gayer, often mentioned here. The Yelnick thread looks at multiple Elliott sites and derives a consensus opinion. The STU from the Prechter camp is usually the best source; also very good in the orthodox Elliott camp is Ryan Henry, whose work is available under the name Wavespeak online here. Some of the more active Yelnick readers share their views either with me or the group, and that is encouraged.

The basic ewave is either a 5-wave impulse or a 3-wave correction. Impulses travel in the direction of the trend, corrections counter. The impulse is counted as waves 1 - 2 - 3 - 4 - 5, where the odd waves go in the direction of the trend and the even waves go opposite. The correction is counted as A - B - C, where A and C go in the corrective direction and B goes the other way. You can count the bull market this way:
> wave 1 from 82-87
> wave 2 correction from 87-91 (the Crash of 87 plus the Gulf War)
> wave 3 from 91-97 (includes the first Internet mania in 95-96)
> wave 4 correction from 97-98 (the Asian Flu)
> wave 5 to the manic peak in 2000 (dot-com fever!)

Impulses only have two basic forms: the standard five wave and an overly enthusiastic variant of 9 waves where one of the segments 'extends' or breaks into a mini-5 wave of its own. Corrections come in 11 variants, including:
> Flat, an ABC in a trading range, which subdivides as 3 - 3 - 5 waves
> ZigZag, an ABC which goes deeply down, which subdivides as 5 - 3 - 5 waves
> Extended flats and zigzags, where you get double or triple ABC moves
> Triangle, a very extended series of five ABCs that have lower highs and higher lows

The ewave is a fractal, meaning it has the same form at all degrees (minutes, days, decades, etc.). Within a impulse pattern, each wave itself breaks into subwaves. The odd waves in the direction of trend, waves 1 - 3 - 5, subdivide into impulse patterns. The even waves, 2 - 4, subdivide into corrective patterns. So after a 5-wave wave 1 up, we see an ABC wave down, then the wave 3 starts, etc.

The waves follow certain rules, the most important of which are:
> fives waves in the direction of trend, three waves counter
> wave 4 cannot go lower than the start of wave 2 (the top of wave 1)
> wave 2 cannot go below the start of wave 1 - if it did, the pattern would be counted as 3 and not 5 waves
> wave 3 is never the shortest wave - indeed, it usually is the most intense
> waves 2 and 4 alternate in form - so if 2 is a Flat, 4 is a ZigZag or Triangle

The rules as stated are for a bull trend; the rules reverse if the trend is down (eg. wave 4 cannot go above wave 2)

These rules are in play right now. At the top on Monday, we reversed and came down in a 5-wave pattern. This suggests the trend has changed. Today we corrected that 5 wave move in 3-wave pattern. The first 5 waves make a wave 1, the second 3 waves make a wave 2. Tomorrow will be very interesting. The wave 2 correction may not be over yet; futures are up overnight. If the market breaks its Monday highs, then the rule about wave 2's not breaching the start of wave 1 fails, and we know we have not yet changed trend. if the market turns down again, it would have entered wave 3, which is usually the most intense.

It is easy to get lost in numbers. Also, watching the ewave theory over the past two decades, it doesn't seem to work as well during corrections. This is where Zoran may be about to improve on the theory, since he has been developing a way of fixing the Bifurcation Point when the correction ends.

One way to understand the waves is that the market does not recognize a change in trend until wave 3. That is why wave 3 is the most intense. Everyone piles on! This lack of recognition of trend is what is happening right now. Everyone is eager to call a bottom and get back on the Bull. We have come down in a wave 1 to the low in October. Was that the end of the Bear? We have now come back in a wave 2. Bullishness is at levels not seen since 1987! This is extreme, but typical of wave 2s. When wave 2s fail to exceed the prior level, then the herd begins to recognize the trend and a wave 3 starts.

Another way to understand this is the difference between stock distribution and stock accumulation. After a peak, the waves A and B down (if corrective) or 1 and 2 down (if trend change) can look the same. Often they will mirror the waves 4 down and 5 up from the prior trend. This pattern forms a classic Head and Shoulders pattern. The traders who bought during the wave 5 up but didn't sell at the peak will try to get out during wave B or 2. If the stock is being distributed not accumulated, wave 2 will fail, and we turn down into wave C or 3. At some point wave 3 reverses in wave 4. If at that time stock is accumulated, wave 4 could exceed the start of wave 3. This changes the count from 1 - 2 - 3 - 4 down to A - B - C down followed by wave 1 up. If wave 4 fails to exceed wave 3, then the final wave 5 down will follow.

Final part of the basics is fibonacci numbers. Prechter believes what separates Elliott Wave Theory from Ptolemaic epicycles is that it reflects underlying social mood, which follows certain biological patterns based on mass psychology. Many aspects of biology show fibonacci relationships. The ratio of fib numbers is the very interesting number Phi, which is more irrational than Pi or e. Often Elliott Waves show numeric relationships based on Phi ratios. Phi is approxiamtely 1.618, and the inverse of Phi is 0.618. The square of 0.618 is 0.382. Often waves 2 reverse 61.8% of wave 1, often wave 3s are 1.618 the length of wave 1, and often waves 4 reverse 38.2% of wave 3, which happens to also be 61.8% of wave 1 if wave 3 goes 1.618 times wave 1.

This relationships can be used to predict both reversal levels and durations of waves. A full 5 wave pattern often runs 2.4x its first leg, for example, which can be calculated from those fib relationships. Usually wave 2s do not exceed 61.8% reversal of wave 1. And usually in ABC corrections wave C equals wave A. The current wave 2 is running into a number of these relationships. It topped on Monday at close to 61.8% of wave 1 and also where its A wave = its C wave.

Thus the next few days are extremely interesting. The wave pattern strongly suggests we have or are about to end wave 2 and start wave 3. Yet bullishness is rampant. One of these two perspectives will have to break, shortly.

Key Reversal Day

Today is a classic reversal day - break of trendlines followed by an impulsive 5-wave drop below the trendline, particularly on the Naz. Dow is hovering right above its upper trendline. Dow still might make a second run at 9043, its Dec high, but watch closely to see if S&P breaks SP980. If the reversal has happened, it shouldn't.

Some of the Elliott Wave pundits with sites went short today. Aggressive move, but they may have caught it at the peak. Futures are down at the moment.

Contrarian Crash Course

According to Ned Davis, as reported in the EWI monthly report Friday, bullish sentiment has not been this high since 1987, just before the crash! The STU goes even further, and compares this to the bullishness at the end of great wave 2 in 1930 after the Crash of 1929. The true market debacle followed. Is the market about to get a crash course in contrarian thinking?

The bullishness has so infected market analysts that even some Elliott Wave pundits are wavering, and seeing us beginning a wave 3 up rather than the big wave 3 down. It would be quite a flexible theory if that interpretation were possible, but fortunately for Elliott Wave as a practical tool it is not. The recent wave action is a diagonal triangle, which is a wave ending pattern, and cannot fall within a third wave of a five wave impulse.

Now that the short vacation week is done, the market players will get serious. Wave count would suggest we are in wave 5 of an ending C wave, and have one more up move to go. Futures are up at the moment, so a number of bullish buy orders may be coming in over the weekend, leading to an up market at the open. Resistance remains at the SP975 area. The S&P and Nasdaq have both exceeded the Dec high, with the Dow lagging by 200 points, so watch as well for a Dow move of that magnitude.

Are we then on a crash watch? Severe downturns occur after extreme bullishness, when the bulls have placed their bets & have little dry powder. For those of you enjoying the World Poker Tour on TV (much recommended!), think of it as the moment where a player goes all in in a table stakes game. We certainly have such a situation brewing, but we are not there yet. Given the switch in count to wave (2) from Oct rather than a subwave 2 of (3) down, expect the following scenario to play out: a final up move to end wave (2), a drop in wave 1 of (3) down, followed by a 'summer rally' in wave 2 of (3), and THEN we should beginning worrying over rarities like market crashes. So enjoy the summer, and be wary of October.