Is Elliott Waving?

Decades before fractals became fractals, or at least were recognized and named fractals, Ralph Elliott discovered and published The Wave Principle. Elliott spent his career as an accountant in Latin America, filling various positions, private and public, finally returning to the United States when debilitated by an intestinal tropical parasite. Initially, the Elliott wave, as it became known, was applied to the stock market, but later to any number of natural phenomena.

Elliott extracted from the seemingly random market excursions repeating patterns that had five waves upward, followed by three waves down. That pattern is both a part of larger patterns and contains smaller, similar patterns. As can be seen from the adjacent diagram, the five waves upward are actually three waves upward with two “corrective” waves downward. It is not unlike the adage of two steps forward, one step back, except here it is three steps upward with two steps back. The three waves down similarly contain two waves downward with a single “corrective” wave upward. Note the “impulse” waves, as Elliott called them, the wave moving in the direction of the major wave (waves 1, 3, and 5, of the larger upward wave, and waves A and C of the downward wave) have five imbedded waves while “corrective” waves (waves 2 and 4 of the upward movement, and wave B of the downward movement) have three waves. This will be important in interpreting.

The real world, of course, is not quite some simple. The adjacent graph of the Dow-Jones Industrial Average (DJIA) for the 20th century shows the five upward waves, peaking with wave five in the year 2000. The initial wave 1 ended in 1929, wave 2 in 1932, after the market deteriorated 89%. Wave 3 ran from 1932 until 1965, when wave 4 began and moved the market sideways until 1982. This wave 4 was a sideways or “flat” variation of a corrective wave. Wave 5 ran until 2000, ending with the “dot-com” or “tech” bubble bursting.

The ABC corrective pulse began in 2000 and continues through the present. The DJIA shows another Elliott variation, where the B wave peak is higher than the wave 5 peak. The Standard & Poor’s 500 shows a peak equal to the wave 5 peak, but this index was only started in1957, so cannot show the entire 20th century. It would initially indicate another sideways or flat correction like the 1970s, but there is a rule stating that correction types alternate. Since the 1970s were flat, the 2000s cannot be.

Even more indicative is the NASDAQ Composite, which shows the traditional ABC formation. The currently in-progress C wave should carry below the downward excursion of the A wave in 2002-03. The other indexes already have.

A study of the various corrective patterns shows that corrections can never be fives. Only impulse waves can be fives. In other words, an initial five-wave movement against the larger trend is never the end of a correction, only part of it.

That means that this downward movement should end the ABC correction and a new 5-wave upward move should start. Yes!

If the movement off the C point goes up, then forms another leg downward, the entire ABC correction since 2000 is actually an A impulse wave down of an even larger ABC correction. Oops!

Like most things, Elliott better interprets the past than the future, but two alternatives are far better than infinite. The HiLo index from the previous essay, “Being on the Right Side,” will guide you profitably in either case.

The point most applicable perhaps comes from the 1932-37 market. After dropping for almost three years from 1929-32, the market bottomed and began the greatest bull market in history until the 1990s. This 1930s bull was in the midst of the Great Depression, and the market appreciated from a low of 42 to a peak of 187—over 400%—in five waves.